With heavy state involvement and the occasional scandal, China’s trade finance sector may not be perfect. But significant change is under way as government policies facilitate growth and diversification in the country’s industry and financial sector. 

Trade finance in China targeting domestic firms is poised for a new wave of expansion as government policies aim to develop and diversify Chinese industry. The country's business landscape is changing. Colossal state-owned enterprises (SOEs) no longer dominate Chinese commerce; privately owned enterprises and small and medium-sized enterprises (SMEs) have become just as influential. New sectors are emerging and manufacturing, construction and real estate no longer monopolise the pulse of trade. Technology and consumer-durable firms targeting domestic buyers are expanding quickly, in turn becoming key clients for trade finance service providers in China.

Although trade finance across the Asia-Pacific can still be challenging, a softening of Western markets since the 2008 global financial crisis and recent growth in emerging economies have unveiled trade opportunities in the region. “Trade finance in Asia was not always this popular. Financial institutions are realising now, also out of necessity after the crisis, that there is potential to support trade finance in these emerging markets,” says Steven Beck, head of trade finance at the Asian Development Bank (ADB).

According to The Banker Database, Chinese banks are outstripping US financial institutions in volumes of loans and advances to corporate clients. China’s most active banks in this field – the ‘big four’ Industrial and Commercial Bank of China (ICBC), China Construction Bank, Bank of China and Agricultural Bank of China – each have between $840bn and $1000bn outstanding in loans and advances to corporate clients. By comparison, although almost 600 banks engage in this business in the US compared with 34 in China, each of US’s top four banks have loans and advances issued to corporate clients of between $160bn and $292bn outstanding.

Low rates allure

On the demand side, trade finance often means access to cheap offshore borrowing for Chinese companies. With the People’s Bank of China frequently setting interest rates far above international markets, Chinese companies are keen to snap up loans in foreign currencies. The current borrowing rate in China is set at 6%. The US’s rate of 0.25%, for instance, is meagre by comparison.

According to the Bank for International Settlements, China’s offshore borrowing in the first quarter of 2014 increased year on year by 38% to $796bn. This is a fourfold increase compared with 2010 figures. In China, trade finance loans are typically denominated twice as often in US dollars as they are in renminbi.

However, this could change as the internationalisation of the renminbi gathers pace. Only in 2009, China first launched a pilot programme allowing the use of the currency to settle trade in specific mainland regions. The renminbi has now become the world’s seventh largest payments currency. Its two-way cross-border sweeping structure, recently launched in the China (Shanghai) Pilot Free-Trade Zone, will undoubtedly act as a catalyst for the currency’s internationalisation.

Renminbi-denominated trade finance loans could also increase after ADB announced in August 2014 that it will add the Chinese currency (and the Indian rupee) to its trade finance programme before the end of the year. So far, the ADB has only worked on transactions denominated in US dollars, Japanese yen or euros.

The ADB programme aims to fill gaps in Asia’s trade finance by providing guarantees on transactions or loans to corporates. It also looks to prove that supporting trade in challenging economies is possible without incurring losses.

“The private sector often has problems moving into these markets. Funding institutions are not comfortable with the political risk associated with these countries and are unfamiliar with their banking sectors. Our aim is to close market gaps and pull the private sector into these markets to the point of making ourselves redundant,” says Mr Beck.

Corporate loans and advances – Chinese vs US Banks

Qingdao investigations

Despite the huge advantages in offshore borrowing, market participants are concerned over Chinese companies’ potential exposure to rising global interest rates, especially now that the US economic recovery is accelerating.

Cheap offshore borrowing could also pose threats when monitored inadequately. The Qingdao Port scandal is a case in point. Privately owned firm Decheng Mining was accused in June this year of using the same metal cargoes multiple times as collateral to obtain offshore loans. A number of institutions including HSBC, Citi, Standard Bank, Mercuria Energy Trading and Citic were impacted by the alleged scam.

The investigations are ongoing. Citic Resources – Citic Group’s commodity trading unit – announced that the metal it owns in Qingdao Port may be affected. Another big player in the region, Standard Chartered, however, remains optimistic. “We do not see the Qingdao Port investigations affecting our business. We have a process in place to deal with our clients and with transaction risk,” says Biswajyoti Upadhyay, head of transaction banking at Standard Chartered China.

Some market participants think the investigation will create only a short-lived slump in trade finance. However, additional controls on lending requirements are necessary if this market is set to grow sustainably and it is possible that appetite for lending on metal collateral will drop.

Going global

In spite of the Qingdao investigation, the demand for trade finance from Chinese companies remains strong. With state policies encouraging domestic firms’ global expansion and a more diverse industrial base, trade finance remains a key support system to achieve these objectives.

The state is keen to implement a ‘go outwards’ strategy – a reversal of China’s heavy intake of foreign direct investment of the past three decades. ICBC is contributing to this policy by helping domestic firms settle in foreign countries, following the theory of W Chan Kim and Renée Mauborgne, academics from Insead business school, who argue that firms successfully expand abroad by creating ‘blue oceans’ of uncontested market space rather than by fighting competitors. This unlocks new demand and destroys competition. An ICBC senior official in Beijing’s international department espouses this theory: “We need to continue increasing product innovation [such as] carving out a ‘blue ocean’ market for Chinese business in Africa and the Association of South-eastern Asian Nations [Asean].”

Some top Chinese names have already made the jump overseas. In January 2014, ICBC bought a 60% controlling stake of Standard Bank’s London-based business in what was China’s first incursion into the UK wholesale market. Last year, the Hong Kong branch of GF Futures, a division of Shenzhen-listed GF Securities, purchased the Natixis commodities division.

Having a solid international network has become essential for Chinese banks’ trade finance teams. All of the big four institutions already have significant international franchises. The head of Bank of China’s trade finance in London, Ping Xiao, tells The Banker she is witnessing unprecedented growth in her department.

“In the past three years, we have seen the strongest progress in our trade finance division,” she says. “More and more Chinese clients are becoming aware of the advantages of doing business overseas. This is in line with the central government realising that relaxing and restructuring some policies is needed to increase trade.”

Policy innovation

Trade finance teams in China (or working with Chinese companies) have positive outlooks based on state policies of further opening up the economy and financial sector. Free-trade zones and the internationalisation of the renminbi are two of the most promising measures.

The China (Shanghai) Pilot Free-Trade Zone is attracting a lot of attention at the moment. Established in August 2013, it is the first free-trade zone in mainland China and in the heart of pioneering reforms. With ad hoc laws and regulations, it is a state platform to experiment in liberalising and restructuring the Chinese economy and financial sector. It has therefore become the top destination for innovative Chinese firms keen on going global.

“The government is making an effort to get commodities trading companies and futures exchange companies to do business in Shanghai,” says Ms Xiao. “This will help Shanghai become a real international financial centre. It will also increase global trade finance transaction opportunities as these firms start expanding abroad.”

The Shanghai International Energy Exchange (INE) is a case in point. Set up under the Shanghai Futures Exchange in November 2013 in the city’s free-trade zone, INE is the latest step towards internationalising China’s crude oil futures market. Building domestic, modern financial sector capabilities of this kind, which add to China’s financial strength and independence, is a government priority.

In March this year, INE signed a debut agreement with Bank of China. It aims to open up China’s futures market by building its own international energy trading platform with the bank’s funding support. The platform is set to fuel rapid growth in China’s derivatives business and develop the country’s banking industry by attracting foreign investors, according to Shanghai Futures Exchange.

Two-way thinking

The renminbi two-way cross-border sweeping structure is another policy that has bankers in China buzzing. Companies can now automatically transfer money exceeding or falling short of a predetermined level into higher yielding investment options at the close of every business day. They can also move renminbi between their onshore and offshore units without additional documents or case-by-case authorisation.

According to Mr Upadhyay, this will facilitate the creation of trade finance products to meet demand from Chinese firms. “Our future objectives include combining trade finance with cash management to support new-age technology and retail companies. It would be helpful to set up cash pools supporting clients moving money in and out of the country while executing trade finance on top of it,” he says.

Reportedly, Bank of China, Citi, HSBC and Royal Bank of Scotland have already set up the renminbi two-way sweeping programme for Asian agribusiness group Wilmar, industrial products and equipment manufacturer Dover Corporation, Swiss healthcare company Roche and French distributor Sonepar, respectively.

Asia-Asia trade

Intra-Asian trade is ballooning as countries in the region turn to their own neighbours for trade opportunities, in no small part because of Western markets deflating post-2008. According to a HSBC report, Chinese export growth to South Korea was flat in June 2013 but increased to 32% in June 2014. Export growth to members of Asean increased from 10% to 12% in the same period.

In China’s case, firms are taking advantage of growing demand from Asia for exports of equipment. But with importers often originating from less developed markets, whose regulations and banking sectors remain unfamiliar to exporters, Chinese companies are relying on trade finance teams to carry out due diligence and provide guarantees on transactions.

Two of the 828 Chinese trades supported by the ADB trade finance programme so far this year, for instance, were export transactions into Bangladesh. The first trade, worth $30m, included plants, equipment, materials and machinery for a gas-fired combined cycle power station. The second, worth $982,000, involved exporting pharmaceutical machinery for storage, distribution, distillation and filtration of water.

Trade finance teams are facilitating intra-Asia trade by building Chinese firms’ confidence in emerging markets. “Banks provide firms with a guide throughout the entire process, from production to trade. [We offer] all-round services including settlement, financing, money management and hedging. Comprehensive cross-border trade finance services have become a powerful trend,” says a senior official at ICBC.

He also underscores the importance of establishing uninterrupted services to facilitate cross-border trade. “How to supply credit guarantees as a middleman figure and providing continuous rather than case-by-case value-added services will become key points for the future of our trade finance business,” he says.

Mr Upadhyay agrees that offering a global client network and overarching transaction coverage is key for Chinese firms expanding abroad. “End-to-end structures help handle market risk. If the client knows you're both providing a letter of credit and are also the advising and negotiating bank in the counterpart country, it will facilitate the transaction,” he says.

New-age industry

The broadening of Chinese industry is further boosting trade finance business in the country. Since the reform of SOEs and the financial sector in the 1990s, private companies have grown to be as competitive as state firms, especially in the international space, and favourable government policies have opened the floodgates to SME development. According to a report from consultancy Oliver Wyman, Chinese SMEs accounted for 60% of the country's gross domestic product and 68% of trade volumes in 2011.

“Big SOE names were the first to realise the benefits of doing business abroad. Now also SMEs and private companies are quite active. The government is encouraging them to become more international,” says Ms Xiao.

SMEs are now the hub of China’s new-age industry. “It is no longer only about looking at the big names,” says Mr Upadhyay. Private companies and SMEs are at the forefront of China’s industrial base diversification away from construction and real estate into technology and consumer durables.

While the key focus for Chinese SOEs and privately owned enterprises is global expansion, smaller new-age enterprises rely on the domestic consumer pool for growth. This is in line with state policies looking to make China’s economic model more sophisticated. That will involve moving from an export-driven model, for which China was termed the ‘factory of the world’, to a consumption-led economy.

In the past three to five years, banks in China have responded to this new trend by developing supply chain services. “We are focusing on financing clients to support their supply chain, including procurement, distribution and warehousing,” says Mr Upadhyay. “While our clients used to be mostly foreign multinational corporations with catchment areas for manufacturing and distribution in China, we now also serve a number of Chinese privately owned enterprise and SOE clients for domestic and offshore requirements. SME clients continue to be part of a large client ecosystem.”

The senior ICBC official adds: “Demand for enterprise platform services is clear, demand for cash management is very strong and banks are increasingly promoting supply chain financing services.”

Basel III deadline

Despite inconvenient changes to liquidity coverage ratio rules, trade finance remains attractive for Chinese banks in regulation terms as the country will implement Basel III in 2015. “China will be moving from Basel I to Basel III next year, which means banks in China are very keen on making sure they comply with the latter over a period of time until 2018 or 2019,” says Mr Upadhyay.

Under Basel III, while trade loans are deemed low-risk assets on financial institutions’ balance sheets, trade finance instruments including letters of credit, import financing and other trade loans now incur higher capital and funding costs.

However, lobbying by the International Chamber of Commerce has recently generated changes to Basel regulations in favour of trade finance. The one-year maturity floor for self-liquidating trade finance instruments has been removed, reducing capital charges when calculating risk-weighted assets. Banks were initially obliged to set aside capital for tenors of no less than 360 days, while trade finance deals are often at tenors of less than 180 days.

Under Basel II, the credit conversion factor – what the instrument’s face value needs to be multiplied by to arrive at its risk-adjusted value – was set at 100% for all exposures. Since January 2014, the Basel Committee on Banking Supervision decided that short-term, self-liquidating letters of credit and guarantees would receive a credit conversion factor of 20% and 50%, respectively. This has further reduced banks' capital charge.

The Basel Committee also waived the sovereign floor. Originally, claims on an unrated bank could not receive a risk weight below the bank’s country of origin. Financial institutions can now change the risk profiles of trades – a less costly proposition. The run-off rate for trade finance-contingent facilities has also been modified. It is now capped at 5% instead of being at the discretion of the national regulator.

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