Chinese Lessons: Avoiding the Liquidity Trap

The rapidly growing Chinese market offers significant expansion opportunities for foreign corporates, but also substantial risks for treasury managers, unaware of China’s unique circumstances. Michael Nelson and Sarah Zhou of J.P. Morgan Treasury Services highlight the key pitfalls to avoid, and suggest strategies to optimize a corporate’s liquidity management in this challenging emerging market.

China has unquestionably become the engine of growth for the global economy, with its enviable real GDP growth rates of above 9%, while traditional powerhouses like the US and Europe struggle post-crisis to avoid slipping back into recession. This makes the country ever more vital for multinational corporations looking to grow their businesses, with many either ramping up their existing operations in China, introducing new onshore treasury operations, or if not yet present, looking to establish a presence.

Capitalizing on China’s growth opportunities is complicated by a range of legal and regulatory complexities, and optimizing liquidity can prove challenging. China’s strict rules on a whole range of issues including tax, registered capital, and the convertibility of the renminbi, can present unique problems for multinationals that differ from their experiences in most global markets. The difficulties here are compounded by the fact that China is not a static legal environment – what is and is not permissible changes month by month. Corporates operating in China need to pay extra attention to navigating the uncertainties, whether it be releasing trapped cash or avoiding the build-up of liquidity management problems in the first place.

How Cash Becomes Trapped
The liquidity management challenges in China can essentially be broken down into two components: the difficulties with managing liquidity onshore, and difficulties moving money across borders. The former is perhaps the more straightforward to deal with; the biggest headache for multinationals revolves around cross-border transactions and making money in China available to parts of the business outside the country, a difficulty that can become particularly acute if the firm has a long-standing presence and has built-up substantial cash reserves that cannot be moved offshore – otherwise known as trapped cash.  

There are various restrictions on currency conversion on foreign currency capital and current accounts in China. In addition, for every cross-border transaction, its nature must be clearly explained to the transaction bank and/or the regulator, both for inflow and outflow. The good news is that a broad swathe of changes over the past seven years or so has contributed to greater liberalization of the renminbi, for example, the dim sum bond market in Hong Kong, cross-border settlement schemes and the most recent regulation on certain renminbi capital items inflow. The future also looks bright for further internationalization. While these liberalizations make the job of cross-border liquidity management somewhat easier, and in particular encourage foreign corporates to become more comfortable holding renminbi, challenges to moving money cross border still persist.

Dealing with Domestic Liquidity Challenges
Due to regulations, direct inter-company lending is not technically permissible – which is problematic because optimizing usage of internal liquidity is typically a primary objective for most companies. However, there are a range of possible solutions available to mitigate this problem such as entrustment loan structures, with a bank standing between the lenders and borrowers, acting as an intermediary agent to move funds from the entity with surplus cash to the entity requiring cash. These arrangements can also be made multilaterally to multiple entities, with a number of entrustment loans covered under a single legal agreement. 

The basic principle of entrustment loans can be expanded into a range of ways to better manage liquidity within China, for example under a zero balance account centralized structure (ZBA). Under this structure, one or more corporate entities automatically sweep all positive balances to a header company at the end of each day, and likewise, use a sweep payment from the header to cover negative balances within the entities. This is useful for reflecting the ‘net off’ position of the balance sheet of the header company, in turn making administration and automatic reinvestment easier. Similarly, a de-centralized approach can be achieved with a ‘sweep as required’ structure whereby the individual entity only maintains the cash surplus if its own ‘net off’ position is positive. If negative, the participant company retains the deficit. Such an arrangement helps minimize cost by reducing the entrustment loan interest as well as meeting decentralized group requirements for individual cash flow control. 

Releasing Trapped Cash – Cross Border Opportunities
Once cash has become trapped in China, there are still a number of options available to release it. The first option for most firms is to use the well-known traditional channels for repatriation such as dividend, royalty payments and service payments. However, all of these channels come with their own restrictions, for example: dividend payments need profit generation for the fiscal year before dividends can be paid whilst royalty payments require approval from State Administration of Foreign Exchange (SAFE) and related local authorities, with the approved amount related to sales or contract value, and subject to tax. 

The second option for trapped cash involves leveraging the trapped cash to benefit the group. Some of the more recent strategies being developed use cross-border lending to help multinational firms release their trapped cash on a temporary basis. This involves the Chinese onshore company posting a renminbi deposit as collateral with a bank like J.P. Morgan China, with the collateral used as a financial guarantee for the offshore trade. J.P. Morgan’s overseas branch then makes a working capital loan to the onshore company’s affiliate offshore company. One of the benefits of this strategy is that SAFE approval may not be required for most structures, but the trade must fall within the bank’s external guarantee limit. The onus is on the bank to validate the financial status of the corporate entity and the commercial agreements.

Alternatively, straightforward cross-border lending to related companies was introduced and is only available for multinational corporations that have their onshore entities incorporated in the Pudong district of Shanghai. Trades using this strategy must not exceed the onshore entity’s unallocated or unpaid dividend, and there are particularly stringent SAFE requirements for eligibly. Because of the strict requirements, this type of trade attracted limited interest, but as the renminbi internationalizes, customers are seemingly increasingly interested in sending renminbi abroad.

A new possibility, though still subject to approval from the Ministry of Commerce, uses trapped cash for overseas direct investment in renminbi. This option is only available to entities incorporated in China. The new development encourages local firms to expand overseas and promotes renminbi internationalization. However, a clear trend recently has been the increasing number of multinationals setting up holding companies in China – though again, this strategy is dependent on firms becoming increasingly comfortable holding renminbi, and their business development strategies. Such an option benefits the user by avoiding the need to carry out two currency conversions – once out of the country, and once back in to reinvest.

The third option for dealing with trapped cash is to simply leave that cash ‘trapped’ onshore in China, but seek to optimize the returns that the cash generates – though the universe of investment products in China is limited. Because rates in China are regulated, featuring a ceiling rate on deposits dictated by the central bank, in certain market environments this can produce poor returns. An alternative investment for consideration is in a form of money market funds, or structured deposits which offer a possibility for higher yield and greater flexibility of tenor.

A Case in Point: Tailoring the Right Liquidity Structure
The solutions discussed can be tailored to best meet the corporate’s individual requirements. For example, a J.P. Morgan client, a large multinational manufacturer, with a substantial presence in China, comprising 18 plants and 15 legal entities, had begun to accumulate a significant concentration of cash onshore. The firm utilized a tailored loan structure solution which allowed some of the firm’s legal entities that had accumulated surplus cash to lend to those that required it within China. This particular structure featured an automated sweep to do just that, enabling an efficient liquidity management structure within the country.

The Temptation to Keep Cash Onshore
In the current climate, due to the relative higher yield that can be earned onshore versus in other markets, it is almost tempting for foreign corporates to keep cash inside China. Raised reserve and interest rates in China ensure the returns corporates receive on deposits are currently relatively good. However, China is keen to ease inflationary pressures following its credit expansion program, and in addition to the more stringent monitoring of inflows, another means could be by allowing corporations to more easily move money offshore. Despite currently enjoying good returns from the Chinese market, corporations should continue to review their trapped cash situation and be prepared for any change in the market.

Approaching Liquidity in China as a Newcomer
The ideal situation of course, is to avoid having trapped cash in the first place. China is currently experiencing a slew of new entrants to the market – mostly mid-sized corporates from the US or Europe – and, to an extent, such firms can best manage their liquidity at the point of entry. There are several options available, most importantly, optimizing the firm’s capital structure. It may not be ideal for firms to fund their onshore vehicle entirely by equity. Instead they can look to take full advantage of the permitted debt-to-equity ratio. A vehicle funded with 100% equity can encounter problems further down the road. When the vehicle starts to become profitable it is almost impossible to take that equity out of China, while capital reduction in China remains extremely rare. Firms can instead use a maximum one-third equity and two-thirds debt. The debt can be funded by a cross-border shareholder loan, which can later be repaid as the company becomes profitable, effectively avoiding trapped cash.

An increasingly popular second strategy is using what is called toll manufacturing. The multinational corporation limits the amount of capital that is held by the vehicle in China – for example, the Chinese vehicle might only own the plant and the equipment, while an associated offshore company owns the equity, working capital, inventory, materials, work in progress, and so on, therefore revenue is earned primarily by the offshore entity. Limiting the amount a company needs to bring to the country limits the amount of trapped cash.

Beyond Liquidity Structures: Further Considerations
Simply putting the various liquidity management structures to use will not achieve all of a corporate’s liquidity objectives. Another vital aspect of liquidity management for any multinational corporation is the ability to view liquidity firm-wide, taking into account in-country cash positions even in restricted markets like China. Few banks offer online liquidity management platforms that give treasurers visibility of their cash positions across different countries or banks, but those that do, like J.P. Morgan, can help manage and monitor treasury activities across the region and globally. In particular this allows treasurers enough real-time information to be more ‘hands on’ in China.

Investing time and effort to managing liquidity can have a broad range of benefits: improving cash forecasting, minimizing financial costs for external borrowing and overdraft, not to mention optimizing returns on surplus cash. In China especially, corporates need to constantly monitor their liquidity management strategies, and application of best structures. Moreover, firms should be looking to partner with banks that have not only strong local expertise, but also a strong global network and infrastructure, as well as the know-how to move with the fast-changing markets and tailor the kind of liquidity structures that work. Finding the right banking partner will enable corporates to leverage off the bank’s global platform and really optimize their cash portfolios, especially in challenging but ultimately rewarding markets such as China.

For more information, please contact

Michael Nelson
Head of Corporate Sales, China
J.P. Morgan Treasury Services
michael.r.nelson@jpmchase.com
Tel: (86-21) 5200 2778

Sarah Zhou
Head of Cash Management Product, China
J.P. Morgan Treasury Services
sarah.bl.zhou@jpmchase.com
Tel: (86-21) 5200 2716 

 

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