Emerging markets have undergone a great deal of turbulence in the last year or so. But the volatility isn’t expected to scare off the multinationals operating in those countries, given their growing importance in the global economy.
The recent hard times started with the collapse in the prices of crude oil and other commodities, a painful development for the many emerging markets that depend heavily on extractive industries.
Another problem has been the anticipation that the Federal Reserve would start raising interest rates for the first time in a decade. The very low interest rates, not only in the United States but also in Europe and Japan, resulted in a flood of capital flowing into emerging markets as investors sought a better return on their cash. The fear is that Fed tightening will cause much of that money to flee the developing world.
China and Brazil, the two largest emerging markets, are in very different places. China continues to grow, although at a slower pace than previously, while Brazil has toppled into recession.
What the two have in common, though, is that they are among the emerging markets that pose special challenges to corporate treasuries because of regulations imposed in areas like foreign exchange.
Overview of Investment in China
China’s slowdown resulted from its government’s effort to retool the economy, moving it away from an orientation toward heavy industry and exports to one dominated by domestic demand and consumer-oriented goods and services.
China’s GDP is expected to grow about 7% this year, which is a drop from the double-digit growth rates the nation was posting just a few years ago, but still far ahead of the growth projected for developed nations like the U.S.
Jan Randolph, the London-based director of sovereign risk for economic consultancy IHS, noted that the Chinese government has the wherewithal to support the economy if it slows too much. “They can manage the situation; they have the administrative and financial resources to manage it,” he said.
The slowdown hasn’t discouraged big companies from operating in China.
“China today is the second-largest country, ranked by GDP at $10.4 trillion, just behind the U.S. at $17.4 trillion,” said Kelvin Ang, director of the treasury advisory group at Citi Treasury & Trade Solutions. “What this really means is that companies cannot ignore China; they absolutely cannot lose interest in China.”
And while China’s expansion has slowed, “it is still growing at a very strong pace compared to any other developed countries out there,” said Ang, pictured at left.
“China should still retain economic growth at 6 to 7% on an annual basis for the next 10 years,” said Seth Brener, head of cash management corporates for the Americas at Deutsche Bank, who cited the “continued opportunities for multinationals” in China.
“We have seen a number of multinationals further increase their investment into China,” sid Brener, pictured at left.
Ang suggested that companies will use the slowdown as an opportunity to position themselves for the next surge in Chinese growth.
“What they do now is really more from a consolidation standpoint,” he said. “They will be looking to do things that help them to gain on their competitors when the market does pick up sometime in the future.”
And although growth has slowed, the Chinese government has taken various measures in recent years that make life easier for global companies that operate there.
“China has been quickly evolving in terms of regulatory changes in the past few years, since the Chinese government began to position RMB as an international currency,” Brener said. “Quite a few regulations with regard to foreign exchange have been abolished, and new infrastructure in promoting RMB international settlement has been implemented. These are fundamental changes of the treasury landscape.”
The changes mean a corporate treasury can “treat China as part of its regional/global treasury operations,” he said, adding that things which are now possible include establishing a shared service center in China and using the Chinese currency as a regional or global liquidity management structure.
Current Rules Around Use of RMB
China has been liberalizing the rules around its currency, the renminbi (RMB), in recent years.
In 2012, China’s central bank, the People’s Bank of China, began to allow the currency to swing up to 1% a day against the dollar. China also signed bilateral swap agreements with other governments, a move that involves an exchange of currencies between the governments and in turn allows those countries’ central banks to lend renminbi to banks in their country. And China set up bilateral renminbi clearing systems with a few countries, including Hong Kong, Singapore, and the U.K.
By this year, the renminbi was the fifth most widely used currency for payments in the world, according to SWIFT.
“From a directional standpoint, a lot more companies today are doing business in renminbi than a year or two ago,” Ang said. “The reason is they want to leverage on this, to be able to create natural hedges or natural offsets in the currency exposure. They want to bring the currency management from China onshore to the offshore centers, like regional treasury centers.”
Ang noted that the offshore renminbi market, known as the CNH market, has helped companies operating in China to transfer their currency risk offshore.
“A lot of multinationals can bring that exposure out of China and have their central risk management manage the Chinese currency risk today,” he said. “It really changes the game in the way they manage these two key activities.”
Ang added that this fits with many treasuries’ interest in centralization.
“Centralizing is key to a lot of corporate treasuries. They would prefer to hedge such activities at corporate headquarters or the regional treasury center,” he said.
China’s currency made headlines last month when the International Monetary Fund (IMF) voted to include the renminbi in its basket of reserve currencies, where it joins the dollar, euro, pound, and yen.
Randolph described China’s current foreign exchange regime as “a crawling peg, halfway to free float.” China is headed toward making the renminbi a freely floating currency, but it is moving in that direction on its own timetable.
The IMF’s decision is important as a recognition of the changes China is making, he said, and it also suggests additional developments in the years to come. “In the next 10 years, we’ll be able to invest in RMB debt—corporate debt, Chinese government,” Randolph said. “That’s the sort of thing that will follow.
“China’s not a planet that moves around the U.S.,” he added. “It’s going to be its own planet.”
From a directional standpoint, a lot more companies today are doing business in renminbi than a year or two ago.
—Kelvin Ang, Citi
Shanghai Free Trade Zone
One major move was the Chinese government’s establishment in 2013 of the Shanghai Free Trade Zone (SFTZ), which was designed as a testing ground for more liberal economic regulations.
Ang said the Shanghai Free Trade Zone is the most useful of the changes that have occurred in China. “Shanghai is really the one that truly liberalizes the cross-border sweeps, which is the most useful tool for corporates these days,” he said.
In March, China announced that it would establish three more free trade zones, in the provinces of Guangdong and Fujian and in the city of Tianjin. Ang said it was too early to say what regulations might look like in the additional free trade zones.
Susan Hillman, a founding partner at Treasury Alliance Group, noted that businesses within the borders of the Shanghai Free Trade Zone “get preferential treatment in terms of what they can import and export.”
Previously, export payments required validation that involved presenting manual documentation to the bank to initiate the outgoing payment transfer, Hillman said. “It made it cumbersome to remit payments. Now, pilot programs within the SFTZ—and other arising trade zones—are liberalizing export payments for certain goods and services that allow electronic presentation of documents, which expedites the cross-border transfer.”
Hillman noted that China’s banks have also become more sophisticated, moving over the last decade from a reliance on cumbersome, paper-based systems to electronic banking. Big Chinese banks now have “very well-developed electronic banking and lots of well-developed cash management services that are often delivered in a partnership arrangement with one or more of the large global banks,” she said.
The development of the banking system has allowed for more centralization of companies’ treasury and cash management operations within China, she said, although companies still need a bank account for paying taxes in each region in which they operate.
“Some large companies have set up shared service centers for processing payments, either for a region or all of China,” Hillman said. “This would not have been possible a few years ago because of the lack of bank connectivity and infrastructure.”
Brazil Battling a Recession
Brazil’s current situation is much gloomier than China’s. The country was hurt by the global slowdown in growth and the plunge in commodities prices. Amid the slowdown, the government’s deficit grew rapidly, leaving President Dilma Rousseff struggling to cut spending. Brazil’s problems have been compounded by a corruption scandal at state-controlled oil company Petrobras.
“After seeing its economy quadruple from 2003 through 2010 in dollar terms, the nation is now suffering from a rout in commodities prices, soaring inflation, and a growing fiscal budget gap,” said Kika Ricciardi, head of global transaction banking for Latin America at Deutsche Bank, pictured at right.
A recent survey of Brazilian economists showed they expect the nation’s GDP to contract by 3.5% this year and 2.3% in 2016.
Meanwhile, the president has been threatened with impeachment. And earlier this month, rating agency Fitch cut its rating on Brazil to junk level, matching the current rating from Standard & Poor’s Corp. A pair of junk ratings could well force some institutional investors to sell their holdings of Brazilian debt.
But again, as with China, Brazil’s economy is too large for companies to ignore it.
Citi’s Ang noted that Brazil’s GDP is the world’s seventh largest, at $2.3 trillion, which puts the country just behind Germany and ahead of Italy. “And from a regional standpoint, they account for about half of Latin American GDP,” he said. “We don’t see a lot of companies pulling out; they are there to stay.”
Ang said, though, that the current situation in Brazil has pushed many companies into “a consolidation phase.”
“They are taking the opportunity to rationalize their operations,” he said. “Indeed, because the valuations in certain companies are also attractive today, a lot of them are contemplating merger and acquisition activities.”
In addition to the current economic and political problems in Brazil, companies have to deal with other obstacles, Ricciardi said. She cited “the high costs” associated with many aspects of doing business in Brazil, such as setting up an infrastructure, the tax burden, a costly labor force, and logistics including the fact that almost all transportation in Brazil occurs by road rather than rail. Those factors in doing business in Brazil have been dubbed “the Brazil cost,” Ricciardi said.
“One way the Brazilian government boosts the local industry is by requesting a high percentage of Brazilian content in the products in order to obtain any government finance,” she added. “Therefore, many multinational corporates choose to partner with local businesses.”
Multinational companies increasingly have been pursuing the regionalization and centralization of their treasury activities in Latin America, Ricciardi said, noting that that often involves establishing shared service centers for the region.
FX Restrictions in Brazil
From a treasury perspective, the biggest challenge in Brazil is the restrictions on foreign exchange.
The difficulties that corporates face in Brazil are similar to those seen in China before the institution of free trade zones, Ang said. “They are not able to freely move cash out of Brazil.”
Treasury Alliance Group’s Hillman notes while Brazil has FX controls still in place, the country has had one of the most electronic banking systems in the world for decades.
Brazil’s foreign exchange controls mean companies can’t have dollar accounts; they can only have accounts holding local currency, Hillman said. “If you are exporting, the payment currency is U.S. dollars. But as soon as the payment is received, it has to be converted immediately to [Brazilian] real,” she said. “The exchange control process is pretty automated and efficient, but it still is a limitation in Brazil.
“Excess cash is not a good idea in Brazil as there are limited short-term investment opportunities and there are taxes imposed on financial transactions—including sweeping funds into short-term investment accounts,” Hillman said, so “it’s best to keep the company in a low-cash or slight borrowing position.”
Another challenge for companies is the volatility of the Brazilian currency. The real (BRL) was trading at 3.76 to the dollar on Dec. 9, after starting the year at about 2.65 to the dollar.
Ricciardi noted market expectations for further weakening in the Brazilian currency, and said Deutsche Bank’s official forecast puts the real at 4.10 per dollar at the end of this year and 4.00 per dollar at year-end 2016.
“Most corporates with operations in Brazil have long BRL exposures across balance sheet, cash flows, and net investment,” she said.
Given the currency outlook, “leaving those positions unhedged may be very costly in case of further BRL weakness, but hedging with committed hedges may be expensive because of huge carry,” Ricciardi said. “For this reason, we currently see a lot of corporates adding some optionality to their hedges, to protect against BRL depreciation and maintain participation in favorable spot moves. However, as the cost of ATMF [at-the-money forward] options has increased, corporates have showed interest in solutions whereby they buy cheaper downside volatility or sell high levels of implied volatility.”
Ricciardi also cited the lack of predictability in Brazil’s tax regulations. “Since this is an aspect used as a tool for economic policy, it creates more barriers for multinationals to operate in the country.”
The challenges companies face in Brazil related to foreign exchange controls and taxes contrast with the sophistication of the country’s banking system, Hillman said. “There’s a big move to have shared service centers in Brazil because of the efficiency of the Brazilian system.”