We are all familiar with the China phenomena, but what we may not be so aware of is its impact on trade finance, working capital and financial operations.
After years of communist rule under Chairman Mao, China gradually opened its doors to world trade under the benefactor leadership of Deng Xiaopeng. As the walls came down, China saw its rise to prominence begin, moving from its position as one of the world’s poorest performing major economies in 1980 to the second largest global economy by 2012.
From 1979 until 2010, China’s average annual gross domestic product (GDP) growth was 9.91%. During this time, it has seen its economy leap past that of Italy in 2000, the UK in 2006 and Japan in 2010, with the US economy the only one left to surpass. A number of key factors drove this massive growth, the most important being access to the raw materials and natural resources necessary to generate a large scale, low cost manufacturing system, using labour from a population that was eager for fruitful work.
Another crucial development was its accession to the World Trade Organisation (WTO) in September 2001, allowing China to finally access the free trade flows with Europe and America. As China joined the WTO, its financial borders also came down as many American and European banks moved into China gaining stakes in the largest institutions. Today, China’s banks have turned that around and are a formidable force in the global economy with the Industrial Commercial Bank of China (ICBC), the People’s Bank of China (PBOC) and China Construction Bank (CBC) joining the top 15 banks in the world as major players.
Issues with Trade in China
This does not mean that China’s rise, alongside that of India and other developing economies, has been without issue. There has been significant trade friction with the US and much of this arises due to the huge trade surplus between the world’s two largest economies, with US officials claiming that China manipulates the renminbi (RMB) to favour its exporters. China, on the other hand argues that America’s disputes appear to have increased as a result of the post-2008 western economic crisis, as the US struggles with high unemployment and slow growth figures.
The fact of the matter is that the two economies rely on each other and are inextricably linked: China enjoys trade with the US which keeps its economy buoyant, while the US benefits from cheaper goods and services. China’s growth and control over its economic power is evident, but China also has vast amounts of US dollar reserves which is a key factor in the fission between these two nations.
What Does This Mean for the RMB?
The biggest issue in trade imbalances has been the rise of the RMB. Until 2005, the RMB was pegged to the US dollar. It was allowed to float in 2005 and, since then, has risen by an average of 7% per year (excepting the period from 2008-2010 when the RMB was frozen). However, this rise has not been as fast as those trading with China believe it should be. According to American and other economists, there has been a conscious manipulation of the currency by the Chinese authorities who, by keeping the value of the RMB artificially low, have ensured that manufacturing export levels have remained high.
The fear for China is that a strong currency will make its goods more expensive to foreign buyers, while at the same time the profits of manufacturers may also be dented when they repatriate their foreign earnings back home. The control of the currency’s movements has now become a major source of global trade agreements and disagreements. In addition to the trade dispute resolutions lodged by the US with the WTO, the US Senate passed legislation in October 2011 aimed at punishing China for alleged currency manipulation. The bill allowed the US to impose tariffs on imports from China, to counteract the country undervaluing its currency.
This on-going tension is now being defused as Premier Wen Jiabao announced in March 2012 that, from 2015, the RMB will be allowed to float freely on the world’s markets. This is being combined with other free market principles in an ambition to move the currency to being a true alternative to the euro and dollar, as the world’s third reserve currency for use across global markets.
What Does This Mean for Treasury Operations?
The RMB cannot be ignored given the extent of goods and materials sourced from China currently. The changes under consideration by the Chinese government may well help the RMB’s rise to become a third reserve currency for trade during the next decade alongside the US dollar and euro. As a result, global companies with operations extending to the Far East need to recognise how to invoice trade and organise payables and receivables in RMB denominations.
Companies doing business in China have traditionally billed in US dollars because they had the infrastructure in place to manage dollar risk and suppliers have been happy to charge in US dollars, making it clear they are charging a margin. This has been a great source of convenience for many and negated the need to manage RMB currency risk.
One of the limiting factors for foreign companies who want to use the RMB is that they cannot access financial markets in mainland China, and therefore hedging RMB is only offered in the Hong Kong market, which sees around 80% of all RMB overseas flows today. This is why the UK government recently endorsed the opening of a specialist offshore RMB trading capability in a deal with Hong Kong, and whyonly a third of the world’s banks currently provide RMB services.
Given the appreciation of the RMB over the past 18 months against the US dollar, contractors may not continue to bill in this way. Crucially, there is no contractual protection for the current arrangements. As such corporates will have to adopt infrastructure that enables them to bill and accept payments in RMB. Already we are seeing a transition in mechanisms so that if volatility in exchange rates does rise as anticipated, companies at least have some of the mechanisms they need in place to deal in RMB.
Some of these are impacted by the RMB only in an economic sense, such as the cost of goods and for these, offshore hedging is an effective way of negating volatility. However there are others that need physical delivery of RMB and here the issues grow much more complicated. Few banks have the ability to deliver the RMB onshore and much work remains to be done in enabling and enhancing the RMB capability.
The RMB may still have a way to go before it stands equal with the euro and dollar in its position as a global currency. What cannot be doubted, however, is that it is on the rise and will come to play an increasingly important role in the operations of global companies. It is crucial that firms embrace the RMB, the cost efficiencies that can be achieved and the growth opportunities set to come. The growing pains of the RMB will make it worthwhile.
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