Published: May 01, 2013
Treasurers globally have prioritised risk management over recent years, adopting a more rigorous approach to identifying, monitoring and managing exposures. In many cases, particularly since the global financial crisis, treasurers and CFOs have recognised that risk management policies cannot be simply left in the drawer and the dust brushed off every few years. Risk is a living, breathing beast that demands constant attention. In most ‘traditional’ economies, such as Europe and North America, it is less challenging to tame the company’s financial risks, not least as a limited number of currencies are involved that are easily convertible. Similarly, risk intelligence on customers and suppliers is generally accessible.
As companies of all sizes extend their activities in emerging markets of Asia, Latin America, Middle East & North Africa and, in the future, sub-Saharan Africa, the beast’s fire-breathing potential becomes far more apparent. This article, featuring comment and insight from Dennis Sweeney, Managing Director and Treasury Solutions Executive, Bank of America Merrill Lynch, considers some of the additional risk management issues that treasurers need to consider when expanding their business activities into ‘emerging’ markets.
As growth in developed economies continues to be reluctant at best, corporations in all industries and of all sizes are looking further afield for growth opportunities, as we have discussed in a number of articles in TMI recently. Asia and Latin America are the most familiar target regions, but Africa is also starting to blossom for both sales and sourcing. Pursuing a growth strategy in these regions is a different proposition entirely to the more familiar territories of Europe and North America. Dennis Sweeney, Bank of America Merrill Lynch emphasises the importance of managing risk management as part of a corporate expansion strategy,
“The size of emerging and developing economies is driving the world’s economic growth and by some measures could overtake that of advanced economies for the first time in 2013. Before taking steps into an emerging market, companies should know the risks, understand the culture, and make use of local and global expertise.”
He continues,
“Managing risk in emerging markets brings a unique set of challenges, such as currency controls, restrictions on investment flows and diverse regulatory, market and tax infrastructures.”
To these issues can be added cultural differences, a less developed physical and communications and power infrastructure, geographic scale and varying sophistication in payment and collection methods, amongst many others. Furthermore, whereas financial management in Europe has become more integrated, not least due to the single currency, Payment Services Directive (PSD) and SEPA (Single Euro Payments Area), every country in emerging regions has its own specific challenges and opportunities. So, it appears, we are dealing with not one fire-breathing risk dragon, but many….
So, where should a treasurer or CFO start when planning a risk management approach in a new market? The first requirement is to find a credible banking partner to make sure that the company can make payments, collect cash and possibly obtain access to local financing and investment. Ideally, this should be a bank with which the company already has a relationship to enable integration with existing processes and technology platforms for visibility and control over cash. This can prove problematic, of course. There are many examples where banks have a branch in a country, but this does not necessarily mean that they are in a position to manage payments and collections, particularly in countries that have a high dependency on manual payment methods where a branch network may be required. Dennis Sweeney notes,
“When a company moves into a new market, treasurers and finance managers may not have the same support base as in more familiar markets. For example, their global banking partner(s) may not have a presence there, or they lack access to the local clearing system. Therefore, the first move, in particular, can be challenging as companies develop relationships and expertise.” [[[PAGE]]]
He continues,
“Working with local banks can address the issue of local clearing and provide access to a branch network that may be required for collections, but they may be less creditworthy and have less automated and robust systems and processes than global banks. Using a hybrid approach to banking can address this challenge. A company works with its global or regional banking partner and its in-country partner, thereby gaining the benefit of regional or global risk management cohesion, together with local services and coverage.”
The issue is not only with managing supplier/ salary payments and customer collections. Achieving treasury visibility and control over cash is an essential prerequisite for managing risk. Where a company can work with an existing international banking partner, this is typically more straightforward, but local banks (particularly those that are not partnered with an international bank) may not be in a position to channel bank account information through a multi-banking electronic banking platform or SWIFT. International banks are working to help their customers with this challenge as far as possible, as Dennis Sweeney explains,
“At Bank of America Merrill Lynch, our aim is to provide comprehensive solutions and services in every country in which our customers require our support, either directly or through our extensive partner bank network. This enables customers to use the same technical platform and leverage common standards across every country, such as the use of SWIFT Corporate Access and XML ISO 20022 standards.”
In some cases, however, companies may be obliged to work with one or more local banks for official payments such as tax, customs and duties, resulting in a proliferation of accounts with different banks, complicating the issue of visibility and control over cash even further. In some countries, such as some ASEAN countries, governments have built, or are building, electronic portals to ease processes for official payments; however, local banks may not be in a position to support SWIFT access or XML formats. In these instances, treasurers need to establish a robust process for obtaining timely, accurate balance information as regularly as possible in a format that can be converted or integrated into internal systems.
Having achieved visibility, the second step is to gain control over cash. Almost every treasury event discusses the issue of ‘trapped’ cash (an expression disliked by many banks) referring to cash balances that cannot be repatriated or channelled to other parts of the business. There are a variety of reasons why cash can become ‘trapped’, including restrictions on cross-border flows and/ or intercompany lending (which therefore has an impact on the ability to include accounts in cash pools), currency controls, and regulatory restrictions on the use of accounts for certain business purposes, such as tax and customs payments. Dennis Sweeney discusses,
“Banks need to offer variety and flexibility in their liquidity management solutions. Managing excess cash, and transferring it from highly regulated economies can be difficult: while sweeping and overlay structures may be effective in some cases, in others, techniques need to be adapted to each country. In China, for example, this may involve an entrust loan arrangement and interest optimisation in other regions. A good global bank, like ours, can provide considerable consultative support appropriate to the type of business, regions and business challenges experienced by each customer.”
Notional pooling and interest optimisation structures are becoming increasingly popular as companies expand their geographic reach and the materiality of cash balances held in more restricted markets. Rather than physically sweeping cash between accounts, the value of cash balances can be netted against deficits to avoid the need to fund accounts and therefore reduce the cost of borrowing. For these structures to be feasible and useful, however, treasurers need to work with an international bank across a number of countries or a region as a whole.[[[PAGE]]]
In addition to market, and potentially tax regulation, the other key factor when managing cash and liquidity in emerging markets is the variety of currencies of course. Not only do currency controls frequently exist, such as in China, but the volatility of emerging currencies may be greater than more familiar, ‘hard’ currencies. In some cases, China again being an example, treasurers have not always worried too much about cash balances held in emerging currencies, either because the amount has been relatively immaterial, the currency is forecast to appreciate (as has been the case with RMB in the past) and/or the company anticipates future investment in the local business for which surplus balances can be used. Currency volatility, growing cash balances and a more rigorous approach to managing risk are all contributing to treasurers placing a higher priority on emerging market currency risk.
Many treasury departments have a well-defined approach to managing currency risk in frequently traded currencies. In emerging markets, even if a currency is tradable, there may be fewer options for hedging risk. Dennis Sweeney outlines,
“Hedging risk may also be difficult, and often quite different in each new country, and companies will typically have less expertise in doing so. Hedging instruments may be more limited in both their availability and duration, so treasurers need to work with their banks to craft hedging solutions appropriate to each market, which may include a variety of risk mitigation techniques.”
One approach taken by companies with relatively limited foreign currency requirements is to use multi-currency payment platforms such as Bank of America Merrill Lynch’s CashPro™, Citi’s WorldLink® and Deutsche Bank’s FX4Cash, that enables payments and collections in multiple currencies (well over 100 in both of these examples) through a single account, typically in the company’s base currency. While this may not be the preferred option for companies with high volume/ value of transactions in a particular currency, it is a very useful means of avoiding the proliferation of foreign currency accounts and avoiding the need to manage exposures in these currencies.
Treasurers’ concerns when expanding the business into new markets extend beyond financial risk. Counterparty risk is also a major consideration, not only for banking counterparties, but also customers and suppliers. Looking first at customer credit, Denis Sweeney, Bank of America Merrill Lynch discusses,
“While companies may have extensive customer credit assessment capabilities in established markets, it may be more difficult to make well-informed credit decisions in new markets. Know your customer (KYC) processes are still required, and may be onerous at times, particularly as business practices will often differ, and a wider range of risks may need to be assessed, such as the customer’s political connections. Furthermore, legal redress for non-payment by a customer will also differ according to the legal environment.”
He continues,
“Counterparty risk also extends to suppliers. For example, a concentration of suppliers in any country (whether emerging or traditional markets) brings risk, particularly in regions susceptible to natural disasters such as earthquakes and floods. In addition, the legal framework may not protect the company in the case of non-delivery.”
Companies therefore need to focus on building up their own intelligence on customers and suppliers, which requires specialist technology and centralised processes for managing credit terms and provisions. In addition, a valuable way of managing credit risk in emerging markets where credit reference information may be patchier is to use trade finance instruments such as letters of credit. Prior to the financial crisis, there was a gradual but definite shift away from trade finance instruments in favour of open account. There were a variety of factors that contributed to this shift, including the perception that trade finance instruments were more cumbersome, expensive, labour- and paper-intensive, with long, unpredictable periods before payment or collection takes place.
The preference for open account is returning, but trade finance instruments still have an important role to play as part of an effective risk management strategy in emerging markets. With electronic trade platforms such as Bolero.net and SWIFT’s Trade Services Utility (TSU) together with trade automation initiatives by a number of banks, there is now greater opportunity for streamlined trade processing. This is often part of a wider strategy by major banks to integrate trade and cash more closely, which is often an objective mirrored by corporate treasury and finance departments in order to achieve an integrated view of cash and risk. Dennis Sweeney, Bank of America Merrill Lynch describes,
“While the use of trade finance tools is generally declining in favour of open account, tools such as letters of credit provide an essential means of making transactions more secure, particularly in countries where there is less transparency over the financial standing of either suppliers or customers. In many cases, use of SWIFT TSU (Trade Services Utility) and BPO (Bank Payment Obligation) transactions is now helping customers to acquire transactions as well as providing a form of financing. As this is a flexible, electronic and automated solution, as compared with the typically more manual processes associated with trade finance instruments, it is becoming easier to integrate trade finance and cash management.”
Integrating cash and trade, typically through a centralised business function, is one example of the way in which treasurers and finance managers are seeking to minimise operational risk and maximise financial efficiency. Centralisation of treasury, payments and collections is becoming easier in some parts of the world, particularly regions that have a high degree of legal, regulatory and market infrastructure cohesion, such as North America and Europe respectively. In emerging markets such as Asia and Latin America, centralisation becomes more difficult due to the diversity of market conditions. However, a centralised view of liquidity and risk, and standardised processes and controls, are essential to maintain operational and financial efficiency and effective management of operational and financial risk. Therefore, even if some elements of execution need to be conducted locally, or processes adapted to local requirements, treasurers and finance managers should still aim to implement best practices in operational and financial management wherever possible. Dennis Sweeney concurs:[[[PAGE]]]
“Most companies are moving towards centralised financial operations, such as treasury and payments, and in some cases collections. While this brings considerable advantages in terms of efficiency, control and standardisation across countries, it may be difficult to introduce processes and techniques that are used elsewhere in the world in less-developed economies. For example, restrictions on intercompany lending may prevent ‘payments-on-behalf-of’ or ‘receivables-on-behalf-of’ efficiency models being applied. While these variations should not mean that treasury and financial processing should be separate for these countries, some adaptation and potentially more manual activities may be required.”
He continues,
“Wherever possible, companies should apply the same financial and operational best practices in emerging markets as they do in existing markets, and leverage centralised business functions, ERP and Treasury Management Systems (TMS) wherever possible. While there may be challenges in doing so, lack of transparency and a more challenging risk management environment may make this even more important than in traditional markets.”
Having tackled the risk management challenges of each new market, unfortunately treasurers and finance managers cannot put their feet up. While in Europe, SEPA was more than 10 years in the making, with a six-year transition to the new SEPA payment instruments, developments are happening in emerging markets far more quickly. Five years ago, there was no cross-border trade in RMB; today, RMB has overtaken RUB on SWIFT, with a dynamic offshore market and a variety of new opportunities for intercompany lending and liquidity management both within and beyond China. Consequently, treasurers need to maintain a detailed awareness of the regulatory landscape in each market in which the company operates, and adapt their risk and liquidity management strategy to take advantage of new opportunities and maintain competitive advantage. Banking partners can have a significant role to play in enabling this on-going awareness of the changing regulatory picture, as Dennis Sweeney emphasises,
“Regulations in many emerging economies are changing quickly, so the chosen bank should have the market proximity and up-to-date local insight to understand and recommend responses to these changes.”
It is unrealistic to think that financial, credit and operational risks in emerging markets can be vanquished; rather, treasurers and finance managers should focus on how they can be tamed. Visibility over cash and risk is an essential first step to achieving this which requires effective bank partnerships, the right technology infrastructure and best practices in financial management. Added to this, a healthy dose of pragmatism, flexibility and willingness to evolve policies and procedures over time will place treasurers in the best position to manage their risks effectively and leverage opportunities.
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