Bilateral Netting in Forex

A substantial number of international companies are multilayered; that is, they have manufacturing operations in both the parent country and a number of other countries that are often tied in with an additional structure of selling companies.

It has been our experience that a sizable expense is incurred and time is unnecessarily consumed in the international transactions between the individual members of such groups. More specifically, payments may go back and forth between affiliates when actually only a net amount need be transferred. However, amounts must be relatively large in order to generate substantial savings by netting. Otherwise, the system changes and the cost of management time may not be offset by the savings on the transfers.

Bilateral netting arises when two affiliated companies have complementary or reciprocal sales. A number of industries, particularly in the automotive, electronics, and farm equipment fields, have a structure wherein subsidiary A buys components or materials from subsidiary B and assembles them for resale to subsidiary B and incorporation in a final product.

Specialization by country and product also leads to bilateral sales, when one subsidiary buys from another for resale in its local market. Reciprocal invoicing ensues, and if no action is taken, there will be a two-way flow of funds and a double purchase of foreign exchange. Given the two-day value system and the transfer lags, the amount of time during which funds are unavailable to both companies is not negligible.

Most countries permit bilateral netting when it reflects actual trade transactions between a domestic company and a related foreign company. Fees, royalties, and dividends are not so readily included in bilateral or multilateral programs, because the possibility of income transfer or manipulation is more apparent.

Bilateral netting calls for the simple netting of amounts due and receivable between two affiliates at a fixed date. If subsidiary A owes affiliate B DM 500,000 and B owes A DM 1,000,000, only a net amount of DM 500,000 is sent from B to A at the due date. Any payment commission, the exchange spread, and other fees on DM 1,000,000 are saved in this example.

In addition, value compensation can be used for the payment so that a same-day value transfer is accomplished. A qualification to this simple system is that intercompany transactions may not be ex pressed in a single currency. If they are not, it is necessary to convert them to a common currency denominator. That raises the question of how the ultimate exchange rate for the net transfer of deutsche marks is determined.

If the prevailing IMF parity is used, it can have a quite different effect than if the daily spot rate between the deutsche mark and another currency is the basis. Depending upon whether the second currency's spot rate is above or below its parity, the net transfer may have a cost relatively less or more than its nominal balance sheet designation.