Growth in cross-border trade, coupled with an increased incidence of natural disasters and adverse events, has left many Asian corporates more aware if the operational risks to their business.
Recent catastrophic natural disasters, political unrest in certain countries and concerns over the crisis in the eurozone have made corporates more aware of the need for effective risk management across their businesses – and Asian companies are no exception.
Increasingly, they are recognising the need to guard against risks associated with trading in a more difficult economic and financial climate globally, as well as the operational risks inherent in their own international and regional supply chains.
“When you talk about the risks faced by Asian companies, apart from operational risk, today the biggest risks are market risk, credit risk and settlement risk,” says Joseph Sum, head of corporate trade product for APAC at Bank of America Merrill Lynch (BofAML). He identifies market risks associated with the global economy, the slower than expected recovery of the US economy and foreign exchange risks as very pertinent to Asian exporters.
“From a seller’s risk perspective, the biggest risk is usually still the risk that he will not be paid. This credit risk will affect liquidity and subsequently have a big impact on operations.”
However, strong growth in intra-Asia trade flows is helping to alleviate some of these concerns, says Ken Stratton, managing director and global head of sales, global transaction services (GTS) at DBS.
“Traditionally, Asia has been very susceptible to adverse economic events in regions such as the US and Europe. However, because of the transformation taking place in Asia – and China and India in particular – we have seen significant growth in intra-regional trade flows,” he says. “While trade relations with the US and Europe remain important, these intra-Asian trade flows are currently offsetting a drop-off in trade flows with Europe and the US.”
For many Asian corporates, the importance of managing operational risks has been accentuated in recent years by the growing scale and complexity of their own supply chains, which now span multiple markets.
“To really optimise an international physical supply chain, companies had to expand the network of supply chain participants which naturally increased the complexity of, and risks within, the supply chain,” says Simon Constantinides, regional head of trade and supply chain, Asia Pacific at HSBC.
Meanwhile, Jonathan Heuser, head of corporate trade advisory and solutions delivery, Asia Pacific at JP Morgan treasury services, explains that growth in intra-Asian trade has added to the complexity of supply chains, which are no longer focused on the creation and delivery of goods for western markets.
“Many Asian companies are now experiencing ongoing changes in their supply chains in terms of both the consumer markets they serve and the markets from which inputs are sourced,” he says, noting that this development calls for higher level, strategic supply chain management.
“In the past, many companies relied on the arbitrage achieved by low-cost sourcing; they would source in a low-cost country and sell into a higher cost market. But their models here are also changing. China, for example, is an evolving story on two fronts: it is an increasingly important consumer market and, on the supply side, can no longer be seen as competing only as a low cost provider.”
The increased incidence of both geological and hydrological disasters in the Asia Pacific region has also increased awareness of operational risks.
Kuresh Sarjan, head of Asia trade and supply chain at Bank of America Merrill Lynch, explains that crisis events and disasters experienced in the region over the last year alone have brought supply chain risks to the fore.
“In terms of operational risks, this has been a year like no other with the tsunami in Japan and the flooding in Australia and New Zealand bringing into question the just-in-time model that many Japanese companies follow,” he says.
“The flooding in Queensland set back iron ore shipments in the first half of 2011. When companies become exposed to events like this, they do start to look more closely at how their supply chains are organised.”
Physical supply chain risks
Such events have highlighted the need for Asian companies to guard against physical supply chain risks that may threaten not only their ability to maintain production levels and meet orders on time, but also dent their bottom line.
Today they are becoming increasingly aware of supply-side risks – the possibility that their suppliers may not be able to deliver much-needed inputs on time as a result of disruption to their businesses or a major crisis, as well as the worst case scenario of a key supplier suddenly going out of business altogether.
“There exist a number of operational risks to effective supply chains which include supplier downtime, caused by a breakdown in the manufacturing process, to supplier failure and/or bankruptcy,” says Stratton at DBS, adding: “In times of economic hardship, production line breakdowns can be an issue as suppliers reduce production line maintenance to free up cash.”
HSBC’s Constantinides also acknowledges that one of the biggest risks corporates face in their physical supply chains is “managing the ability of suppliers to deliver the right product, at the right price and at the right point in time”.
“To mitigate this risk, buyers should have a diversified supplier base as this not only enables companies to manage the physical risks but also the financial risks within the supply chain,” he says.
“A key consideration for buyers must be to identify good quality suppliers, be more strategic in how they manage relationships with their suppliers, and diversify their supplier base,” adds BofAML’s Sum. “To alleviate the risk of a supplier having financial problems, the best solution is supplier diversification, and this is now a major aim for many buyers.”
Finding the optimal balance for supplier diversification is key.
Constantinides explains that if a small company has 50 suppliers and one fails, such diversity provides flexibility to move production. Being able to effectively manage a diversified supply chain is absolutely critical; hence the number of suppliers must be controllable to be effective.
“If you rely 25% of your product on a single supplier you will have the ability to effectively understand the risks and behaviours within this supply chain quite well – both the physical and financial impacts,” he says. “On the other side of the equation, if you as a company account for only 1% of that supplier’s business, you will have no relevance in the overall equation. If you account for 75% of their business, you will have a bigger influence.
“It is all about getting the balance right. Companies have to look at all their relationships and the risks emanating from these dependencies.”
JP Morgan’s Heuser adds: “Companies can manage physical supply chain risks by having a diversity of inputs and holding higher levels of inventory, but there is always a trade off here as it can lead to more diverse and complex supply chains – as well as reducing economies of scale.”
Country risk is another important risk that has to be factored into this equation, and corporate buyers are advised to consider different countries’ political situations when selecting the suppliers they rely on for components.
“It is important to consider, for example, does your company source or sell 100% from a supplier or buyer in countries such as Taiwan or Pakistan, bearing in mind the political tensions they have with their neighbours,” says Stratton.
The right level of inventory
The recent crisis events in Asia have also drawn attention to the levels of inventory that major companies maintain to ensure the availability of inputs.
Recent years have seen more Asian companies adopt just-in-time production methods to reduce in-process inventory and the costs associated with carrying it on their balance sheets. By delaying taking ownership of components until they are actually needed in their own manufacturing processes, they have been able to improve their own financial performance.
However, reliance on this model revealed some weaknesses in the aftermath of the Japanese earthquake and tsunami in 2011, which impacted the ability of many companies to source the components they needed to maintain production levels.
For example, leading car manufacturers such as Toyota, Honda and Nissan, were forced to cut back production at factories in Europe and introduce shorter working hours for several months because of the unavailability of key components made in Japan.
There are also concerns that Asian manufacturers’ use of the just-in-time model has increased financial pressures on smaller suppliers.
“There has been an ongoing trend for many years for buyers to push inventory holding onto their suppliers. This not only impacts the suppliers’ working capital, but suppliers can get hit with the risk of product obsolescence through holding too much inventory for too long,” says Stratton.
However, he also notes: “Over the last 10 years, many companies have looked at ways in which they could get inventory off their balance sheet as early as possible, which sometimes included the use of special purpose vehicles (SPVs).”
Another solution to this problem is the more widespread adoption of the vendor managed inventory model, which involves the buyer providing its suppliers with electronic access to information on its own orders and sales so that the latter can more accurately forecast the buyer’s requirements.
Risks to production
Aside from supplier risks, many Asian companies also now recognise that their own factories and production lines can represent a major physical supply chain risk if they are too concentrated in a specific region or geography.
Having seen their manufacturing businesses hit by the Japanese earthquake at the start of 2011, some major Asian companies experienced further disruptions to production by severe flooding in Thailand in October.
Here, HSBC’s Constantinides points out that managing such physical supply chain risks brings costs: “There are two different dynamics when it comes to managing this type of physical supply chain risk. Some companies may gamble against a once in a 100 year-type disaster ever happening, whereas others may invest in new factories based somewhere else,” he says. “There is no perfect answer to this. Businesses generally want to guard against the possibility of redundancy in their factories because they need to stay competitive.”
Financial supply chain risks
When it comes to managing supply chains risks, two main risks need to be considered: sell-side risks, namely the risk that a company will not be paid by its buyer, and buy-side risks – the risk that a company’s suppliers will not have the financial capacity to meet orders accurately and on time.
A number of financial products are now becoming more widely used across Asia to mitigate buy-side risks and ensure that suppliers can access the finance they need to meet required production targets.
“During the last financial crisis, liquidity was scarce and financing costs increased. This really hit suppliers that were providing key components to buyers,” explains JP Morgan’s Heuser, pointing out that the financial crisis precipitated the movement towards supply chain finance in Asia.
“Supply chain finance makes logical sense for companies because it provides a ‘win-win’ situation for both buyers and their suppliers.”
“Historically, a supplier would continue to face payment risks after its goods were shipped up until the point of receiving cash in hand, but supplier financing enables them to simply access a platform and seek confirmation of payment – and receive it – much sooner,” adds Sum.
Although in the past, supply chain finance in Asia stemmed from international structures, Bank of America Merrill Lynch is now setting up programmes locally between buyers and suppliers in markets such as Korea, China and Japan.
“We are seeing increased demand for supply chain finance programmes – and the big change is that buyers are now approaching their banks to see if they can arrange facilities, rather than things being the other way around,” says Sum. “There is a growing recognition that supply chain finance brings benefits for the buyer as well as the supplier.”
Greater financing flexibility can also be achieved with supply chain finance, and this is recognised as providing even greater comfort to buyers because it facilitates their ability to source more components from a chosen supplier should the need arise.
For example, should a buyer’s receipt of key inputs from one supplier in a programme come to a halt as a result of business disruption or a crisis event, more money could be made available to another supplier in the programme so that it can increase its production – and make up any shortfalls experienced by the buyer.
“Supply chain finance is a robust structure that provides a lot of flexibility. There is not a credit limit placed on the individual supplier so credit can be channelled to where it is needed most,” says Heuser. He notes though that differences in the legal or regulatory environments that suppliers work in – and their use of different currencies – can present potential challenges to the flexible delivery of a supply chain finance programme.
“Traditionally, bank facilities were limited to the size of that facility. However, with supply chain finance, in most cases, there is not a limit placed on a particular supplier. The total programme size limit is based on the buyer as the risk is based on the buyer not the supplier,” concurs Sum.
“This means that from a supplier’s perspective, if it suddenly faces a much larger order, it can turn around the cash needed quickly to meet that order. Supply chain finance improves the supplier’s ability to meet bigger business volumes.”
Stratton is also enthusiastic about the merits of supply chain finance: “The supply chain finance model is an important proposition as this model, if structured correctly. It can significantly lower the cost of funding as the underlying risk hinges on the smaller entities’ relationship with the anchor buyer or supplier,” he says. “By leveraging the tight working relationship with their anchor client, the smaller client can gain access to reduced funding costs of the goods in the transaction flow.”
A risk for banks
Various types of supply chain finance are available to mitigate risks relating to the financial capacity of suppliers, including post-shipment finance and pre-shipment finance, although most banks typically favour the provision of the former.
Here, HSBC’s Constantinides points out that offering pre-shipment finance is higher risk for banks and companies that provide it as it involves:
Supplier performance risk – the supplier may not meet the order as required; Supplier financial risk – the supplier may use finances obtained for other purposes (or even not be financially stable);
Buyer contract risks – the buyer may renege on the financed order.
“Purchase order financing is available but not easy to manage without true on-the-ground presence. A bank offering this type of financing needs to have a presence in the country where the suppliers are based so that it can understand the risks involved,” he says.
Bank counterparty risks
The financial crisis of 2008/09, and resultant squeeze on bank lending, has also left many Asian corporates more aware of bank counterparty risks.
Stratton explains that before 2008 there was a shift by many Asian corporates to reduce the number of banks with whom they transacted. Their intention was to gain leverage from directing all their business to a lesser number of bank providers, thus gaining reduced fees and bank charges. But they then “learned a valuable lesson”.
“During the global financial crisis and the resultant liquidity crunch, a number of banks pulled credit lines, so over the last two to three years, corporates have been looking to increase the number of banks they work with, with a focus on large Asian regional banks,” he says.
Meanwhile, Sum points out that although the risks presented by banks in supply chain finance programmes are not direct risks, there may be a risk to the continuation of a programme.
“Where a supplier is very reliant on supply chain finance as a financing tool, and the bank cannot continue with that programme, then there is a risk that the supplier will lose planned cash flows,” he says. “What many buyers would prefer, however, is to have less dependency on any one bank. They are less concerned about bankruptcy than they are about strategic constraints, and therefore will seek to diversify their dependency by using more than one bank.”
He adds that where an international programme is set up, it is very unlikely that one bank will provide all of it – unless it is a top 10 bank – and bank counterparty risk is thus a lesser concern.
“However, when it comes to domestic programmes, pricing is a key driver,” he continues. “If you try to share a programme between banks, you are likely to have less bargaining power.”
“Some companies choose multiple bilateral programmes in an effort to manage the risk of relying on a single bank and to widen their access to liquidity and onboarding resources,” adds Heuser.
But he also notes: “They do have to guard against the possibility that their programmes may become too complicated to manage. From a technological integration perspective, having different partners can also bring challenges, so many companies prefer a single party to own the entire programme.”
Constantinides concludes that to mitigate bank counterparty risks today, corporates have to make sure that they have the right banking partners, and that their bank relationships are diversified. While many Asian traders bank with local banks, they also need the services of an international bank.
“We are also hearing that Asian customers are now becoming choosy as to which banks’ letters of credit they will seek. When a company makes and ships products, it needs to ensure it gets paid for the shipment,” he says. With the economic operating dynamics being quite different between Asia and Europe, this is all part of effective financial supply chain management.
“The most common practice used here is to have one bank assume the credit risk of another bank, as well as the country risk. Banks working with banks to support one another is now a well-established practice.”