This article first appeared in June’s issue of FOCUS Magazine, the official publication of the China-Britain Business Council and British Chamber of Commerce in China. Learn how you can read the current issue here.
Many British companies pay their Chinese business partners in US dollars, despite the fact they operate in British pounds. But for businesses based outside the US, relying on dollars can lead to hidden fees and unseen risks that can hurt your bottom line.
Don’t be limited by US Dollar. There are now other alternatives for payments to China (Picture: FOCUS Magazine)
Why Do We Use Dollars?
For developed economies, it’s more convenient. Businesses purchasing goods or services know their supplier abroad will accept dollars, and suppliers quote invoices in dollars because they know their partners can pay in them. But UK companies getting paid in pounds, and Chinese companies buying raw materials in RMB are both paying currency conversion fees for these same dollars.
The Hidden Cost of Conversion
Savvy travellers steer clear of airport currency conversions, but few businesses question banks when making overseas transactions. Businesses need to be diligent in performing their own conversion calculations and ensuring they understand the mid-market rate. This is the mid-point between the buy and sell price in the currency markets, increasingly known as the real exchange rate. Deviance from this rate means that money is being lost in the transaction. In the UK, converting from pounds to dollars means losing between one to four percent depending on the amount. Smaller payments lead to greater fees, which means small and medium-sized businesses pay the most. And while companies usually account for every expense, few record their exchange rate loss or their payment processing costs. Things are even more confusing on the supplier side, where the dollars received must be converted to RMB. Luckily, converting foreign currencies within China is a far cheaper transaction, with currency conversion losses ranging between 0.5 to one percent.
Putting a Price On Currency Risk
Owing to varying exchange rates, suppliers need to protect themselves from USD-CNY currency fluctuations. The time between issuing their invoices and receiving payment can take two to three months – and anything can happen. In August 2015, the RMB was devalued by over three percent in just two days. Buyers in the UK should also worry about currency risk. If British companies do not maintain US dollar accounts (at the expense of cash flow), a depreciating pound versus the dollar would mean more expensive goods or services when it comes to the settlement date. Europe’s more mature financial markets allow companies to hedge products to fix an exchange rate for a set time in the future. But Chinese suppliers are often forced to take a cruder approach; they increase the invoice’s value to include a ‘buffer’ against any potential currency fluctuation. In general, this currency risk hedge used by suppliers is around 5 percent. If the RMB devalues against the dollar, then the supplier wins twice – but is unlikely to pass the savings on to you.
Costing It Up
Taking all this into account, value leaks from every transaction. Small business might lose up to 10 percent per invoice, just for paying with dollars. The wrong approach is to see part of these losses as ‘not our costs’. The invoice price versus production cost is all that matters. By reducing your suppliers’ costs you should also decrease the costs of the goods or services being purchased.
Obstacles to Change: Tax Avoidance and Inertia
One factor behind Chinese suppliers’ preference for US dollar settlements is tax benefits. Exporters in China may set up offshore bank accounts in jurisdictions such as Hong Kong, Singapore and Taiwan. After receiving payments to these locations, the Mainland company re-invoices the offshore company at a lower price, leaving the majority of profits in offshore accounts – which, owing to looser financial regulations, are more liquid and flexible. Furthermore, the exporter only pays taxes on the small margin between their expenses and the new invoice. Despite the conversion costs, tax savings are a big incentive for suppliers to avoid seeking any other solution. Unfortunately, this can sometimes scupper attempts to improve the payment process.
Breaking the US Dollar addiction in trade with China
Times are changing, however
China’s stellar economic growth is slowing, and regulators are realising that well-earned export profits are languishing outside the country’s coffers. On-shore settlement will soon be the only available option for payments to China, and suppliers will be looking to optimise margins. The other big obstacle to change is familiarity. Processes have been established around using US dollars in trade, and asking either company to upend years of tradition can be challenging.
What Are The US Dollar Alternatives?
As a British company making purchases from China, the obvious alternatives are RMB or pound settlements. Either option means that payments are only subject to one conversion loss, and one dimension of currency risk.
The Rise of the Redback
Increasingly, companies are turning to RMB settlement. By paying in RMB, the supplier no longer has to worry about currency fluctuations, and discounts should be more easily negotiated. According to a 2014 HSBC survey, 55 percent of Chinese suppliers are willing to give discounts of up to five percent if the buyer can settle in RMB. A prime example is British supermarket chain Tesco. Realising the possible savings gained through clever currency management, the company has insisted that all Chinese suppliers accept RMB settlement. By controlling the payment process, Tesco has minimised the value leakage during transactions.
Pounds Are Good Too
While Chinese suppliers should technically prefer RMB settlement, it’s not always an option – and in this case, UK businesses should push for invoices in pounds. This still pins the currency risk on the supplier, who will implement the usual price buffering. However, at least the payment undergoes only one conversion, which ideally should be performed within Mainland China where exchange rates are better.
Weighing Up Your Options
The US dollar is still, without a doubt, the world’s dominant currency, but thanks to a fast-evolving cross-border payment space, it is no longer the only option. Investigating new payment solutions takes time, but long-term rewards will more than cover the investment in research. It is no longer acceptable to ignore the costs of dollar overuse. By taking responsibility for the total cost of cross-border payments, businesses can improve their bottom line.