In China, Cash is (Still) King!

0019b91ed7d11152229210Over the past several months, stories that China is running short of cash have become prevalent. For example, a recent Wall Street Journal article featured Xie Daoliang and the financing issues faced by his company, a Chinese manufacturer of bulldozer treads for heavy machinery. A U.S. capital goods company looking to enter China asked for my opinion.

The article explained how China’s cash shortage is bringing IOUs to the forefront. The use of acceptance drafts, a piece of paper with a value printed on it and a promise from a bank that it will pay at a specified date in the future, is growing as the country’s economy slows and banks hesitate to lend. In explaining his company’s dilemma, Mr. Xie said that when he makes a sale today, he seldom gets paid in cash and instead receives acceptance drafts.

China’s economic slowdown may be making the cash issue worse for many companies, especially small and medium enterprises that have always had trouble accessing capital in China, but the difficulty of collecting cash has been part and parcel of doing business in the country ever since I’ve been here. Throughout the 1990s, my managers had to collect as much as 40 percent of their accounts receivable by selling trucks. Strapped for cash, it was common practice for the large state-owned truck makers to pay their suppliers with trucks. Our diesel engine customers simply passed along some of those trucks to us as payment for our components — and so it went.

By the turn of the century, this barter trade was more or less replaced by today’s practice of using acceptance drafts. While the total amount of acceptance drafts in circulation has grown since then, it still represents about 16 percent of China’s money supply, roughly the same as in 2004.

The lack of liquidity in China is part of a larger problem — the country’s under-developed capital markets. Contrary to what some may think, there’s plenty of capital in China. Like every other product in the country, though, the problem is the lack of effective distribution channels. There is simply no way to distribute the capital that is already in the country to businesses that need it. In mature markets, capital is distributed efficiently through the capital markets.

In China, established companies can obtain local currency loans from the major state-owned banks to finance working capital, but the loans are short-term and generally have to be repaid by the end of one year. The banks are good about rolling over loans, extending them for another year, but that assumes that operations are going well. If not, the banks will insist that the loans be repaid. Needless to say, it’s very difficult to run a business with this type of financing.

In the U.S., companies have a large menu to choose from when financing their businesses. They can obtain multi-year bank loans or negotiate private placements of long-term debt with insurance companies or pension funds. Companies can use sale leasebacks or equipment leases to finance capital expenditures, or they can issue equity or place mezzanine securities with a wide range of investment funds that have been established to provide such financing. In China, few of these options are available.

Doing business in China requires taking China for what it is, not what we’d like it to be. In order to address the liquidity issue, we took a number of steps.

First, we gave priority to customers with the ability to pay by consciously developing relationships with the international companies doing business in China and focusing on the best of the local companies.

Secondly, we paid salesmen based on collections, not sales. Relationships are important in China, and it’s amazing how persuasive a motivated salesman can be in getting his company’s receivable paid.

Finally, “accounts receivable days outstanding” became one of the most important metrics by which we evaluated the performance of our general managers. While 30 days is the norm at most U.S. companies, 90 days was considered very good for China, and 180 days a problem in the making.

If you are thinking about starting, investing in, or acquiring a business in China, pay attention to cash collection. A stronger economy may help, but China’s liquidity problem will not be solved until China develops its capital markets.

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