Unwrapping Renminbi from ‘Red Tape’: A Perspective on China’s Currency
It
is clear that China’s new leadership, which took office in March this year, is
more open to change than ever and the country’s pace of financial market
reform is expected to accelerate further. However, a certain form of control
is still in place and will probably remain so for the near future.
There is a sharp contrast between the shift to full renminbi (RMB)
convertibility and an upscale of portfolio flows between mainland China and
overseas. The essence of full convertibility is renouncing control, thus
allowing market forces to fully and freely respond to price signals in
international markets. Scaling up portfolio flows can be done gradually though,
in a very controlled way. Although many believe that liberalisation of the
Chinese currency will continue, there are potential dangers in liberalising the
yuan (CNY) too quickly ahead of domestic market reform, especially in the
interest rate market.
RMB Participation in Offshore Cash Pools
A quick browse through the International Monetary Fund’s (IMF) annual report
on exchange arrangements and restrictions reveals that many countries have
enforced measures of some sort to prevent free flow of currency across the
border. So China is definitely not the only culprit. What does set the country
apart is how the international financial community decided to refer to the
Chinese currency, or more precisely how we differentiate between onshore
renminbi (CNY) and offshore renminbi (CNH).
Offshore renminbi has
already cleared the China border, hereby meeting the requirements set by
foreign exchange (FX) controls. The main portion of these flows would be trade
and approved capital flows. These CNH can indeed be part of an offshore cash
management solution; not that recent an innovation – as a niche liquidity
management bank, headquartered in the Netherlands, Bank Mendes Gans has been
providing CNH in offshore notional cash pools since 2009.
Corporate
treasurers and their colleagues seeking an opportunity to consolidate CNY with
other currencies in an offshore multi-currency, multi-entity, notional
liquidity management structure, will encounter a couple of other challenges.
This is not only because of the same FX controls, but also due to the
limitations of most cash management solutions in the market. Treasurers with
multinational corporations (MNC) will find multi-entity liquidity structures
effective, especially if they wish to avoid related party funding without
giving up the benefit of reporting net on the balance sheet in order to keep
interest bearing debt low. However, for a mainland Chinese subsidiary to
participate, it would have to open an account offshore and also be allowed to
transact a free flow of funds to this offshore account from an onshore account.
Unfortunately the Chinese financial market reform has not yet reached this
ultimate degree of RMB liberalisation, although this doesn’t necessarily mean
that all is lost.
The Two-step Best Practice
Approach
The current regulation landscape in China allows
utilising CNY for offshore purposes. With the approval of the State
Administration of Foreign Exchange (SAFE) or the People’s Bank of China (PBOC)
it has been possible to connect domestic pools to offshore CNH liquidity
management. The approval will stipulate a maximum sweep amount.
Background:
Current best practice is based on
so-called ‘Cross Border Intercompany Renminbi Lending’. In July 2013 the PBOC
issued the ‘Notice on Simplifying the Procedures of Cross-border Renminbi
Business and Improving Relevant Policies’. This clearly demonstrates how
rapidly China’s central bank can move forward, favouring companies that keep
in touch with indigenous relationship banks. What started as a pilot in
Shanghai in 2012 is now widely available in China: companies can request their
mainland relationship bank to extend the loan to their overseas parent or
affiliates, without regulatory approval – although there is a maximum limit
applied. The loan amount cannot exceed the so-called loan quota, which – among
other criteria – is based on total shareholder equity and RMB cash balance of
total cash balance. Bear in mind that this loan quota might be removed in the
foreseeable future, in designated cities such as Shanghai.
Step 1 – Lend offshore:
The current pilot allows
lending RMB directly to an overseas parent or affiliate. This is the first
step of the two-step best practice. As treasurer of an onshore company you
will find your efficiency greatly improved when it comes to dealing with your
surplus cash. On the other hand offshore companies get funding at relatively
low cost. From a liquidity management point of view this is still far from
ideal. As the Chinese entity doesn’t participate in the offshore notional pool
directly, funds must actually move to an offshore entity. These RMB flows
between the accounts of different legal entities create related party lending
which, in turn, leads to an administrative burden if not tax challenges. For
now this is unavoidable and has to be tolerated.
Step
2 – Pool notionally:
Ideally, the offshore company does not have
to convert RMB into another currency, as the repayment of the loan will also
be in RMB. Any exchange would immediately result in a foreign exchange (FX)
exposure that needs to be covered by some sort of hedge. To avoid this
complexity and cost the RMB are, where possible, placed in a notional cash
pool. The deposit serves as collateral for borrowing in other currencies. This
is the second step of the two-step best practice. In true notional liquidity
management structures, banks offer full offset between currencies without
converting. However, it pays to look more closely.
Liquidity
management structures are intended to help companies to bridge liquidity gaps.
Some entities use their own excess cash (or local cheap funding) to fund other
entities’ operations that need cash. By freeing up internal working capital
banks are circumvented. A proper liquidity management structure should
facilitate subsidiary-based funding, whereby overdrafts at one end are funded
by credit balances somewhere else. Key to this principle is the concept of one
single interest rate per currency. Any other proposal – with a spread – would
enable banks to earn a margin on money that wasn’t theirs in the first place.
Additionally, interest should be determined based on typical money-market
rates.
What to avoid:
As a number of the
commonly-offered liquidity management structures are intended for cash
concentration purposes only, it is advisable to look at the mechanics in
detail. Cash concentration is often perceived as a technique to sweep credit
funds into a single location, allowing the master to withdraw the excess.
Efficient as this might seem, it carries an unexpected underlying limitation.
It may very well be that the structure doesn’t allow participating entities,
except the master, to overdraw their account. In other words, only credit
funds are allowed and overdrafts are not permitted. This side might seriously
diminish the efficiencies you’re looking for.
In those cases where
overdrafts are permitted, don’t forget to check how they are priced. Is the
debit interest rate identical to the credit interest rate, or will a spread be
applied? Furthermore, is the pricing based on a credit assessment of
individual entities on a stand-alone basis, or on the head office?
Working with Multiple Relationship Banks
Delving
a little deeper, what else might be of interest to the treasurer of an MNC
during his/her liquidity management exercise? A bank-neutral solution perhaps?
The vast majority of companies with global coverage would have already
selected the best bank(s) in every region. Setting up a global liquidity
management structure – in most solutions – involves having to move your
accounts to the bank that is going to manage your liquidity. All the time and
effort spent on account administration is money down the drain. Instead, you
might opt for the simplest structure with the least number of accounts and
layers, as they are usually only added to facilitate the bank’s processes and
not your own.
A bank-neutral solution, as offered by Bank Mendes
Gans and some of its peers, allows global companies to consolidate their
liquidity in an overlay structure that doesn’t affect existing relationships
with local banks. This is also of benefit to companies domiciled in China.
Pursuing a global liquidity management solution without giving up local bank
relationship is not impossible.
The Solution is Available
Admittedly, for those treasurers familiar only with doing
business in fully deregulated currencies this doesn’t sound like ‘Columbus’s
egg’ (a brilliant idea that becomes obvious with hindsight) just yet. But it
is just a matter of time until the benefits can be distinguished from the ‘red
tape’. As far as RMB is concerned, the combination of notional pooling and
cross-border intercompany RMB lending is the next best thing. It’s out there
and it’s readily available; you just have to be firm in asking for it.