STRATEGY
Enhancing Your Working Capital and Liquidity Management
September 6, 2007
Cline Zhang, Head, Liquidity and Investments - China Global Transaction Services, Citi

With the rapid growth of China's economy, multinational companies are quickly expanding their business. A critical mission for most companies is efficient management of working capital and liquidity needs across business entities in China. In this article, we provide an overview of the current liquidity management environment, discuss the issues that companies need to consider when setting up liquidity structures, and share some emerging trends.

Regulatory background

Currently, People's Bank of China (central bank) regulations do not allow direct lending between different legal entities, whether on an episodic basis, or by using zero balancing physical sweeps. Nor do regulations allow multi-entity notional pooling, a structure often used in other locales for inter-company liquidity management.

In China, physical sweeping normally runs under an entrustment loans model, where the bank acts as an agent of "entrusted" funds from a depositor (the "Principal") and on-lends the funds to a borrower designated by the Principal.

Since introduction of the entrust loan in 2001, leveraging this model to facilitate renminbi (RMB) liquidity management has been greatly expanded. In late 2003, the first RMB multi-entity physical sweeping via entrustment loan structure was introduced. Now, RMB 1physical sweeping, also called physical cash pooling, has become an efficient way to manage internal funding and its use has become widespread among multinationals operating in China.

For foreign currencies, multi-entity physical sweeping became permitted when the government approved the first such USD structure in 2005. However, these structures are still constrained by China's FX policy. There has been some relaxation in rules since 2006: the "Pudong 9 Measures" allow domestic and foreign multinationals to perform foreign currency multi-entity physical sweeping. The basic qualification requirements include establishment of a holding company or regional headquarters in Pudong certified by the local government; and, approval from the State Administration of Foreign Exchange (SAFE). The result is that there are a limited number of multinational companies that are candidates for these structures, and there have been few live cases so far.

Using liquidity management structures

Renminbi

Zero balancing (or "target balancing") sweeps facilitate the automated physical movement of funds between entity bank accounts, to achieve target balances in the accounts at the end of the business day. For RMB, entrust loan-based multi-entity physical cash sweeping structures are a straightforward way for management of inter-company liquidity. Funds can be swept automatically to or from a master concentration account and other entity accounts, with an overdraft line made available at the concentration account, as desired.

Foreign currency

As noted earlier, foreign currency, multi-entity physical cash sweeping has many regulatory constraints. The process still uses entrust loans but we diagram it out here, as the structure is a little more intricate for foreign currencies.

The structure operates according to SAFE's principle of separate payment and collection lines. The header and sub-entities open an entrust loan header account and entrust loan sub-accounts, respectively, at the concentration bank. Deposits from the sub-accounts (settlement account, capital account, and entrust loan sub-account) will be swept to the entrust loan header account automatically at day's end. Daylight overdraft facilities support the sub entrust loan accounts' payment flows during the day, with the header account sweeping to fund the sub-accounts at the end of the day.

Considerations

Concentration header selection
The concentration header account may be any of the group entity accounts. Usually, a company will choose the entity that: has the management power (holding company or management company, for example) to coordinate communications within the group entities - i.e., the selection is management structure driven; or, is the most cash-rich entity because it will effectively serve as the group's funding source - i.e., the selection is tax savings driven.

Inter-company lending / borrowing rates
The total group cost saving depends on the Self-funding amount, for example: Total Cost Saving = Self Funded Amount x Bank Spread (6.03%-0.81%).

In China, as elsewhere, companies can set inter-company lending and borrowing interest rates for group entities participating in this structure. Below are three scenarios for setting inter-company interest rates.

To balance and distribute group cost savings, companies often reallocate the interest benefits among group entities. The bank calculates and apportions interest benefit between the header and other participating entities, based on the monthly average entrust loan amounts.

Potential accounting treatment
While accounting treatment is a matter for your corporate accounting policy and external auditors, the entrust loan-based physical cash sweeping structures might be regarded as replacing bank exposures (cash and overdrafts) with inter-company exposures (entrust loan to and from parent). In this scenario, for a participating company, the corporate asset becomes an entrust loan to the parent, instead of cash in bank accounts; and the corporate liability becomes entrust loan from parent, instead of bank overdrafts.

Potential tax implications
Tax treatment must be reviewed with your tax counsel, but the following can be noted: Stamp Duty: Each party, including all the participating companies and the Entrust bank, is obliged to pay 0.005% stamp duty on the entrust loan amount. If the company requests to change the contract principal amount at a later date, both parties will have to pay additional stamp duty on the incremental amount.
Interest Income Business Tax: This is 5% on the interest income for the interest earner, and is withheld by the entrust bank. To reduce business tax impacts, some companies have implemented specific tax efficient structures.

Trends

There are three important trends worth noting.

Managing foreign currency positions: With China's focus on export growth, the authorities recognize the increasing need for multinationals to be able to centralize management of foreign currency funds. Since 2003, SAFE has introduced a series of initiatives to help group enterprises centrally manage foreign currency funds. These measures are in line with SAFE's policy of gradual and supervised adjustment that is controlled across the total volume of funds in the market. This process seems likely to continue.

Optimizing investments: The process of deregulation has also been extended to the investments arena, with recent changes making it much easier to invest cash generated in China into higher yielding instruments. We will cover these developments in a future article.

Integrated local and global banking: Multinationals operating in China are transitioning from fractured local treasury and banking structures towards greater centralization. Companies are selecting pan-China single overlay-bank structures to provide centralized visibility and access to the full suite of liquidity management, payments, and collections services across the local banking spectrum. By linking their pan-China structure into their global banking structures, companies are getting close to achieving the vision of an integrated global banking system - with end-to-end, centralized management of liquidity and transaction processing, and consistent service levels around the world.

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