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  • TRADE FINANCE: REBOOTING THE ENGINE

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    Trade Finance: Rebooting the Engine

     

     
     
    International Trade Forum - Issue 1/2009

    © World Trade Organization Pascal Lamy

    Finance is a crucial component of the world economy, underpinning some 80% to 90% of world trade. As a result, the tightening of trade finance market conditions, which has been steadily worsening since the beginning of 2008, is particularly concerning.

    Public-backed institutions have responded rapidly in the course of 2008, but still their efforts have not been enough to bridge the gap between supply and demand of trade finance worldwide. Recognizing the need for further action, the G20 has pledged another US$250 billion in support of trade finance.

    1. Why does trade finance matter?

     One of the reasons for the collapse of world trade is insufficient trade credit financing. The global market for trade finance (credit and insurance) was estimated to represent approximately 80% of 2008 trade flows, valued at US$15 trillion. The World Bank estimates that a fall in the supply of trade finance has contributed some 10% to 15% of the decrease in world trade since the second half of 2008.

    Despite the overall fall in trade transactions, quantitative and qualitative surveys confirm a general increase in trade credit prices, as banks demand risk premiums often far in excess of loans made to other banks. This has led to a mismatch between supply and demand for credit.

    Two arguments are often put forward to explain the presence of trade finance gaps. The first relates to market failure arising from the inability of private sector operators to avoid herd behaviour when credit and country risks become highly uncertain (e.g., existence of rumours of sovereign default). Secondly, on the regulatory side, commercial bankers have long complained about the implementation of Basel II rules, which are regarded as having a pro-cyclical effect on the supply of credit. Under poor market conditions, trade finance would be unfairly treated as capital requirements are significantly increased, particularly for counterparty risk with developing country customers. In addition, the system of rating agencies does not help, as such counterparty risk tends to be biased against developing countries, according to reports from several developing countries and, in particular, the World Trade Organization (WTO) Working Group on Trade, Debt and Finance.

    2. WTO's involvement in trade finance issues

     Trade finance is generally considered a very secure, short-term and self-liquidating form of finance. Nevertheless, the reluctance of many lenders to finance short-term credits confirms that trade finance markets have not been immune to the present crisis.

    The current credit crunch is having a direct negative effect on trade due to reduced access to trade finance. The same scenario was experienced by emerging economies in the 1990s. According to market specialists, demand for trade credit is far from being satisfied, and prices for opening letters of credit far outweigh the normal reassessment of risk, particularly in developing countries.

    Changes in the general perception of the commercial risks related to trade finance derive from increasing doubts about the creditworthiness of banks, a rise in country balance-of-payment risks, and the presence of large exchange rate fluctuations. An expected increase in payment defaults on trade operations in the second part of 2008 meant that some banks were unable to meet the demand from their customers for new trade operations, leaving a 'market gap' estimated to be around $25 billion in November 2008. In addition, the price of transactions increased sharply. A re-assessment of customer and country risks and the lack of liquidity - which has spread to the developing country money markets - is making it difficult to back up loans.

     The institutional case for the WTO to be concerned with the present scarcity of finance is clear. The experience of the Asian financial crisis led to the establishment of a group of trade finance experts in 2003 by the heads of the WTO, International Monetary Fund (IMF) and World Bank - under the umbrella of the Marrakesh Mandate on Coherence - to examine the causes of the financial crisis and prepare contingencies. The group concluded that rapid action was needed to promote a menu of instruments to facilitate co-financing between private and public sector trade finance providers. This would allow for risk-sharing in an increasingly unstable market environment. In the immediate aftermath of the Asian crisis many outstanding credit lines for trade were rescheduled by creditors and debtors in order to reignite trade flows. The expert group has continued to operate since, and has gained relevance in the wake of the current global economic crisis.

    3. What is the situation now?

    According to the joint IMF-BAFT (Bankers' Association for Trade and Finance) survey - undertaken in the context of the WTO Expert Group Meeting on 12 November 2008 and presented at its meeting on 18 March 2009 - flows of trade finance from developing country banks appear to have fallen by some 6% or more between the end of 2007 and the end 2008. The fact that this number exceeds the reduction in developing country trade flows during the same period, indicates that the lack of available trade finance is indeed an issue.

    Results from a survey undertaken by the International Chamber of Commerce (ICC) were also released for the WTO Expert Group of 18 March 2009 and further updated before the G20 London Summit. This survey, relying on a wider panel of banks and countries (122 banks in 59 countries) also confirmed the conclusions drawn by the IMF-BAFT analysis: trade has decreased as a result of the recession and tight credit conditions.

    Business associations including BAFT, ICC, Business Europe, as well as individual commercial banks, have been making recommendations to the G20 Summit in London, in the following areas:

    Reviewing Basel II rules. Results from a survey conducted by the ICC United Kingdom in parallel with the ICC Global Survey indicate that the implementation of the Basel II framework has eroded the incentive of banks to lend short-term for trade, because capital weightings are not fully reflective of the low-risk level and short-term character of the activity. In a risk-weighted asset system, increases in minimum capital requirements had particularly adverse consequences on trade lending to small and medium-sized enterprises (SMEs) and counterparties in developing economies.

    Creating a ring-fenced liquidity pool for trade finance. The general proposal was to design a small and targeted liquidity fund run by international financial institutions and useful for smaller segments of the market or new countries, in particular those most likely to be hit by the contraction of trade credit supply.

    More co-sharing of risk with public sector-backed institutions. The idea would be to encourage co-finance between the various providers of trade finance. Public sector actors, such as Export Credit Agencies (ECAs) and Regional Development Banks, should be mobilized to shoulder some of the private sector risk.

    4. Public and private players to boost supply of trade finance

     One clear lesson from the Asian financial crisis is that in periods prone to a lack of trust and transparency, and herd behaviour, all actors - including private banks (which account for some 80% of the trade finance lending operations), export credit agencies and regional development banks - should pool their resources, as far as practicable.

    Furthermore, the design and implementation of finance facilitation programmes should be undertaken cooperatively. Cooperation would involve both the beneficiaries (exporters, importers, banks) and all export credit agencies in a region, if not globally. The Asian example of export credit agencies supporting both intra- and extra-regional trade by working as a network should be taken as an example by other regions. The WTO has been working to foster cooperation among participants.

    Between the fall of 2008 and the G20 London summit in April, I have intensively advocated in favour of increasing the capacity of International Financial Institutions (IFIs) and ECAs to shoulder the risk with private sector partners. As a result, capacities in three types of activities have been enhanced significantly:

    • The regional development banks and the International Finance Corporation (IFC) have, on average, doubled capacity under trade facilitation programmes between November 2008 and the G20 Meeting.
    • Export credit agencies have also stepped in with programmes for short-term lending of working capital and credit guarantees aimed at SMEs. For instance, Germany and Japan have made strong commitments on the amounts; and very large lines of credit have been granted to secure supplies with key trading partners in the United States with Korea and China.
    • Central banks with large foreign exchange reserves have been able to supply foreign currency to local banks and importers generally through repurchase agreements. This has helped banks and importers in developing countries to acquire scarce foreign exchange. Since October 2008, Brazil's central bank has provided $10 billion to the local market. The Korean central bank has pledged $10 billion of its foreign exchange reserves to do likewise. The central banks of South Africa, India, Indonesia and Argentina are also engaged in similar operations.

    Filling information gaps between public institutions and the private sector is also a high priority. While more financing capacity is provided by public institutions, it seems that the private sector's ability to respond, particularly in developing countries, continues to deteriorate. For instance, BAFT members have complained that the series of measures announced by ECAs and Regional Development Banks were hard to track and that they lack information on who is providing what, and under what criteria.

    Another reason why strong links are needed among the various players is the absence of a comprehensive data set on trade finance flows. This makes the collection of informed views and surveys from various institutions the main channel for making a reasonable assessment of the market situation.

    5. The G20 Summit in London: A Trade Finance 'Package'

     The trade finance 'package' proposed during the G20 London Summit responds in large measure to the criteria developed by the WTO Expert Group on Trade Finance. It also takes into account the recommendations made by the private sector.

    The principal aim of the financial package is to strengthen public-private sector partnerships in the context of existing trade finance facilitation programmes, which will be further enhanced, not only in respect of credit insurance, but also by opening and expanding liquidity windows of regional development banks to allow greater co-lending with banks.

    The IFC is reinforcing its global trade finance facility through the introduction of a liquidity pool. A 40% to 60% co-lending agreement with commercial banks has been put in place. The IFC's Global Trade Finance Liquidity Fund started with $5 billion in funds (raised by both the IFC and several individual donors). According to the co-lending formula, these funds should be matched by $7.5 billion in commercial bank funding. The IFC Fund could increase over time by attracting more donors and hence more funding by banks. The objective of doubling the Fund's total capacity in the next two years, from $12.5 billion to $25 billion, is feasible and will cover financing for up to $50 billion of trade transactions. The Standard Chartered Bank and Standard Bank have already signed off on credit lines, with hundreds of millions of dollars for financing Africa's trade.

    Another main point of the package is to strengthen the capacity of Organization for Economic Co-operation and Development export credit agencies, allowing them to offer more finance and a wider spectrum of instruments. These ECAs will be encouraged to provide more direct funding in the short run (such as working capital lending and other forms of short-term direct support), via increased capacity on the insurance side.

    Finally, several institutions, such as IFIs, ECAs and other government agencies, will try to revive the secondary market by intervening directly in that market.

    The logic of acting by way of increasing co-financing and co-risk mitigation has been followed by the Heads of States and Governments. Since the package is expected to be implemented over two years, early commentary by some press and academics about the lack of new funding should be put in a longer-time perspective, bearing in mind that the package has been designed with the objective of raising rather than reallocating existing funds.

    The WTO stands ready to continue mobilizing governments, IFIs, export credit agencies and the private sector to implement the G20 commitments. Support for trade during a difficult juncture is a win-win strategy for both developing countries facing all kinds of contractual payment pressures and for developed countries, where output and trade are closely linked to emerging market economies through complex supply chains.

    The WTO will continue to assess market developments, mobilize political energy and funding to restore the role of trade finance as the oil needed to keep the wheels of trade turning.


    The necessary institutions

    WTO: World Trade Organization
    IMF: International Monetary Fund
    BAFT: Bankers' Association for Trade and Finance
    ICC: International Chamber of Commerce
    ECA: Export Credit Agency
    IFI: International Financial Institution
    IFC: International Finance Corporation