Corporate TreasuryFinancial Supply ChainTrade Risk & LawSupply Chain Operations: A New Look at Counterparty Risk in the Middle East

Supply Chain Operations: A New Look at Counterparty Risk in the Middle East

A critical role in guarding against financial risk and ensuring the ready availability of cash has made treasurers much more visible within their organisations. Since the credit crunch and economic downturn took hold, a treasurer’s day-to-day job – especially if it involves activities in the Middle East – has become more difficult. In the context of recent events in Dubai and the fallout that followed, it has become very clear that now is the time to help treasurers and treasury staff broaden their understanding of the kinds of regional risk inherent in both physical and financial supply chains.

Finance professionals are certainly starting to ask questions about the physical supply chain and its relationship to working capital. Forward-thinking organisations employ working capital champions who take responsibility for the supply chain’s core elements – from procurement through to customer delivery. Unfortunately, most finance professionals are still not formally communicating with their supply chain director on a regular basis, except perhaps at monthly management meetings.

One way treasurers can add value within their organisations is to ensure that they connect with their supply chain colleagues – building closer relationships with them and gaining a better understanding of their respective roles. If a company wants to optimise its working capital, it must link the company’s physical and financial supply chains through the people who manage them.

New Risks to Consider

One reason for nervousness in 2009 was the perceived opaqueness of general business operations, particularly in the Middle East region. From the perspective of inward investors, accounting and financial reporting of key Middle East government organisations and businesses tended to lack transparency. Traditional instruments, such as performance bond guarantees and letters of credit (LCs), go some way towards mitigating the payment risk in a normal environment. However, the region’s ongoing volatility suggests that even these traditional methods of providing assurance may be insufficient. In 2010, treasury and financial professionals must take risk management practices a step further and consider counterparty risk in terms of the physical supply chain.

As before, payment risk remains a chief concern. If customers raise the possibility of deferring payments, treasurers and their colleagues should agree to discuss the possibility only if they can expect detailed transparency regarding developments in the counterparty’s underlying business.

Logistics operations risk

Since inventory is a major component of working capital, wise treasurers help minimise the level of stocks their companies hold. In terms of traditional operations risk, today’s financial professional needs to consider what factors may cause disruption to the flow of inventory through the physical supply chain – and the increased stockholding that ensues.

The Middle East has undergone phenomenal changes in recent years, mainly through taking advantage of its geographical position between Asia and Europe. To some extent, this has been intensified by a key trend in world economic growth – manufactured goods production moving from west to east. The Middle East is attempting to turn itself into a key staging post and trans-shipment hub for multimodal transport, and has built its physical infrastructure in order to meet that strategic objective. The result has been a startling increase in the region’s warehousing capacity and related transportation hubs.

Greater freight volumes now transit through the region more frequently, and as additional warehousing facilities come on stream, it is important for companies to understand what is happening. What level and quality of logistics services are provided in the Middle East? While it is always difficult to compare levels of service across the globe, it is fair to say that sometimes service quality in the Middle East falls short of the benchmark-handling standard evidenced in other geographies. Documentation standards can fall short of those maintained by companies in other locations, a problem which leads to import delays in the country of destination. Investment in facilities, systems and training had been improving the situation before the recent crisis, but there will most likely be a fall-off in that investment. Whatever the outcome, companies need to be aware of shortcomings and involved with their supply chain partners, with the goal of improving working practices in critical areas.

Until recently the severe shortage of warehouse space in the Middle East, with all facilities working at full capacity, led to commensurately high pricing. However, the recent worldwide drop in consumer confidence has reversed this trend, and there are now large areas of empty warehouse space throughout the region. Jebel Ali, the free-trade zone in Dubai, is now much quieter, with some logistics providers only charging handling and associated services in order to stay in business. Such fast expansion followed by sharp contraction is not good in any industry – and in the logistics business the effects can be crippling.

The Middle East has its share of basic operational risks that can impact treasury operations. Last year, a spate of warehouse fires attributed to extremely high temperatures and problems with electrical systems blazed through the region. In many organisations, insurance premium payment and management falls under the domain of treasury. When questions arise as to the type and nature of the insurance cover in force, treasurers will need a good grasp of the issues in order to develop effective mitigation strategies.

Border regulation

Most of Dubai’s freight is in-transit. It is therefore important to take into account the import/export regulations that apply to cross-border movements in the region. Take, for example, the United Arab Emirates (UAE)/Saudi Arabia border, where it is common to see trucks idling at border crossing points while stringent Saudi documentation requirements are fulfilled and reviewed. Failure to understand certain Middle Eastern restrictions on imports can be costly. Besides regulations, most Western treasurers struggle to attain an understanding of Middle Eastern culture and local customs that will allow smooth movement of goods and services.

Treasurers need to immerse themselves in local ways of doing business, understanding that it is often difficult to apply ‘traditional’ Western ways of doing business. For instance, it is common Western practice to pay an expediting fee to ensure that something happens by a specific deadline. This option is unavailable in parts of the Middle East, and an attempt to pull certain levers may not have the desired result. In this part of the world, things often simply take the time they will take – a challenge for a time-sensitive goods movement.

Human resources

Some interesting human resources challenges arise from the region’s rapid growth. To date, there has been a shortage of skilled logistics and finance professionals in the Middle East; a large group of expatriate workers typically close the gap. These workers turn the situation to their advantage by becoming very mobile in their search for salary and title raises, with high staff turnover the inevitable result. New staff are constantly being trained, but they also fall into this mobility scenario once training is completed. Staffing therefore looks set to remain a key issue, and companies need to ensure that they have strong procedures to negate potential recruitment and retention challenges.

Political risk

Treasurers based in the UK but working for subsidiaries of US corporations should recognise and mitigate a specific geopolitical risk when conducting business in the Middle East. Iran is subject to a US embargo, and it is necessary to be acutely aware of these trade restrictions when shipping goods across Middle Eastern borders. Companies must take care not to fall foul of US Office of Foreign Asset Control (OFAC) compliance regulations and therefore facilitating trade with Iran. In addition, companies need to be on the lookout for shipments that legally come into the region with the intention of illegally re-exporting to a restricted nation. While all companies need to be satisfied as to the final destiny of goods under their control, it is particularly important for US-owned corporates and their subsidiaries.

Treasurers should also be involved in pricing policy and giving their colleagues an overall understanding of the region’s duties and taxes, which have a material impact on product profitability. Treasurers need to ensure that the business can reliably source current duty and tax information in order to make sensible commercial decisions.

Currency risk

While it is important to consider specific regional variations, universal treasury issues, such as exchange rate risk management, are just as important to remember. Many corporates run currency risk management out of central treasury operations based outside the Middle East, yet there will be times when either local knowledge is needed or a local decision must be made. The importance of having a management communication structure in place to manage this kind of risk was highlighted recently by events in the Middle East that precipitated an exodus of the staff that would ordinarily have performed those functions.

Communication links

A business needs to develop a correspondingly robust treasury and finance structure to support day-to-day demands placed on the function by local entities. The Middle East crisis of late 2009 alerted companies to their need for resources and systems alerting them to upcoming problems in the local business and finance environment with ‘red flags’. Given the less-than-stellar track record of communication between regional offices and headquarters, this challenge remains in 2010. Treasurers should be involved in improving communication and in helping to refocus their organisation on key risks. Treasurers should also apply techniques such as stress testing to see where the company may be vulnerable. Those vulnerabilities can then be addressed by implementing contingency plans to mitigate the risk.

Managing the Middle East

The pace of change in the Middle East continues to be rapid, and the region presents great opportunities for business. Recent events have focused attention on building transparency into business operations and the desire to really know business partners and counterparties, including financial institutions. Going forward, the treasurer function can play a vital role in ensuring that these business opportunities are realised by understanding the impacts on working capital of physical supply chain risks. This critical activity can do much to overcome the challenges of doing business in the Middle East.

To read more from JP Morgan, please visit the company’s microsite.

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