BANKING
Changing China: a Cash Management Update
June 7, 2007
Karen Chan, Standard Chartered Bank

China's macro-economy is slowing, but it is a very gradual process. During 2005, there were a number of signals - slower import growth, slower profitability growth in many sectors, slower growth of foreign direct investment, reports of overcapacity in a number of sectors, and a relatively tight credit environment - that suggested the 2004 peak in growth had passed.

However, China's 2005 buoyant growth of 9.9% surprised most analysts and suggested, after three quarters of slower investment growth, that a mild revival in domestic demand was occurring. Increased investment in areas such as coalmines and other energy-related projects, as well as property, were apparently behind the stronger figures. Standard Chartered does not expect this mini-revival in investment to last long though since it believes that structural pressures will reassert themselves. Despite the fact that consumption growth was stronger, China's economy in 2005 was also much more reliant on the external sector, meaning it was vulnerable to a slowdown in the US in 2006.

Standard Chartered predicted official real gross domestic product to grow by 9.2% in 2006. Key risks included the response of Chinese private firms to slower profit growth, tighter bank lending and the state of the US economy. Given the surprising weakness in recent data, the bank estimated a 2006 increase in the consumer price index of 1.5%. The bank continues to back its call that the yuan be allowed to appreciate by 2-3% a year against the US dollar.

Common Cash Management Problems
Looking at transaction banking as a 'pyramid of needs' (Figure 1), you can see that a good cash management structure must take a holistic approach and build on a platform of solid transactional services. Company treasurers in China are well aware that multiple collection accounts, separate clearing systems, manual processing and other sources of delays in collections and payments can cripple a business. With more multinational corporations (MNCs) establishing shared service centres (SSCs) and regional treasury centres in China, there are higher requirements in the market for streamlined payments, collections and reporting services, and consolidated bank relationships.

The Pyramid of Needs
For historical reasons, many MNCs use too many banks. With SWIFT technology not yet common for yuan transaction reporting between banks, it is difficult for company treasurers to obtain a good picture of cash positions. Liquidity management was a challenge until entrustment loans became a good tool for group companies to move cash around. Eliminating the need for an entrustment loan will be an important development in China. However, there is no agenda for China to accept other sophisticated liquidity management structures, such as netting and pooling.

The 'cash trap' is perhaps the biggest challenge for many MNCs. Standard Chartered views the October 2004 Notice on Management of Foreign Currency Liquidity as the first step by the State Administration of Foreign Exchange (SAFE) to free up the cross-border movement of cash. More liberalisation in this area is expected.

An Update on Clearing Infrastructure
A major development is the upgrade and expansion of the China National Automated Payment System (CNAPS). The system is fully developed and maintained by the People's Bank of China (PBOC). It is a nationwide clearing system that operates in real-time gross settlement mode for inter-city and intra-city payments (Figure 2). CNAPS links more than 30,000 bank branches throughout China. Inter-city turnaround for remittances has now been reduced to under two hours and in some cases just minutes. PBOC requires every bank branch to have access to the system, either as a direct member or by appointing a direct member as the clearing agent. It is expected that all local and foreign banks will directly link with CNAPS at head office level by 2007.

In the fourth quarter of 2005, PBOC started a pilot in Fuzhou and Tianjin of a low-value automated clearing house system called the Bulk Electronic Payment System (BEPS). Cities such as Beijing and Shanghai are scheduled to be included in early 2006 with PBOC formally launching the system in all cities by June 2006. In the first phase, PBOC has set favourable pricing for transactions via BEPS as compared with those for the existing CNAPS. The threshold for payment value is CNY20,000. Such a system will be ideal for low-value same-city payments and will enable direct debit to become another effective collection method. The 'big four' local banks - the Industrial and Commercial Bank of China, the Bank of China, the China Construction Bank and the Agricultural Bank of China - have the largest networks in China, and each has invested heavily in developing its own internal clearing system. For intra-bank funds transfer, it takes 24 hours or less. Until the full coverage of CNAPS and BEPS is complete, the big four's intra-bank settlement systems will remain, running in parallel.

Collection and Reconciliation
Even with the development of a clearing infrastructure that improves payment efficiency, there will still be challenges to collection and reconciliation of accounts receivable because of a lack of transparency. CNAPS and BEPS have largely resolved inter-city issues. However, it is not easy for companies to track where floats are trapped and information is lost if inter-bank fund transfers take place through non-PBOC systems. Collections via cheques and bank drafts involve manual processing, which is even more complicated for reporting and reconciliation.

With more companies using enterprise resource planning (ERP), accounts receivable reconciliation becomes an important objective. To determine the level for reconciliation - such as the ERP reference number, payer level or invoice level - a company needs to rely on information provided by its bank.

Trends in Liquidity Management
Interest rate regulations, a weak banking infrastructure and the prohibition on inter-company financing have, in the past, meant that advanced liquidity management methods have been difficult to introduce. However, the landscape is changing with banks implementing innovative solutions that can help companies to overcome regulatory hurdles.

The entrustment loan was the first real instrument that allowed a company to share liquidity across business entities. A few banks in China have created more client-focused solutions by using the entrustment loan concept to create multi-party loans. This allows companies to more efficiently arrange entrustment loans between multiple entities. In the past two years, this arrangement has been further superseded by group cash concentration solutions that are not dissimilar to zero-balance or threshold pools in more mature, less regulated markets. In mid-2005, Standard Chartered set up a daily zero-balance pooling solution in partnership with a local bank where many of the transaction accounts remain with the local bank (Figure 3).

Foreign currency liquidity management options have also improved following SAFE's October 2004 notice. Similar to the yuan regulation a few years earlier, the notice permits inter-company lending backed by entrustment loans. For group companies with multiple entities, one foreign bank and one local bank have been given SAFE approval to conduct pan-China foreign currency pooling. In October 2005, SAFE issued nine new measures for foreign currency liquidity management for MNCs registered in Shanghai. Under the new rules, MNCs are able to concentrate foreign currency on a daily basis through entrustment loans.

The market in China is changing rapidly with the regulators allowing more opportunities for forward thinking. Companies and banks will be able to creatively structure effective liquidity management solutions. At the time of writing, it is understood that the regulators are about to abolish the need for entrustment loans for inter-company yuan lending. This will be an important breakthrough and a clear sign that China is sailing in the right direction to become a less strictly regulated market.

Centralisation in China
Most MNCs in the Asia region have moved or are in the process of moving towards centralised finance and accounting functions through SSCs. Although China is considered in the centralisation process, companies face the following challenges:

• Foreign banks have had difficulty providing a comprehensive pan-China solution on a par with other more open countries in Asia due to regulatory restrictions.
• Local language input and reporting requirements for payments and collections.
• Slow uptake of international ERP systems - many companies rely on local ERPs.
• The domestic payment system is still largely underdeveloped, albeit quickly improving under CNAPS.
• Regulatory control on cross-border payments, requiring physical documentary checks and reporting on a local basis.
• Regulatory restrictions on bank account usage by function.
• Regulated interest rates and fees charged by financial institutions, therefore diminishing the benefit of volume discounting.

In its most developed form, a SSC requires standardisation of processes, liquidity management and rationalisation, and almost always a degree of outsourcing of payments and collections to the partner banks, plus the establishment of a common ERP and management information system. As China follows up its commitment as a signatory to the World Trade Organisation, more of the barriers to establishing true SSCs are being lowered.

Tax Strategies
Given the tax complexities in China, planning is critically important in a company's tax strategy. This includes corporate structure design, transaction arrangements, document preparation, seeking advice from external consultants, and benchmark studies of industrial practice. For example, a tax clause incorporated in the contracts with overseas service vendors may be very useful in settling a dispute in withholding tax levied on the service charge. On the other hand, a reasonable and consistent internal pricing policy may help to mitigate much of the concerns from local tax authorities in terms of transfer pricing.

Planning minimises the cost of repairs afterwards and reduces the panic when tax issues arise. China offers many favourable tax policies to attract foreign investors, such as tax holidays, preferential rates and tax refunds for qualified investors. A comprehensive study and understanding of the local tax system is one of the critical success factors for foreign investors. A tax strategy for an investment in China may include the following considerations:

• Local tax and state tax hierarchies and tax revenue split system.
• Taxation law system (laws, regulations, detailed rules for implementation and circulars).
• Tax reform that is progressing to keep in line with the economic development.
• Source and channel of taxation information.
• Interpretation of taxation law and communication with tax authorities.
• VAT, business tax, consumption tax, in addition to profit tax.
• Tax holidays.
• Reduced tax rates (e.g. in special economic zones).
• Effective tax rate.
• Resource and costs for tax compliance.
• Industry practice benchmark.
• Overseas charge and internal pricing policy.
• Bilateral tax treaty (e.g. withholding tax scope and rate, permanent establishment, methods to eliminate double taxation).

The complexity of China's tax rules means that, for a company to achieve its strategic goals, it should have a good tax team in place with sound knowledge and experience of handling issues and communicating effectively with the authorities.

Copyright © ChinaForum 2007