Supply chain finance: huge opportunities in MENA

As economies in the Middle East continue to grow and diversify, supply chain finance can provide a crucial source of funding while delivering benefits for both buyers and sellers, explains FARAZ HAIDER, managing director, trade head, Middle East and Pakistan, for Citi

The Middle East’s economic prospects are impressive – especially compared to the weak growth being experienced in much of the developed world. Despite political turmoil over the past 18 months in some parts of the region, the Middle East enjoyed average GDP growth of 4.9% in 2012 (with many oil-producing countries growing much faster than this average), according to the International Monetary Fund[1].

Trade within the region and with the rest of the world is also increasing. The World Trade Organization reported that trade grew 3.3% in 2012 compared to 2.6% in South and Central America, 2.3% in North America and -0.1% in Europe[2].

In most Middle Eastern countries, the overwhelming means of trade financing and the prevailing mode of transactions continues to be letters of credit (LCs). While there are multinational flows on open account through documentary collections, it is LCs and confirmed LCs that remain the dominant payment instruments for financing trade transactions.

There are concerns that changes to bank regulation will impact the ability of lower-rated suppliers to access funding. Basel III, which increases the amount of capital that banks have to hold against certain assets, is likely to constrain liquidity to smaller, lower-rated suppliers, potentially introducing risk to the supply chain. Supply chain finance (SCF), which has become increasingly popular globally since 2008, could hold the solution to companies’ funding challenges in the Middle East.

How supply chain finance works

A key feature of SCF is that it offers benefits for both the buyer and the supplier simultaneously. In a commercial terms negotiation, buyers and suppliers have conflicting objectives. Buyers want to extend Days Payable Outstanding (DPO) while suppliers want to reduce days sales outstanding (DSO). The basic principle underlying SCF is a decoupling of a supplier receiving payment from a buyer making the payment. It is this decoupling of the payment date from the collection date through a supplier receivables purchase that creates a win-win for both buyers and suppliers.

The buyer is able to extend payment terms and benefits from an enhancement of its working capital and a potential discount on the cost price. The supplier can receive its payment earlier than would be the case if they simply waited for the buyer to pay – receivables are converted to cash almost immediately without recourse to itself. Moreover, a bank forms a bridge between the two parties and using the superior credit characteristics of the buyer – and close scrutiny of payment documentation – is able to advance funds to the supplier at a much lower cost of funds than they would usually be able to borrow at. In addition, it gains the ability to sell more of its goods as sell limits to the buyer are automatically freed up.

One of the greatest benefits of SCF is hard to quantify: it helps enhance and cement the relationship between the buyer and the seller. By deciding to implement a SCF programme, a multinational is recognising that an increase in its DPO – which improves its cash flow cycle and reduces the need for working capital – has a negative impact on suppliers’ DSO. What is crucial is that the buyer understands such a move can be self-defeating and undermine the stability of the supply chain. Implementing an SCF programme can mitigate this risk, and enable a buyer to extend its payment terms, while still having a positive impact on suppliers’ DSO.

SCF feeds on its own success. Often SCF programmes begin slowly and rapidly gain momentum as the benefits become clearer to all parties. For example, a buyer may launch a programme cautiously with one supplier on board. However, on seeing the benefits to its DPO and its supplier relationships, the buyer usually wants to onboard more suppliers as soon as possible. Similarly, when a supplier is onboarded and begins to enjoy the benefits of SCF, it may approach other companies it supplies to encourage them to launch a SCF programme.

Overcoming challenges to establish SCF

Many corporates have started exploring the potential use of supply chain financing structures in their relationships with domestic and foreign suppliers. However, SCF is still in its infancy in most Middle Eastern countries and usage is behind that of traditional paper-based LCs as a trade financing tool. For SCF to take off, four impediments, which are present in every market globally to some extent, must be overcome: culture, sophistication, bureaucracy and liquidity.

The most important roadblock to overcome to enable the adoption of SCF is a reluctance to abandon paper-based method of financing. In order for SCF to gain substantial traction, businesses need to embrace open-account financing (as well as moving to electronic rather than paper-based processing). Companies around the world are also often unwilling to take the risk of being the first to adopt SCF within their industry. Those in the Middle East have the opportunity to recognise that the benefits of SCF are largely independent of industry sector.

Business culture in many countries around the world can sometimes prevent suppliers from asking for early payment, in case such a request suggests financial instability or weakness and undermines their customer’s willingness to do business with them. Companies in the Middle East can benefit by acknowledging that almost all companies, of any size, would prefer to receive payment early rather than late. Moreover, highly-rated suppliers (often with a rating higher than the customer) are attracted to SCF programmes – despite being able to source financing at an equivalent or better rate – because SCF reduces their credit risk to the buying company, enabling them to do more business.

Another concern of some companies when considering SCF is that it is perceived to be a sophisticated – and therefore unsuitable – financing tool. Before the financial crisis, SCF was not a primary means of corporate working capital optimization. Instead, only those companies that had exhausted other methods of treasury financing – usually multinationals – would employ SCF in order to uncover extra working capital efficiencies and generate a few additional percentage points on earnings per share.

However, the perception of SCF as being a tool for fine-tuning an already sophisticated treasury is mistaken. Since the financial crisis, SCF has become a mainstream financing tool for achieving balance-sheet efficiency and enhancing working capital. Companies in the Middle East – regardless of their level of treasury sophistication – can benefit from SCF.

The organisational structure of many larger companies can act as an impediment to uptake of SCF. Complex and bureaucratic structures tend to be resistant to progress and change and unwilling to investigate the merits of new ideas. Again, this is a trait typical to large companies around the world rather than being unique to the Middle East. However, it has implications for the countries and types of companies in the region that are leading SCF adoption. To date, it is the region’s smaller, more efficient organisations and markets that are proving more open to considering SCF structures as tools for extending payment or supporting suppliers.

One obstacle to the increased use of SCF that is specific to the Middle East is its abundant liquidity, (and resulting low interest-rate environment), which banks seek to deploy via shorter-term investments. The Middle East economy is driven by oil and gas: as long as prices remain reasonably stable/high, liquidity will continue to be strong, and corporate access to capital will be a low-priority concern. However, should prices plateau or decline, liquidity will tighter, and the region will become more dependent on sectors outside oil and gas, potentially encouraging the uptake of open-account transaction flows and SCF.

Paradoxically, another reason why companies are often cautious when considering SCF is that they believe their credit lines will be negatively affected by the existence of an SCF programme. In fact, credit facilities can be enlarged. Ordinarily, a credit line extended to a supplier reduces a short-term credit facility on a like-for-like basis. However, short-term assets under an SCF programme are self-liquidating and are therefore additional to a company’s existing credit facilities. Furthermore, SCF assets can often be sold on to other investors, further freeing up credit lines.

Where is SCF becoming established?

SCF has become hugely popular since 2008 globally and has gained a foothold in some more developed markets in the Middle East, such as the United Arab Emirates. However, in other Gulf Cooperation Council (GCC) nations – Saudi Arabia, Oman, Qatar, Kuwait and Bahrain – SCF remains an under-used tool. Companies in those countries could benefit from exploring SCF as a financing solution more extensively.

Supply chain financing is gaining the greatest momentum in local, domestic trade transactions. Middle Eastern corporates are exploring and implementing supply chain financing structures with domestic suppliers, with which they have the closet relationships.

However, cross-border SCF is growing in some parts of the region, led by global corporates from outside the Middle East. Multinationals have long recognised the working capital benefits of SCF, and its capacity to build better relationships with their suppliers. As a result, it is multinational companies’ Middle East subsidiaries that are driving the take-up of SCF in their transactions with inter-regional suppliers.

Inter-regional multinationals are taking note of the SCF arrangements being used by their OECD counterparts (and the balance-sheet advantages they enjoy). Once the successes of these SCF programmes become evident – and discussed among CFOs in the region – local corporates’ interest in such structures is likely to increase. As a result, Middle East multinationals may begin to use SCF solutions when trading with their suppliers both inside and outside the region in the future.

For those Middle East corporates that are using SCF, the primary objective and benefit being targeted is extension of payment terms with suppliers. On average, a typical buyer may expect to enjoy up to a 25% extension in payment terms when using SCF. The resulting increase in cash-flow can be significant. In addition, buyers are also achieving pricing benefits from suppliers, and are therefore enhancing the sustainability of their supply chain. Pricing structures are impacted by the banks’ role in the process; bank charges are dependent on the buyer’s credit rating, resulting in a range from very tight to very wide spreads.

Two high profile examples involving major companies in the Middle East illustrate clearly the potential benefits that can be achieved by using SCF in the region. A UAE telecommunications provider has achieved both an extension of payment terms and has been able to provide attractive financing to its suppliers, which are based in various developed markets around the world. Meanwhile, a multinational food manufacturer is enjoying both discounts and better payment terms from its suppliers and is now seeking to attract additional suppliers to its programme.

A bright future for SCF

The adoption of SCF in the Middle East has been relatively slow to date. However, SCF offers enormous potential and there are grounds for optimism in sectors such as telecommunications, healthcare, and the industrial and consumer goods industries. Multinationals from both inside and outside the region are thriving in the Middle East and could turn to SCF in the future to support the expansion of their supplier base.

More broadly, the diversification of Middle East economies, which is well underway, could also be a spur to more SCF activity. The GCC nations, and especially Saudi Arabia and the UAE, are determinedly seeking to reduce their dependence on oil and gas revenues. In the UAE, for example, this goal is clearly being achieved: the Purchasing Manager’s Index (PMI) shows 43 consecutive months of growth in non-oil purchase orders[3]. As purchasing increases and business grows, Middle Eastern countries will begin sourcing from outside the region and could use SCF as a useful tool to gain access to suppliers that are encountering challenges procuring credit.

Another potential driver of SCF is the record investment being made in infrastructure in the Middle East. Oil and gas dollars are being invested not just in the petrochemical and hydrocarbon industries, but also in roads, railways, airports and utilities to encourage inward investment in the region. The infrastructure financing gap in the GCC is estimated at $1.5 trillion over the next 10 years[4], with a significant proportion likely to be structured as public-private partnerships to secure necessary financing. The region’s large and expanding public sector infrastructure needs will necessitate significant cross-border flows, which may stimulate SCF in the future.

Implementing an SCF programme is difficult at times but the rewards can be considerable. Trust and commitment are critical to achieving a company’s specific objectives. At Citi, the tangible value created by SCF for our clients and their suppliers is demonstrated by the fact that many of these suppliers have approached Citi to develop a programme for their own suppliers.

How to make SCF a success

There is no single way to guarantee that a SCF programme will achieve a company’s objectives. However, strategy, internal relationships, building supplier trust and choosing the right SCF partner bank are all vital elements for success.

When establishing a SCF programme, companies must define their strategy and what they want to achieve (such as improved payment terms, greater supply chain stability or improved relationships with suppliers).

Secondly, an effective SCF programme must align different internal business functions, including procurement, legal and accounting, as well as treasury. In many organisations, finance is not well-integrated with procurement, for example, individuals do not know each other, and there is no precedent for collaboration. An SCF programme work relies on close co-operation between business functions, particularly in the initial phases.

Thirdly, a SCF programme requires trust – and a change in relationship – between buyer and supplier. While in the past, some companies relied on their strength and size to achieve the terms of supply that they wanted, there is a far greater awareness today of the need for partnerships that recognise the needs and constraints of parties across the entire supply chain. However, it may take time for suppliers to recognise and believe in this change, and companies may therefore need to invest time in building trust. By understanding suppliers’ constraints and pain points, supplier onboarding can be far more successful, and lead to improved relationships more generally.

Finally, a SCF programme can only achieve a company’s objectives if the right SCF provider is selected. Typically providers should fulfil three key criteria:

i) The partner should be able to demonstrate skills, experience and expertise in SCF programme implementation and have the global reach to achieve a company’s goals. A SCF provider should be able to show a deep understanding of the company’s business and its dynamics, as well as having the capabilities and resources to support the implementation, including resources dedicated to supplier adoption. The initial stages of an SCF programme – when the first group of suppliers is engaged – are critical. The right banking provider will monitor the programme constantly and track the appropriate metrics from the beginning of the programme, and continuously identify how improvements can be made.

ii) The SCF platform should be innovative, highly functional and integrate closely with both internal and bank systems.

iii) The provider should be in a position to provide the necessary level of funding, and have the stability and financial strength to continue to provide this in the future.

1. For Middle East, North Africa, Afghanistan, and Pakistan, International Monetary Fund, World Economic Outlook, April 2013
2. World Trade Organisation, April 10, 2013
3. HSBC Purchasing Managers’ Index, April 2013
4. Research Bulletin, Gulf One Investment Bank, July 2012