I’ve recently made my third trip to China this year. At a conference I joked that, if my increasingly frequent trips are any kind of lead indicator then the supply chain finance market there is about to explode.

We’ve talked about the terrific upside opportunities in China many times on these pages. However, there is a ‘but’. Yes, there is exponential growth in supply chain finance and yes there is exponential growth in the kind of game-changing business models that, by their very nature, compel a rethink of how the financial supply chain actually works.

The time is right to sound a note of caution, however. There is a trend emerging in China that, if left unchecked, could see a rerun of the risk environment that emerged in Italy in the 1960s. That probably surprises you because, apart from rapid growth in GDP, you might think that there is very little in common between post-war Italy and 21st century China. And yet it was Italy in 1963 that saw the birth of the modern concept of factoring – of allowing suppliers to get finance on the back of their customer invoices. A new Italian law specifically allowed for factoring, but required that factoring businesses be separate entities from the banks themselves. Some were bank-owned, but others were owned by the large industrial groups.

That is the crucial overlap between Italy then and China now: the factoring industry was largely fuelled not by the banks but by the big corporations who used their cash surpluses to fund their smaller suppliers. The big manufacturers developed in-house factoring operations.

No doubt one motivation for Italian corporates was to help support their suppliers. But that surely was not their only – or even their prime – concern. The truth is, the finance arrangements were structured not as early payment in return for purchase price reductions to help the bottom line, but as finance income on the top line of the profit and loss account, generated by interest receipts from loans to suppliers.

In a steady state of affairs, the net effect may be the same (assuming perfect arbitrage between a price discount, on the one hand, and a straight financing charge on the other). But the revenue-boosting way that Italian companies arranged supplier finance gave the impression that they were somewhat bigger companies than they were (remember that accounting standards were essentially non-existent in those days). Likewise, on the balance sheet, cash foregone was swapped out for another asset, loans owed to the company by suppliers, rather than a reduction in accounts payable.

Suppliers were financed but not paid

In this simplistic environment, suppliers and buyers were both facing increasing risks. From the supplier perspective, they technically still owed those borrowed funds to their customer: if they had 120-day terms, took finance on day 30 and their buyer went bust on day 50, the supplier would have to return the funding, even though they themselves were owed that money by their now-defunct buyer. A painful double-whammy of having to repay 100% of a loan while probably receiving back a fraction of that on the trade receivables side.

From the buyers’ perspective, it suited the big manufacturers to really stretch payment terms – a long-standing characteristic of Italian business dealings – while getting their suppliers over a financial barrel. It made the buyers’ P&L and balance sheet look good. But that increased the risk to the supplier base – and if a supplier failed, the debt owed by the supplier might have to be written off while the trade payable obligation remained: the supplier had been financed, but not paid.

Ultimately these financing operations became too big and unwieldy: the financing tail was wagging the corporate dog. Corporates offloaded their in-house factoring units to the banks, marking the entry of financial institutions into the supplier finance business.

Imbalanced revenue

Let’s get back to China. Large companies in China today are developing their own in-house bank solutions, mirroring in many ways what we saw in post-war Italy. A number of large companies (including state-backed companies) are using their own balance sheets to lend to their suppliers, pushing payment terms to the extreme – out even as far as 260 days or more – and gaining a lot of additional revenue from these activities. At the conference I mentioned at the start of this column, Professor Song Hua of the Business School of Renmin University of China referred to companies that engage in such practices as “supply chain finance hooligans”: in some cases, half of their top line comes from these financing activities. It’s clear to me that such an imbalance in their revenue generation between financing income and operational income is a recipe for disaster – for buyers, for suppliers and for industry generally.

Of course, there are many businesses in China whose corporate behaviour is beyond reproach. For them, financing suppliers is a means of enhancing their stability and derisking their supply chains.

Policy responses

For the others, however, there are two possible government responses that could do much to defuse this rapidly-escalating situation and ensure that the risks not far over the horizon perform a 180-degree turn.

The first policy initiative would be to introduce a cap on payment terms, as we’ve seen in countries from the Netherlands to Australia. Small and medium-sized (SME) suppliers in particular are at risk of being taken advantage of: desperate for the extra revenue, they’ll grudgingly, painfully concede cash flow and profit margin, just to win the business and keep their workshops busy. Putting a payment terms cap of, say, 30 days for SME suppliers would mirror the sort of industry-conscious initiative we’ve seen in many countries. Defining what an SME is may be a challenge, as will the need to ensure that companies wanting prompt payment are, in fact, qualifying SMEs. But these are surmountable hurdles and there is plenty of precedent around the world on which the Chinese authorities may draw.

The other policy measure that would help enormously would be if the Chinese authorities reformed and clarified the law relating to non-recourse financing. This would be a big step towards enabling the kind of supply chain finance that we understand in the west – in particular, institutionally-financed reverse factoring. There is an interesting but somewhat tortuous nuance in Chinese law at present: a buyer will not confirm a payment, but it will confirm that the data on an invoice is correct. That’s a big difference, and one that means the growth of Chinese supply chain finance will continue to be biased towards in-house factoring operations – a much less solid foundation than if a Chinese buyer could easily confirm a payment to a supply chain finance prover.

Getting the legislation and the regulations properly worded is never easy, but the stability that will be created in physical supply chains and financial supply chains will bring benefits to Chinese companies large and small. It will help sustain the growth of banks and other financial institutions in supply chain finance and will ensure that suppliers can enjoy success as their customers succeed.