Challenges and Best Practices in Optimising Liquidity Globally

by Michael D. Golden, SVP, Product Management Executive, Bank of America, Global Product Solutions

The global credit crisis has eroded the availability of financing and liquidity—a company’s lifeblood—and has increased its costs. In this challenging financial climate, it is vital that companies harness internal liquidity and optimise its use.  

Yet for companies operating globally, some excess liquidity may be restricted as it cannot be repatriated easily from another country, due to currency controls and other regulations. This remains a key challenge, as what feels like ‘trapped cash’ has historically been associated with the opportunity cost of underutilised liquidity, especially relevant to emerging markets. However, in the context of current events, this takes on a broader meaning—one which shifts attention from opportunity cost to risk—whether country, counterparty, or FX risk—and from emerging markets to all markets.     

In this article, we explore the movement of local, regional and global cash flows as a key issue in liquidity optimisation, including:

• Examining the typical causes and motivations behind underutilised liquidity in key emerging markets.

• Presenting a client case study featuring the use of a multi-party entrust loan structure to facilitate internal liquidity optimisation in China.

• Reviewing best practices for optimising liquidity—universal strategies that, despite the challenges, can work in both loosely as well as highly regulated markets.  

• Re-examining the concept of restricted cash flows—placing it within the broader context of today’s financial turmoil, and discussing the heightened risk this turmoil has revealed for companies expanding globally.  

Underutilised Liquidity in Emerging Markets:  Causes and Motivations

Governments in emerging markets commonly use regulations to attract foreign direct investment (FDI) to foster local economic growth and stability.

As a company expands and diversifies into emerging markets—sourcing, selling, investing, and establishing on-the-ground operations—harnessing and optimising liquidity in regulated jurisdictions can be challenging.  

Governments in emerging markets commonly use regulations to attract foreign direct investment (FDI) to foster local economic growth and stability. In Asia, for example, Hong Kong and Singapore use tax incentives—including advantageous tax rates and a network of double taxation treaties that minimise tax exposure to other countries for profits earned onshore—to foster their desirability as locations for establishing regional treasury centres.

In conjunction with these measures, governments also may impose restrictive regulations that require cash be left onshore and thus limit the management and optimisation of liquidity—both locally and globally. For example, regulations may serve to:

• promote local business and the domestic banking sector

• encourage the growth of local capital markets

• grow and protect the country’s tax revenue

• protect the local currency from devaluation and volatility, and

• build foreign currency reserves

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Examples of Regulated Transactions: the Purpose and the Impact

Regulations typically serve multiple purposes, working in parallel (and at times in conflict) with other measures, and are aimed at creating a mutually beneficial, friendly business environment. A single country’s regulations may, for example, use business tax incentives to encourage cash inflows for investment while at the same time may place some requirements on cash outflows of local and foreign currencies. Therefore, regulations limiting the flow of liquidity, reflect the local efforts to attract Foreign Direct Investment, while, at the same time, ensuring the extraction of resulting foreign corporate profits is well-managed, and does not cause undue disruption to the local markets.

Some examples follow:

Cross-border cash flows
To foster local investment, regulations may inhibit cross-border cash outflows and limit offshore activities. There may be restrictions on cash repatriation to a company’s home country. For example, some countries require that foreign capital invested in a local subsidiary stay onshore for a period of time, only allowing for profits to be moved offshore.  

Regulations may also restrict local-resident companies from holding offshore bank accounts. For example:

• Resident companies (i.e., locally incorporated entities) may be restricted from holding foreign currency accounts offshore, or be allowed to do so with limits.

• Non-resident companies may not be allowed to maintain local currency accounts onshore.  

Regulations may mandate accounts be held onshore for a range of activities —such as borrowing, currency conversion, and lending. For example, regulations may require the use of local onshore bank credit facilities to convert local currency into foreign currency for offshore lending purposes.

And while certain onshore transactions may require approvals and central bank reporting that add to liquidity management processes, they foster local business and banking activity with full transparency.

Intercompany transactions
Intercompany lending and other netting schemes—whether involving physical or notional pooling—may be prohibited or restricted. For example:

• Local companies may be required to make individual payments for intercompany transactions.

• Intercompany lending may be limited to a percentage of paid-in-capital or cash reserves, which prevents entities from overextending their lending/borrowing capacity within the group of affiliated companies.

• Governments may impose taxes on intercompany loans. Alternatively, they may require that a bank serves as intermediary to facilitate intercompany lending, thereby creating an arms-length investment that results in taxable income.

The limiting of intercompany loans as an internal funding source helps to protect and foster the development of local capital and credit markets. 

Tax revenue
Governments want to attract FDI without forfeiting tax revenues. By taxing cross-border cash outflows, governments gain tax revenue while encouraging companies to keep cash onshore for local investment. There also may be heavy taxation on the repatriation of profits to a company’s home country. Such measures are a counterpoint to tax incentives encouraging foreign investors.

Governments also want to discourage companies from holding excessive debt in their jurisdictions to offset income and avoid taxes. Thin capitalisation rules require that companies maintain specified debt-to-equity ratios, which prevents companies from using leverage to mask profitability and decrease a local entity’s tax liability.  [[[PAGE]]]

Local currency
A local currency may not be freely convertible outside of a country. Governments may impose a fixed rate of exchange, and onshore conversion to other currencies may be restricted.    

The conversion of local currency to other currencies—and a large outflow of foreign currency from a country—can devalue the local currency, impact interest rates, and stifle investment in the local economy. FX controls make it more difficult to trade a local currency, thereby protecting its value, limiting volatility, ensuring its liquidity, and mitigating offshore currency risks.

Foreign currency
Governments may require companies to repatriate offshore profits and convert them to the local currency. For example, a locally incorporated company might be permitted to hold foreign currency trade receivables offshore for the purpose of collecting payment. However, the company may be required to repatriate collected offshore receivables and convert them to local currency within a specified time period. The company also may be required to keep onshore any locally collected foreign currency receivables.  

Requiring the inward remittance (repatriation) of offshore export proceeds, and restricting foreign currency outflows, helps build a country’s foreign currency reserves. Required conversion into local currency contributes to the local currency’s stabilisation and liquidity.

Other onshore inhibitors of liquidity optimisation

Fragmented liquidity structures reflect an inhibited ability to deploy liquidity to optimal use within a global or regional liquidity structure. Within regulatory constraints, companies look to optimise their liquidity held onshore.  Restrictions on intercompany lending, and other regulations mentioned above, also hamper efforts to optimise liquidity locally.  

Additional regulatory barriers to local liquidity optimisation can include, for example:

• Interest rates paid on deposits may be regulated;

• Overdrafts may be prohibited;

• Borrowing may be restricted to a regulated interest rate set by the central bank.  Regulated borrowing rates impede companies with strong credit ratings from using their ratings to more cheaply sourced liquidity. 

A key component of global liquidity management, visibility remains a challenge for many...

Additionally, central bank reporting is typically a requirement for doing business in highly regulated jurisdictions.  For example, regulations may require that all foreign currency investments be reported. Information reporting requirements can be burdensome and impact transaction timing and a company’s liquidity bank can help them to understand reporting requirements.   

Further, certain types of transactions may require advance approval. Unlike in the U.S. and Western Europe, some jurisdictions may not have case law or precedent. There may be ambiguities around the rules related to some types of financial activities, with authorities making some decisions on a case-by-case basis.  

Finally, a company’s own internal treasury policies, investment guidelines, and credit interest limits, as well as tax considerations and legal structures, may create internal challenges to harnessing global liquidity. Even working with the best banking partner won’t accomplish a treasurer’s objectives without internal buy-in and support. It is critical to engage key internal business partners, which might include, for example, in-country controllers Whether the company is centralised, regionalised, or decentralised, there is a strong case to make for how a global liquidity structure can bring greater benefit to the whole than the sum of its parts. [[[PAGE]]]

The Trend towards Deregulation in Emerging Markets

Over the past decade, there has been a general trend towards deregulation in emerging markets, although the pace has varied by country. Despite the easing of currency and other restrictions in some countries, achieving global cash concentration is still challenging. In fact, the recent global financial crisis has caused some reversals of recent regulatory easing as a means of helping to better manage local liquidity markets. [[[PAGE]]]

Best Practices in Liquidity Optimisation

Companies must focus on achieving their strategic treasury and business objectives around the globe. It is possible to optimise in-country liquidity within regulated jurisdictions. The following concepts apply to optimising global liquidity structures.

1.  Lead and Lag your Cash Flows
The practice of structuring operations as a part of a larger global trade structure can help optimise utilisation of cash. Where permitted and practical, using leading and lagging techniques - paying cash-poor entities early and cash-rich entities later – with related companies around the world would facilitate funds transfer to other countries. By doing this, the entities in more restricted markets can achieve the optimal required level of funds sufficient for its daily working capital requirements.

For the excess cash that remains in these countries, work with your global banking partner to use the best available tools and solutions for in-country liquidity management. These may include multi-bank sweeping to a concentration account, bank accounts with an enhanced yield, and time and call deposits.  

The current economic turmoil may increase your FX risk in converting from local currency to your base currency, which makes it even more important to leverage local currency liquidity solutions.  

2.  Strengthen Visibility
As a key component of global liquidity management, visibility remains a challenge for many—regardless of whether or not cash is fully optimised across all entities of a corporation. According to a recent liquidity survey in Treasury & Risk Management magazine, 47% of companies that responded would give more business to a bank that could link cash reporting to the company’s ERP system. Gaining visibility is a key step towards centralising control.

Technology integration allows corporate treasury to centralise visibility and control regardless of physical treasury structure (i.e. whether treasury staff is centralised, regionalised, or decentralised), because it gives treasury the flexibility to choose a structure that best complements its strategic and tactical objectives. As illustrated by the case study on the following page, an in-country liquidity structure can work seamlessly with electronic banking, payments and collections—automating and standardising processes to reduce operational risk, lower cost, and strengthen global visibility and control.

3.  Optimise Liquidity as Part of Working Capital Management
If you are spending resources to manage your accounts receivable in emerging markets, be sure to take the final step to optimise liquidity. Good working capital optimisation requires linkage between payables and receivables management and liquidity structures.

In the global arena, transparency is a key issue in risk assessment.

With a strong global banking provider, and the proper in-country liquidity structure, you can gain visibility and control over trapped cash—even if you choose to work with local banks to collect domestic payments from your customers. In some countries with large geographic spans—such as China, India, Russia, and Brazil—using the extensive branch networks of domestic banks for nationwide collections may be the most effective strategy.

However, to ensure global visibility and control—and local cash optimisation—it is best practice to quickly concentrate daily liquidity with a global banking partner. For example, multibank reporting—which provides current and prior-day information across your banking relationships—can work with multibank sweeping on a same-day or next-day basis. This quickly concentrates liquidity into a pool in order to put it to optimal use—such as paying down debt or investing. It also helps you manage your internal risk requirements—related to, for example, counterparty, country, and FX—depending on your company’s risk appetite or need to use liquidity elsewhere. [[[PAGE]]]

Reexamining Restricted Cash Flows—Global Phenomenon; Anytime, Anywhere Risk

Excess liquidity held in emerging markets does not necessarily equate with increased risk. An emerging market bank, for example, well capitalised or government-backed, can be a very low-risk  place to hold liquidity.  

The global credit crisis underscores that risk—and market perception of it—as fundamental to the continued flow of liquidity at a systemic level. Within this context, cash governed by regulations that limit repatriation with a parent company takes on new meaning—one no longer limited to emerging markets.  

Risk management becomes a central issue in preventing cash that is often referred to as ‘trapped’—now defined as inaccessible liquidity, whether due to the unavailability of liquidity through individual sources or the freezing of liquidity at the systemic level.

An Extension of your Treasury Team
The question becomes:  Which sources of liquidity can you trust? Corporate treasury has a fiduciary responsibility to safeguard cash.. In today’s market, treasurers are struggling to understand what constitutes safety. Old assumptions no longer apply, as companies heighten their focus on due diligence in evaluating risk.

The credit crisis highlights that your bank not only is a source of credit and liquidity, a counterparty, and a vendor, but—in a globally interconnected financial system—an extension of your treasury function. With the liquidity they provide so vital to meeting operating requirements, risk management becomes closely tied to liquidity management.  

Within this context, the need to optimise liquidity becomes urgent and more complex, with counterparty risk a key concern and there continues to be a flight to quality for investments. Increasingly, companies are turning to banking providers with financial strength and stability to safeguard cash and implement solutions to help release and optimise internal liquidity.   

In the global arena, transparency is a key issue in risk assessment. Only a handful of banks are emerging as global liquidity banks. Concentration risk is less of an issue than the quality of the counterparties with which you choose to concentrate liquidity.

Remapping Liquidity Management
In a globally connected financial system, risk is more opaque.This is due, in part, to the complex interdependencies between financial institutions and corporations, which intensify the ripple effect that the problems of any individual member have on the global financial system as a whole. Risk involves not only your bank as counterparty, but the vendors, customers, and counterparties with which it does business.

Managing risk becomes a more complex task. The risk associated with countries, counterparties, FX, interest rates, and the balance sheet, amongst other factors—form a complex mosaic in which individual moving parts must be managed holistically, with their impact relative to liquidity better understood.

As the business community emerges from the current financial turmoil, it will remap the concept of liquidity management. Regulators, in part, will drive this. The integral role of risk as a component of liquidity will be central to change.