Some 80 to 90 percent of world trade relies on some form of trade finance. Since the first half of 2008, there has been evidence of tightening market conditions for trade finance. As expected by market participants, the situation worsened in the second half of the year, and even further in the first quarter of 2009.According to expecta- tions revealed in market-based surveys, there is little doubt that the trade finance market will continue to experience difficulties throughout 2009.This situation is likely to contribute to deepening the global economic malaise. Although public-backed institutions have responded rapidly to the situation over the course of 2008, this has apparently not been enough to bridge the gap between supply and demand of trade finance worldwide. This is why the G-20 adopted a wider package for injecting some US$250 billion in support of trade finance.
Why does trade finance matter?
Part of the reason for the collapse of world trade concerns problems with trade credit financing. The global market for trade finance (credit and insurance) is estimated at between US$10 and US$12 trillion -- that is, roughly 67 to 80 percent of 2008 trade flows that are valued at US$15 trillion. The World Bank estimates that 85 to 90 percent of the fall in world trade since the second half of 2008 is due to falling international demand, and the rest -- 10 to 15 percent -- is attributable to a fall in the supply of trade finance. This chapter lays out some recent developments and explains decisions made at the G-20 London Summit regarding what is potentially one of the main sources of contagion of the financial crisis from a trade perspective -- the supply of trade finance.
The potential damage to the real economy from shrinking trade finance is enormous. International supply chain arrangements have globalized not only production, but also trade finance. Sophisticated supply chain financing operations -- including those for small- and medium-sized enterprises (SMEs) -- place a high level of trust and confidence in global suppliers, relying on their delivery of their share of value-added and on their financial ability to produce and export supplies in a timely manner.
The institutional case for the World Trade Organization (WTO) to be concerned about the scarcity of trade finance during periods of crisis is relatively clear. In situations of extreme financial crises, such as those experienced by emerging economies in the 1990s, the credit crunch reduced access to trade finance -- which was already the short-term segment of the market -- and hence reduced trade, which would usually be the prime vector of balance of payments' recovery. The credit crunch also affected some countries during the Asian financial crisis in 1997 to the point of bringing the affected economies to a halt. In the immediate after-math of the Asian crisis, a large amount of outstanding credit lines for trade had to be rescheduled by creditors and debtors to re-ignite trade flows -- and hence the economy -- as the two are inextricably linked. Under the umbrella of the Marrakech Mandate on Coherence, in 2003 the heads of the WTO, the International Monetary Fund (IMF), and the World Bank convened an expert group of trade finance practitioners to examine what went wrong in the trade finance market and to prepare contingencies. The conclusions of the experts were summarized in two reports.
The economic case for the involvement of international organizations, in particular the WTO, has been discussed. The main arguments are based on the idea that trade finance is, to a large extent, a very secure, short-term, self-liquidating form of finance. Even in some of the most acute periods of financial crises (1825, 1930), international credit lines have never been cut off. For centuries, the expansion of trade has depended on reliable and cost-effective sources of finance backed by a deep, global secondary market of fluid and secured financing instruments and a wide range of credit insurance products, provided by private- and public-sector institutions (including national export credit agencies, regional development banks, and the World Bank Group's International Finance Corporation, or IFC).
However, since the Asian crisis, the trade finance market has not been totally immune from general reassessments of risk, sharp squeezes in overall market liquidity, or herd behavior as demonstrated by runs on currencies or repatriation of foreign assets. Such reactions might happen again in this current turmoil. Commercial risk in trade finance normally stems from the risk of non-payment by the counterparty to the trade operation (either the client company or its bank). The perception of this risk obviously has changed with exchange rate fluctuations, the rise in political risk, and bank failures, all of which may undermine the profit- ability of trade. Such rapid change in risk perception has happened abruptly -- for example, through the Fall of 2008 -- with respect to certain Eastern European countries. At the present moment, many lenders have adopted a wait-and-see attitude triggered by doubts about the creditworthiness of banks in a number of regions in the world, including developing countries, as well as by the increase in the balance of payments risk. What aggravates the situation is that the secondary market has also dried up. Just as lending seems to be directly affected by the tight liquidity situation world-wide, the re-insurance market has suffered from the dif-ficulties faced by American International Group, Inc. (AIG) and Lloyds.
Of course, it can be argued that such exogenous factors as liquidity squeeze, exchange rate fluctuations, and other components impacting risk are not specific to trade finance. Any un-hedged cross-border flow would most likely be affected by these elements. Likewise, the supply of credit would be affected by the greater scarcity of liquidity available to some banks in the inter-bank market. Yet, since trade finance has to compete for an equal or reduced amount of liquidity like any other segment of the credit market, the price of transactions has increased sharply under the combined effects of scarce liquidity to back up loans and a re-assessment of customer and country risks. Spreads on 90-day letters of credit have gone through the roof over the course of 2008 (rising from 10 - 16 basis points to 250 - 500 basis points on a normal basis for letters of credit issued by emerging and developing economies).
It is hard to believe that the safest and most self-liquidating form of finance, with strong receivables and marketable collaterals, could see its price increase by a factor of 10 to 50 even when it is under severe stress. Indeed, this segment of the credit market has been by far the most resilient since the sub-prime crisis began in mid 2007, before signs of market gaps at a global scale appeared in the Fall of 2008, well after they emerged in other segments of the credit market. This strong resilience can be partially attributed to facilitation devices developed by public-backed regional or multi- lateral financial institutions after the Asian financial crisis. Trade finance facilitation programs that provide for risk mitigation between banks issuing and those receiving trade finance instruments have been developed into a worldwide network, in which the IFC, the European Bank for Reconstruction and Development (EBRD), the Asian Development Bank (ADB), and the Inter- American Development Bank (IADB) participate. Institutions such as the Organization of the Petroleum Exporting Countries (OPEC) Fund, the Islamic Development Bank, and the African Development Bank have also developed or are developing similar instruments. In addition, national export credit agencies have expanded short-term trade finance operations and added considerable liquidity to the markets in recent years, according to Berne Union statistics. Both types of institutions have hence recently developed a unique savoir-faire and are potentially ready to add further liquidity and expand their risk mitigation capacity should the need arise.
The current situation
Despite the relatively strong resilience of the trade finance markets, the global liquidity situation -- along with a general re-assessment of counterparty risk and an expected increase in payment defaults on trade operations -- was a major constraint in 2008 for the largest suppliers of trade finance. The market gap initially appeared on Wall Street and in London, as US- and UK-based global banks -- particularly those with deteri- orated balance sheets -- could not off-load or refinance their excess exposure in trade credits on the secondary market. The situation spread to developing countries'markets in the second part of 2008.As a result, some banks were unable to meet the demand from their customers for new trade operations, leaving a market gap estimated at around US$25 billion in November 2008 out of the global market for trade finance estimated at some US$10 - 12 trillion a year. Some very large banks used to roll over up to US$20 billion per month into the secondary market; this amount is down to US$200 million or less right now because there is no counter- party. Demand for trade credit is far from being satisfied, and, according to market specialists, the rise in prices for opening letters of credit by far outweighs the normal reassessment of risk. More disturbing is the fact that large banks have reported on several occasions that the lack of financing capacity has made them unable to finance trade operations. It has, however, been argued by relatively profitable banks that the situation -- particularly in the secondary market -- has softened recently, although not for everyone.
In the course of 2008, the liquidity problem has spread to other developing countries' money markets, with the poorer countries in Asia, Latin America, and Africa being particularly affected. This adds to the prob- lems faced by local banks in such developing countries in normal circumstances: the relative lack of depth of money markets, the lack of capacity to handle large vol-umes of trade credit, and the lack of reliable information on the creditworthiness of customers, to name only a few specific issues confronting these banks. In periods of crisis, such as the one we are in now, these issues lead to difficulties in finding partners in developed countries to accept the counterparty risk.
According to the joint IMF-Bankers'Association for Finance and Trade (BAFT) survey, flows of trade finance from developing countries' banks seem to have fallen by some 6 percent or more year-on-year (from the end of the 3rd quarter 2007 through the end of the 3rd quarter 2008).This is more than the reduction in trade flows from and to developing countries during the same period, implying that the lack of trade finance is indeed an issue for these countries. In late 2008, it was expected that trade finance flows for developing-country banks would fall by a further 10 percent in 2009. If such numbers were to be confirmed (at least developing-country banks seem to agree with this estimate, according to the survey), this would mean that the market gap could be well over the US$25 billion estimate mentioned above -- higher even than US$100 billion, up to US$300 billion. Such scarcity of trade finance is very likely to accelerate the slowdown of world trade and output.
Ahead of the G-20 Summit in London, the IMF and BAFT provided an update of their survey, which indicated that the decrease in the value of trade finance accelerated between October 2008 and January 2009 in almost all regions. While more than 70 percent of the respondents attributed this further decline to the fall in demand for trade activities, six in ten respondents attributed it to restrained credit availability, thereby pointing to the increased difficulties of banks in supplying trade credit -- an escalation caused by the general liquidity squeeze and the amplified risk aversion to finance cross-border trade operations. Spreads (prices) on the open-ing up of letters of credit were up, from 10 to 15 basis points above LIBOR up to 300 basis points in some emerging economies. Some banks even reported 600 basis points for particular destinations.
Results from a survey undertaken by the International Chamber of Commerce (ICC) broadly confirmed the conclusions drawn by the IMF-BAFT analysis, albeit relying on a wider panel of banks and countries (122 banks in 59 countries). The results of the ICC survey were also released for the WTO Expert Group of March 18, 2009, and further updated before the G-20 Summit in London. It is obvious that trade decreased as a result of both the recession and tight credit conditions.