The Dilemma of Cash Management in China

Contents

Executive Summary

Contents

List of Figures

List of Tables

List of Abbreviations

1 Introduction
1.1 The problem
1.2 Objective
1.3 Methodical direction and structure of the paper

2 Cash management
2.1 Definitions and classification
2.2 Aims and objectives of cash management
2.2.1 Management of cash flows and balances
2.2.2 Investment of liquidity surplus
2.2.3 Exposure management
2.3 Selected cash management instruments
2.3.1 Netting
2.3.1.1 The concept
2.3.1.2 Requirements and potential problems
2.3.2 Cash Pooling
2.3.2.1 The concept
2.3.2.2 Requirements and potential problems

3 China’s cash management environment
3.1 Institutional aspects in China
3.1.1 Central bank
3.1.2 Foreign exchange authority
3.1.3 Banks
3.2 Bank account structure and currency controls
3.2.1 Local currency bank accounts
3.2.2 Foreign currency bank accounts
3.2.3 Temporary bank accounts for non-resident companies
3.3 Payments
3.3.1 Systems
3.3.1.1 Local Clearing House System
3.3.1.2 Electronic Interbank Network
3.3.1.3 China National Advanced Payment System
3.3.1.4 Commercial Banks’ In-house Payment Systems
3.3.2 Instruments

4 Implementing selected cash management instruments in China
4.1 The dilemma of netting
4.2 The dilemma of cash pooling
4.3 Entrusted loans as a potential solution

5 Conclusion

6 References

Executive Summary

During the past few years China has attracted investment by foreign multinational companies. With its entry into the World Trade Organization (WTO) on 11 December 2001, China promised to further open up its market to foreign goods and services, and to welcome foreign investment in the following five years in previously restricted sectors such as banking and financial services.

However, China’s cash management environment still provides many impositions and obstacles to challenge corporate treasurers. Moreover, unwritten local customs and practices, coupled with the lack of written regulations, do not ease situation. And making this even more complex is the fact that the regulations are changing all the time.

Therefore, “many companies […] still find it challenging to implement comprehensive cash management arrangements.”^[1] Often complex regulations, foreign exchange (FX) controls, unique operating conditions, and developing clearing and banking infrastructures complicate the implementation of cash management techniques widely used elsewhere in the world.

Hence, this paper introduces the reader to the complex requirements, impositions and obstacles of cash management in China. In this paper the author focuses on two cash management instruments, netting and cash pooling, and presents the associated dilemmas. Furthermore, the author highlights entrusted loans as an alternative solution.

In the course of the paper it becomes clear that implementing cash management instruments requires testing the boundaries of regulation and technology. Meanwhile, but still limited to a few selected MNCs domiciled in certain areas, pilot programs arise relaxing FX restrictions and allowing cash pooling as well as netting. However, despite China’s fast evolving banking and cash management environment, some techniques, e.g. netting, are basically prohibited or at least prevented by extensive FX authority regulations. While some of the cash trap situations can be avoided through proper documentation and careful planning regarding capital structure, others can be handled by implementing particular solutions. The latter holds for cash pooling. Besides processing notional pooling to avoid a prohibited intercompany loan creation, entrusted loans can reduce the operational activity burden on a company’s treasurer.

List of Figures

Figure 1: Structure of the paper

Figure 2: Cash flow forecasting summary

Figure 3: Types of float

Figure 4: Cash Management Instruments

Figure 5: Cash flows before, after bilateral and after multilateral netting

Figure 6: Entrusted loan with a bank as an intermediary

Figure 7: Entrusted loan with a group finance company as an intermediary

List of Tables

Table 1: Connection between instruments and the tasks of cash management

Table 2: Original cash flows before netting

Table 3: Cash flows after bilateral netting

Table 4: Cash flows after multilateral netting

Table 5: Interest compensation after notional pooling

Table 6: Classification of local currency bank accounts in China

Table 7: Classification of FCY bank accounts in China

Table 8: Classification of temporary bank accounts for non-resident MNC in China

Table 9: Summary of payment instruments in China

Table 10: Summary of restrictions on FCY entrusted loans

List of Abbreviations

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1 Introduction

1.1 The problem

During the past few years China has attracted investment by foreign multinational companies. With its entry into the World Trade Organization (WTO) on 11 December 2001, China promised to further open up its market to foreign goods and services, and to welcome foreign investment in the following five years in previously restricted sectors such as banking and financial services. Consequently, “in 2002, China overtook the US as the world’s largest recipient of foreign direct investment (FDI)”^[2], and FDIs rose to more than 60.6 billion dollar only in 2004.^[3] About 30,000 new companies set up with foreign capital were registered in the People’s Republic of China (PRC) during the first three quarters of 2005.^[4] Some multinational companies (MNCs) even have made China, especially Shanghai, their regional treasury center (RTC) for Asia.^[5]

Due to this fact, the need for treasury management techniques is an inevitable consequence to foreign invested enterprises (FIEs) in China. However, “many companies […] still find it challenging to implement comprehensive cash management arrangements.”^[6] Often complex regulations, foreign exchange (FX) controls, unique operating conditions, and developing clearing and banking infrastructures complicate the implementation of cash management techniques widely used elsewhere in the world.

1.2 Objective

It is the objective of the paper to introduce the reader to the complex requirements and obstacles of cash management in China. In doing so the author puts the major focus on two cash management instruments, netting and cash pooling, and presents the associated dilemmas. Furthermore the author highlights entrusted loans as an alternative solution.

1.3 Methodical direction and structure of the paper

Chapter 2 of the paper starts with defining cash management (2.1) and presents its aims and objectives (2.2) as well as selected cash management instruments (2.3), namely netting and cash pooling, in general. Chapter 3 continues introducing the reader to China’s cash management environment. Thereby the author in particular addresses the issues of institutional aspects (3.1), the bank account structure and foreign currency (FCY) controls (3.2) as well as payments (3.3), including systems and instruments, in China.

Figure 1: Structure of the paper

illustration not visible in this excerpt

Source: own graphic

Concluding in chapter 4 and based on the two previous chapters the author discusses the implementation of the two prior presented cash management instruments. Besides presenting the dilemma of netting and cash pooling in China (4.1 and 4.2), he finally highlights entrusted loans as an alternative solution (4.3). Additionally, Figure 1 illustrates the structure and direction of the paper.

2 Cash management

Cash management is a core activity for nearly all corporate treasury operations. Hence, the following three headings should provide an insight into this activity.

2.1 Definitions and classification

Ross gives a broadly based definition. He states that cash management’s “key objectives are to plan, monitor and control the management of the company’s liquid resources which are cash and cash equivalent instruments.”^[7] In the case of consolidated companies the tasks of the cash management department are even greater. “One common trend has been the move by most leading companies to develop a more centralized approach to organizing their cash management activities.”^[8]

Spahni-Klass verbalizes the term more precisely by describing the major task of cash management in multinational companies as the coordination of any short-dated fiscal transactions within a group and the management of liquid funds of any group company. Thereby her definition of liquidity covers means of payment such as cash, bank and quick assets.^[9]

In this context Ross, Westerfield and Jaffe point out that “short-term marketable securities are frequently referred to as «cash equivalents» […]. [And moreover] the balance sheet item «cash» usually includes cash equivalents. [However, in their opinion] cash management is more concerned with how to minimize cash balances by collecting and disbursing cash effectively.”^[10]

This is countered by Kaen stating that “International cash management involves not only collecting and disbursing cash in many sovereign countries but also managing multicurrency cash flows and investments.”^[11]

According to Boemle and Stolz cash management includes cash forecasting to provide enough liquidity and, thereby, to be able to meet daily financial obligations. In this regard the tasks of a cash manager are the management of liquid funds and short term investments as well as short term liabilities. Further responsibilities are optimizing the payments and “managing the float”^[12] respectively.^[13]

However, Schulte states that cash management is not only managing liquidity and profitability it is also about managing interest and currency risks.^[14]

Now that the reader has been given an overview of the issue this paper proceeds in a more structured manner and presents the aims and objectives of cash management in greater detail.

2.2 Aims and objectives of cash management

This paper aims to give an insight into the operational sequences of cash management and to present its objectives. Besides the choice and maintenance of bank relationships there are three further major tasks of cash management, namely

- management of cash flows and balances,
- investment of liquidity surplus and
- exposure management.

2.2.1 Management of cash flows and balances

The management of cash flows and balances is basically about the optimal synchronization of incoming-payments and payouts.^[15] The more precise the forecast of the cash flows according to amount and time, the lower liquidity reserves have to be provided. This issue is also referred to as cash flow forecasting and can be structured into a short-term, a medium-term as well as a long-term forecast.^[16]

Usually the short-term forecast is done weekly on a rolling basis and covers the next month in detail. It highlights the dates of major payments or receipts and, thereby, provides the cash manager with information required to investing short-term surplus on the money market and funding short-term financing requirements. Furthermore, it gives information about the execution of spot and forward FX transactions. The medium-term forecast is done on a twelve months rolling basis. Compared to the short-term forecast it is expanded by FX risk management and planning hedging transactions. Some more characteristics are summarized in Figure 2. Finally the long-term forecast is usually only prepared on a annual basis in conjunction with the business planning process. However, according to Figure 2 it has some more extensive features complementing the prior ones. It helps identifying the long-term funding and investment requirements as well as determining the company’s dividend growth policy. Furthermore it is useful to establish significant changes in future FCY exposures arising from investment and divestment strategies.

Figure 2: Cash flow forecasting summary

illustration not visible in this excerpt

Source: Ross 1997, p. 16

Besides forecasting the cash flows it is essential to minimize the stock of non-interest or just low interest earning cash holdings.^[17] This task is also called managing the float, which means minimizing the float-loses of incoming payments and maximizing the float-gains of payouts.^[18] “The difference between bank cash and book cash is called float […]”^[19] and can be separated into mail float, processing float and clearing float.^[20] While companies mostly cannot exert influence on the mail float^[21] and clearing float^[22], they can optimize their in-house processing and thereby minimize their processing float. Figure 3 illustrates the types of float considering the clearing of a check as an example. Concluding, to be able to manage the float successfully assumes holding a certain know-how about payment instruments and methods.

Moreover, according to MNCs the management of cash flows involves the application of liquidity equalization techniques and thereby certain instruments, like netting and cash pooling, respectively. However, the author introduces selected cash management instruments in chapter 2.3 and therefore defers further discussion.

Figure 3: Types of float

illustration not visible in this excerpt

Source: own graphic, according to Ross / Westerfield / Jaffe 2002, p. 786; Kaen 1995, p. 799

2.2.2 Investment of liquidity surplus

So far the author has examined how the treasurer can increase cash generation by structuring and managing the balances and cash flows effectively. The paper goes on with the investment of surplus funds.

To avoid opportunity costs it is necessary to invest cash surpluses temporarily. These investments are simply deposits^[23] or mostly short-term money market securities^[24] that require high liquidity to satisfy the treasurer’s needs.^[25] “The money market is a subsector of the fixed-income market [and] consists of very short-term debt securities that usually are highly marketable.”^[26] Thereby liquidity is the most relevant criteria because of the liquidity risk contained in every investment. Furthermore investors face the price risk^[27] , capital risk^[28] and settlement risk^[29] in particular which have to be taken into account according to the security of an investment in the money market.^[30] After deciding on liquidity and security, the return should be the treasurer’s lowest priority in selecting the investment instrument.^[31] However, the investment policy widely defines the trade-off between risk and return. Because the purpose of the paper is rather on the cash generation by structuring and managing the balances and cash flows, the author omits a further discussion and presentation of certain deposits and money market securities. Instead the interested reader is referred to supplementary literature^[32].

2.2.3 Exposure management

On the one hand a company has to manage its currency exposure and on the other hand there is the interest exposure which has to be managed.

Because MNCs have to deal with cash flows of different foreign currencies, currency exchanges which implicate a potential currency risk are unavoidable. This can be classified into economic risk^[33], translation risk^[34] and transaction risk^[35].^[36] Hence, it is one of cash management’s tasks to protect the company against exchange losses or even to realize possible rises in the market. Therefore it is the treasurer’s responsibility to identify the level of all net FCY holdings which are closely linked to the cash flow forecasting presented in chapter 2.2.1. It is necessary to analyze or forecast latent currency risks and, finally, manage these currency risks. However, this cannot be done without a comprehensive understanding of available exchange hedging instruments as well as their application. Due to the fact that the paper’s focus is not on exposure management the author restricts the further discussion to an enumeration^[37] of the instruments applicable to hedge potential transaction risks:^[38]

[...]

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^[1] Chin 2004, p. 360

^[2] Lewis 2004, p. 299

^[3] Cp. BayernLB (ed.) 2005b

^[4] Cp. Sieren 2005

^[5] Cp. Wegner 2004

^[6] Chin 2004, p. 360

^[7] Ross 1997, p. 7

^[8] Ross 1997, p. 8

^[9] Cp. Spahni-Klass 1988, p. 33

^[10] Ross / Westerfield / Jaffe 2002, p. 772

^[11] Kaen 1995, p. 821

^[12] Boemle / Stolz 2002, p. 179, quoting Spahni-Klass 1988, p. 96

^[13] Cp. Boemle / Stolz 2002, p. 179

^[14] Cp. Schulte 2006, p. 317

^[15] Cp. Spahni-Klass 1988, pp . 93-94

^[16] Cp. Ross 1997, pp. 13-18

^[17] Cp. Herold 1994, p. 34, quoting Smith 1992, pp. 16-17

^[18] Cp. Spahni-Klass 1988, p. 96

^[19] Ross / Westerfield / Jaffe 2002, p. 779

^[20] Cp. Spahni-Klass 1988, p. 96

^[21] Due to the payment system’s transport time

^[22] Due to the national or international banking system’s terms of settlement

^[23] E.g. over-night-deposit, tom-next-deposit, spot-next-deposit; cp. Nitsch / Niebel 1997, pp. 119-122

^[24] E.g. government securities, local/regional/state government securities, securities guaranteed by major banks or building societies

^[25] Cp. Spahni-Klass 1988, pp. 110-111

^[26] Bodie / Kane / Marcus 2005, p. 32

^[27] Price risk means the risk that the amount of loss arising from a counterparty default is greater than the level of the initial investment.

^[28] Capital risk results in the outright loss of the value of a transaction, following the default of a counterparty.

^[29] Settlement risk is a form of capital risk which arises on the date at which a transaction is due for settlement.

^[30] Cp. Ross 1997, pp. 46-47

^[31] Cp. Ross 1997, p. 50

^[32] See Bodie / Kane / Marcus 2005, pp. 32-35

^[33] Economic risk involves changes in expected future cash flows and hence economic value, caused by a change in exchange rates. Thereby it affects the structure of earnings and costs and the company’s position in the market.

^[34] Translation risk is the change in accounting income and balance sheet statements caused by changes in exchange rates. A company bears a translation risk as soon as it holds liabilities or receivables in foreign currency that differ in currency and according to their amount.

^[35] Transaction risk results from the potential difference between entered revenue and the current exchange rate as well as the effectively carried out payment at a later point in time.

^[36] Cp. Van Horne / Wachowicz 1995, pp. 683-687; Herold 1994, pp. 36-38

^[37] This enumeration does not claim to be complete.

^[38] Cp. Spahni-Klass 1988, p. 125