Factoring is a financing method whereby firms can speed up the collection of accounts receivable by assigning invoices to a third party factor. It is fast gaining popularity in mainland China, where late payment and bad debts are major concerns for companies.
Last year, the number of Chinese banks advertising factoring services increased from two to six – all new entrants were drawn by a six-fold rise in factoring over the previous year (see box on page 23). Foreign banks are also taking a keener interest in the Chinese market, with HSBC for example, opening a Shanghai-based factoring unit in October.
Certainly, improving cashflow and reducing credit risk – the two most commonly cited advantages of factoring – would be welcomed in a market bedevilled by late payment and increasingly by bad debt.
Late payment from buyers can tie up significant amounts of cash and become a major hurdle to growth and reinvestment. There would, on the face of it, appear to be huge potential for financing devices such as factoring which address this problem. A 1999 Dun & Bradstreet survey, for instance, found that manufacturing firms in China had to wait an average of 83 days to get paid, with the delay in the construction, automotive and pharmaceuticals sectors exceeding 100 days.
With factoring, a customer typically agrees to assign some or all of its accounts receivable to a factor or factoring bank in return for an upfront cash payment that covers the bulk of the amount owed minus interest payment and a factoring fee. In its fullest form, the factor takes responsibility for collecting the money owed and assumes any risks associated with bad debt. The client firm's debtors would then deal directly with the factor. This is known as factoring 'without recourse'. The financial package here would usually contain an element of credit insurance.
Factoring 'with recourse' describes a situation where, if a debtor fails to pay an invoice, the factor can still demand the return of a portion of the cash advanced to the customer. In some cases the bank may demand a mixture of guarantees, including more traditional property and letter of credit lines. This type of arrangement is often referred to as invoice discounting.
"The Bank of China and the Bank of Communications have achieved some volume in terms of domestic factoring, but what they are doing is invoice factoring, where there is a charge on receivables rather than an assignment of receivables," says Philip Cheng, China Affairs manager for HSBC Holdings in Hong Kong. Even in Hong Kong, up to 90 per cent of factoring is still on a recourse basis, he says.
Among foreign banks, most activity relates to offering factoring services to exporters. "Most interest among foreign factors is on the export side as credit references [for China-based buyers] are difficult to obtain," says HSBC's Cheng.
The treasury managers of multinationals are no longer content to give their China subsidiaries extra leeway on receivables management as was commonplace in early days of market-entry strategies. Since China's accession to the WTO, many FIEs have been under pressure to move from letter of credit payment terms to open account trading terms. "As long as the open account way of payment becomes more popular, there will be a need for a way to finance it," says Tit Khuen Pang, the Shanghai-based manager of trade services for HSBC in China. "Exporters will have little choice but to seek factoring services even though they might feel that it is expensive".
"We are looking at exporters who have been in the same trade for a long time and know their buyers well," he adds. "They may have used letter of credit in the past but are now under pressure to go to open account. For open account you need finance primarily for working capital, but some also want to cover their credit risk."
An extra source of security in export factoring is the possibility that foreign buyers of Chinese exports may already be involved with a factoring company allowing a Chinabased factor to establish a two-factor system.
Private sector working capital
"The private sector will be very interested in factoring because in many cases they have no other way of raising finance," notes Hong Kong-based Edward Jok, chief credit officer, Greater China for Sun Microsystems. "In some cases they may have clients such as Wal-Mart or ToysRus, and if they have customers of this quality, then factoring will be available to them. Funding is a particularly stressed issue for these firms as, unlike large state-owned firms, they cannot rely on preferential funding from state-owned banks."
Factoring can be extremely useful to those firms in their early stages of develop- ment with a strong order book but a lack of collateral to negotiate working capital. In many cases in China, collateral will come down to the possession of land use rights. This is problematic for many private firms that would, in any case, have to support such rights through the ongoing payment of asset registration fees.
The International Monetary Fund estimated in 1998 that China's private sector, which accounted for 27 per cent of Chinese GDP, made up only 1 per cent of bank lending. Behind these figures is the expectation that, if a large SOE gets into difficulties, the government will bail it out – a luxury that private firms cannot rely on.
There are lingering regulatory obstacles that prevent banks from covering their higher risk profiles with these firms through larger interest payments. Private equity, such as venture capital, cannot fill the funding gap, especially with public listing (a common exit strategy for such funders) remaining closed to many private firms. Indeed, only 1 per cent of listed firms in China are from the private sector.
"The big long-term prospect is for domestic factoring without recourse," believes HSBC's Pang. Such an arrangement is easy enough in the West, where two factors would commonly deal with each other and exchange information. This makes the payment situation much clearer from the factors point of view, but in China the market is "not sufficiently transparent", according to Pang, because it is rare to find both a buyer and seller that use factoring banks.
Lack of transparency is particularly serious in the private sector, where the demand is potentially greatest. In the past, many private firms had to present themselves as collectives or foreign-invested enterprises in order to receive favourable treatment from the authorities. A lack of clear ownership or management structures adds to uncertainties associated with opaque accounting procedures.
Foreign firms selling in the Chinese domestic market are also beginning to take an interest in factoring. Sun Microsystems, which imports into China through a network of about 30 independently owned Chinese distributors, is interested in the potential of these distributors making use of factoring in the future. Typical customers of these resellers include telecoms companies, government agencies, universities and banks. "There is a big difference in cultures between SOEs, who have payment terms of 180-270 days, and multinationals who plan for payment between 60 and 90 days," says Sun Microsystems' Jok.
Chong Mong Ting, managing director of East Asia Heller, agrees: "The major reason for the demand for factoring is that international holding companies are very used to factoring and they do not want their accounts receivables to be overstretched," he says. In Hong Kong, the biggest potential users of factoring services are manufacturing firms in the electrical goods, toys, watches and garment industries whose China domestic sales may now account for up to 20 per cent of income.
East Asia Heller, a joint venture between the Hong Kong-based Bank of East Asia, and GE Capital of the US, specialises in providing asset-based finance to Hong Kong SMEs. It was the first foreign financial institution to gain approval to set up a 'factoring' representative office, which it opened in Guangzhou in 2001.
Barriers to growth
China's entry into the WTO has undoubtedly improved the atmosphere for the development of sophisticated financial services. However, the use of factoring to ease the flow of receivables from Chinese buyers may raise residual fears among the authorities in Beijing over loss of control over hard currency flows. There is also a lack of clarity in Chinese law on the procedures to be followed in assigning receivables to a third party, although the 1999 PRC Contract Law does mention the right of creditors to transfer their right to collect money to third parties.
There are also more prosaic concerns, including the cost of factoring. Whereas letter of credit involves the cost being split between the supplier and buyer, the cost of open account trading (whether supported by factoring or not) falls upon the supplier.
The issue can turn on whether the interest payable to the factor compares favourably with the interest cost of procuring a standard working capital loan. "For export factoring, traders are very price conscious. Lots of factoring deals fall through because they cannot agree on a price," notes HSBC's Pang. Sun Microsystems' Jok points out that "whether factoring is cheaper than working capital loans depends on the quality of the receivables".
Lack of familiarity is an underlying problem. With non-recourse factoring, where the factor takes on full responsibility for credit risk associated with non-payment of invoices, the factor must be disclosed to the buyers. This can provoke distrust among buyers of goods relating to the financial strength of the user of factoring services.
"When factoring was first introduced in Hong Kong it was not well received by buyers," notes HSBC's Cheng. "Nowadays more and more companies in Hong Kong accept factoring, but we had a very tough time when we started nine years ago. We expect that it will be similar in the PRC, which in some ways is behind where Hong Kong was nine years ago.
"Regulation is not what is stopping things in China at the moment, it is the market," he adds. The degree of financial disclosure required may be frightening for some firms. "There are confidentiality issues involved, such as the pricing of product," says Sun Microsystems' Jok. "There are also privacy issues – for instance they may not want information about their income levels to filter back to the tax department."
Lack of support services
The paucity of supporting services such as credit ratings and credit insurance is another potential drag on the factoring market. "Domestic factoring is dictated by problems with credit reference and the collection process," says Cheng. Sinosure, China's first export credit agency, was established as recently as December 2001. It offers credit insurance to China-based manufacturers, including foreign-invested enterprises, which meet certain criteria including local content requirements. East Asia Heller's Chong, however, feels that "credit ratings are a long shot right now", with banks more likely to rely on existing customer relationships to gain credit information.