STAYING AFLOAT
In the global shift to source goods from China, risk has been shifted to China’s suppliers. Here’s what CFOs can do.
By Maria Leone and by Tom Leander

Exporters from China have always faced the same risks as exporters anywhere else in the world. “They wonder,” says Hong Kong trade finance expert Jeremy Hampshire, “Will I get paid?” But China’s suppliers are in a worse quandary, because buyers in the US and Europe are shifting more risk to them than ever before. In response, many CFOs in these manufacturing companies are eyeing an underutilized, but useful, cover called trade-credit insurance.

Trade-credit insurance has been around since the middle of the 19th century, but still remains arcane to many finance professionals. In the simplest terms, it gives buyers an added security blanket in an era when traditional bank letters of credit have fallen out of fashion. Trade-credit insurers provide cover using receivables as collateral. The amount of insurance – and the amount of collateral taken to support the transaction – depends on a credit assessment of the buyer or a group of buyers, essentially a best estimate of their ability to pay.

In China, where suppliers often bend over backwards on terms to close a deal, letters of credit (LCs) are deemed passé, largely because of their expense. In any event, the supplier, in an environment where ten rival suppliers are waiting to fill the same order, can’t afford to be picky. So the deal will be done on ‘open account’ – without an LC to ensure that the supplier’s investment of capital and time will be reimbursed. Without these time-honored constraints, a foreign company might order twice the amount of goods it can pay for promptly. The supplier, in order to get the job and continue the relationship with the customer, might accept the terms. But if the buyer reneges on the terms, it is the supplier that loses. A trade-credit insurer will evaluate the ability to pay of a single buyer, or pool of them, assessing the total risk to the supplier, and establishing the limit of insurance and the premium.

Often the CFO of a selling company will turn directly to a middleman like Hampshire, who is managing director of Hong Kong-based Trade Line, a broker in trade credit and political risk insurance. Sometimes banks, which have long-standing relationships with clients, insert themselves into the transactions as a part of an overall service, buying the receivables as a means to support the transaction on both sides – as the finance manager for the buyer and as receivables financing for the supplier. In this case, the bank applies for trade credit insurance. A broker’s role is to assess the feasibility of a deal at the outset, and to arrange for the most cost-effective cover, usually among one of the five global leaders in this business: Euler Hermes, AIG, Coface, QBE, or Atradius Trade Credit Insurance.

Outside of Europe, market penetration for trade finance coverage is still nascent. In the United States, fewer than 5% of companies buy it, according to the Credit Research Foundation, a nonprofit research group in the US. In contrast, 40% of European companies do. Tradition and culture help explain the disparity. Cross-border trade has been a fact of business life for centuries in Europe, yet many executives there harbor a deep mistrust of foreign receivables. Europeans also tend to have a lower tolerance for risk than Americans, says Neil Leary, CEO of Atradius Trade Credit Insurance, the US unit of Netherlands-based Atradius. By far, the greatest appetite for foreign receivables exists in Asia, where less than 1% of companies buy the coverage, according to Hampshire.

The low percentage of coverage in Asia is counterintuitive, especially because economic forces affecting trade flows have intensified the exposure for Asia’s CFOs. China’s trade surplus will reach US$138.4 bn by the end of this year, according to economists at UBS, and in the first seven months of 2006 has increased 51% to US$76 bn. Moreover, many industries are undergoing consolidation – think retail and telecom, to name just two – making customer-concentration risk a growing concern for many companies.

In fact, the risk of buyer default has increased for Chinese suppliers. Smaller, less credit-worthy enterprises in the US and Europe can convince suppliers to operate on open account simply because of the competitive landscape in China. But the growth of major Chinese exporters, some of which have experienced financial problems of their own, has added a new edge to the risks facing Chinese suppliers. Guangdong Kelon, the white-goods manufacturer, has declared losses of 3.7 bn renminbi this year after disclosing an alleged fraud connected to its former chairman Gu Chujun. Hampshire says that Kelon was forced to delay payment to many of its suppliers.
“A sale is a gift until paid for,” says Hampshire. “Sales teams can sell like hell. But what good is it if Chinese companies are getting too many bad debts?”

Are You Credit-Worthy?

In the US insurers are amid a growing market for trade-credit insurance. The Credit Research Foundation anticipates double-digit growth in these sorts of policies for the next few years. One reason: bankers are pressing clients to buy policies so that they qualify more readily for larger loans.

That’s what happened at Magellan International Trading, a privately-held specialty-steel distributor in the US. At his banker’s urging in the early 1990s, CFO Keith Weiss securitized the company’s receivables and bought trade-credit insurance in order to qualify for a line of credit. Magellan’s bankers were concerned that the distributor’s customers – foreign and domestic steel fabricators – might renege on payments. Magellan’s policy offers the company several advantages, Weiss notes. For one, Magellan is permitted up to an 85% advance rate on its line of credit. Without the policy, he says, Magellan could be financially hamstrung, limited to a far lower advance rate.

Weiss says his insurer provides another valuable service: the credit limit written into the policy works as a short-term braking system. Magellan’s insurer provides “a second set of eyes to evaluate a buyer’s creditworthiness,” Weiss says, until his staff collects enough payment data on a new customer to make a reasoned decision. If the insurer deems a particular Magellan customer too risky to cover, Magellan may use that rejection to negotiate better terms from that customer.

Still, relying on an insurer for key business decisions does have drawbacks. After all, an insurer does tend to be far more conservative than a growth-oriented CFO. “Atradius pulls the plug faster on a company than we do,” Weiss says of his carrier, although he says that it can be beneficial to use the coverage to “help keep a tight leash on customer payments.”

Insurers are intensely sensitive to the first signs of trouble. Their massive and sophisticated databases are churning continually with up-to-the-minute financial information on tens of thousands of public and private companies. Armed with data, insurers often are the first to detect even the faintest whiff of financial trouble in the market.

Trade-credit insurance is fairly broad in its coverage, but it does have some limitations. Policies typically cover instances in which customers simply can’t pay their bills, such as insolvency or natural disasters. Some receivables that are 90 days past due may be covered as well, depending on circumstances. Policies also cover receivables that go unpaid because of war or currency-exchange problems. However, trade-credit insurance won't typically cover receivables that go unpaid because of business disputes over defective products or late deliveries.

Increasingly, there’s a governance aspect to the problem of coverage. The Sarbanes-Oxley law requires proof of adequate risk management systems at US-listed companies. Finance executives of public companies that take a hit to the bottom line because a buyer reneges on a contract will be asked by shareholders why coverage wasn’t obtained. Hampshire recalls a finance manager in Hong Kong who investigated, then rejected credit insurance coverage as too expensive. Three weeks later, one of the company’s major buyers declared bankruptcy. “She was out the door within hours,” Hampshire recalls.

“When that bad debt comes along, it is just going to decimate the balance sheet,” says Hampshire, who then outlines the risk in graphic terms. “A company that is on a 2% margin,” he says, “for every million dollars that they lose in bad debt, they have to do US$50m to make it back.”

Feeling secure yet?