Leveraging RMB to Reduce Risk & Fix Costs
by Simon Jones, Managing Director, Head of International On-boarding, J.P. Morgan Treasury Services, EMEA
With China now the second largest economy in the world, no company can afford to ignore the strategic opportunities for sourcing and selling in China. With significant restrictions on the RMB posing particular challenges for companies operating in China in the past, there has been reticence in many cases to invest too heavily in China due to the potential issue of “trapped” cash. With fiscal and currency reforms gradually being introduced, including the development of an offshore RMB market (CNH), a key issue for treasurers and finance managers, and their colleagues in procurement and sales, is how to take advantage of new opportunities to enhance their trading activities in China.
RMB cross-border trade settlement
A major example of currency liberalisation in China is the RMB cross-border settlement scheme, launched in 2008. Initially, the scheme was launched on a pilot basis, enabling foreign companies to settle cross-border, authorised trade transactions with a limited number of mainland designated enterprises (MDEs) in specific cities. As the scheme became established, the eligible cities and provinces, and therefore the number of eligible MDEs quickly grew. In June 2010, all Chinese importers in the pilot regions became eligible, and by December 2010, the number of designated exporters had grown to over 67,000, representing 30% of total exporters. Since August 2011, the geographic boundaries have been lifted so exporters across China are eligible to apply for MDE status.
A major example of currency liberalisation in China is the RMB cross-border settlement scheme, launched in 2008.
The gradual expansion of the RMB cross-border settlement scheme, together with growing familiarity and confidence by foreign companies, has resulted in the volume of cross-border trade settled in RMB accelerating considerably over the past two years. While initially Chinese buyers fuelled the growth in RMB-denominated cross-border trade, which indeed was a major driver behind the scheme, the volume of exports under the scheme is also now increasing as the restrictions on exporters have continued to lift. According to the Hong Kong Monetary Authority, while the RMB-settled volume accounted for less than 1% of cross-border trade during the first half of 2010, by the end of the year, this had risen to 4%. In quarter 1, 2011, RMB cross-border trade grew 7% and had reached 10% by the end of quarter 2. Estimates earlier this year suggested that 12% was possible by the end of 2011 but based on recent growth, this is likely to be conservative.
While the ability to settle cross-border trade transactions in RMB is a new phenomenon, larger MDEs in China with sufficient negotiating power have been pricing sales to foreign customers in RMB and demanding RMB-denominated pricing from foreign suppliers for a long time. At the point of settlement, the transaction was then settled in the agreed foreign settlement currency (e.g., USD) at the exchange rate valid on the settlement date. This applied not only to transactions conducted on open account, but letters of credit were also being denominated in RMB, with settlement in foreign currency equivalent, and MDEs too can now settle these in RMB. Settling transactions in RMB is clearly an advantage for Chinese companies as their foreign exchange risk is eliminated, but there are increasingly advantages too for foreign companies, particularly those with both payables and receivables in RMB. By enabling exposures to be netted, currency risk is removed and margins can be preserved, greatly enhancing companies’ ability to do business in the region without ‘trapping’ cash or creating significant currency exposures.
Transactions priced in USD or another foreign currency have not been immune from risk for foreign suppliers or buyers. With rapidly increasing labour costs as well as currency appreciation, longer-term USD-denominated contracts have often been subject to renegotiation, which has resulted in uncertain costs and revenues for foreign companies. These issues that result in fluctuation of contract pricing are only set to continue, with many industries and companies located in the coastal cities in particular struggling to attract a suitably skilled workforce to deal with increasing customer and supply demands, despite workforce surpluses in other parts of the country. In March 2011, Yin Weimin, Chinese minister of human resources and social security, explained that the minimum wage was expected to increase by 13% over the next five years, but some industries are seeing double digit rises, particularly assembly line businesses where staff turnover often exceeds 25% and wages increased by over 40% in 2010.