Article

by Mark Ford

When the G20 leaders met in London in April and announced a multi-billion US dollar package to help revive international trade financing, there was already a substantial shortfall of trade finance, with letters of credit in very short supply.

Now, in addition to a trade finance shortfall bigger than estimates, other factors are also driving up L/C demand. These include an increasing number of disputes in non-guaranteed transactions and traders seeking more security in transactions that only a year ago they might have been happy to conduct on open account.

Yet most banks remain reluctant to supply the L/C market, even though demand is surging, because they consider the risks to be too high. This is why the G20 funds need to be released into the market as soon as possible so governments and international financial institutions (IFIs) can share the risks that commercial lenders are unwilling to take alone.

Global shortfall

The G20's decision to put USD 250 billion into the global trade finance system - with a particular emphasis on emerging markets - surprised most pundits, who had anticipated support of around USD 100 billion. The trade finance funds announced by the G20 will be channelled through export credit agencies (ECAs) and IFIs. These agencies will work with commercial lenders to guarantee trade finance.

One ECA already contemplating an L/C support scheme is the UK's Export Credits Guarantee Department (ECGD). In May, it launched a public consultation for a scheme to confirm L/Cs for British exports. For the UK government, announcing this type of scheme was a substantial U-turn; the UK was one of several governments that, over the last 20 years, eschewed the short-term credit market, believing the private sector would meet demand.

It was in 1991 that ECGD transferred tranches of its short-term credit insurance - generally for a period of no longer than six months - to a private sector that now appears unable or unwilling to underwrite sufficient business to facilitate global trade. The current economic downturn has decreased the supply and increased the price of export finance at a time when, as ECGD says in a statement, "the demand for such financing remains strong."

ECGD's consultation on what is called the Letter of Credit Guarantee Scheme (LCGS) closed on 3 July. The proposed scheme envisaged a master guarantee issued to participating UK banks, under which these banks may cede to the guarantee, within limits, potential exposure they would incur by virtue of confirming L/Cs issued by overseas banks in favour of UK exporters. The scheme is targeted primarily at emerging markets and developing countries, with ECGD guaranteeing repayment to confirming banks of sums owed to them by the issuing banks for transactions eligible under the master guarantee.

Governments and IFIs

Most of the G20's USD 250 billion package comprises funds already proposed by individual governments and IFIs to support short-term credit business. Substantial funding is already getting into the system. For example, the Chinese government introduced a 4 trillion renminbi stimulus plan in November 2008 and ordered banks to make credit more available.

However, yet more funding promised by the G20 is still in the pipeline, including one important catalyst in the package, the International Finance Corporation's (IFC's) Global Trade Liquidity Program (GTLP). It aims to bring together governments, IFIs, and private sector banks to support trade. According to the IFC, with targeted initial public sector commitments of USD 5 billion, the program should be able to support up to USD 50 billion of trade. The GTLP would fund co-lending on a 40:60 or 50:50 basis with commercial banks on a short-term basis, typically of between 45 days and 180 days.

The IFC is still signing up public and private sector partners to the program. In June, Canada finalized an agreement to provide USD 200 million to the GTLP. In the same month, Citigroup said it had signed a memorandum of understanding (MOU) with the IFC to create a USD 1.25 billion funding facility under the program. The MOU contemplates funding of USD 1.25 billion, with Citigroup providing 60 per cent (USD 750 million) while the remaining 40 per cent (USD 500 million) will be taken up by the IFC and other IFIs. Standard Chartered Bank and South Africa's Standard Bank have also agreed to participate in the GTLP.

Since the program's success depends on its ability to sign up enough governments and then leverage private sector resources, it is unclear whether the target to entice USD 50 billion into the trade finance system is achievable.

In fact, several IFIs - including the IFC, the European Bank of Reconstruction and Development (EBRD), the Asian Development Bank (ADB) and the Inter-American Development Bank - already operate L/C-oriented trade finance schemes and, in accordance with the G20 funding package, some have extended their reach in response to the global downturn.

The EBRD's Trade Facilitation Program's (TFP's) budget, for example, will see a significant increase from EUR 800 million to EUR 1.5 billion in 2009 to boost trade finance from and within central Europe and central Asia. According to EBRD, current counterparty limits will be increased to support trade flows and to compensate for finance withdrawn by the commercial banks. The EBRD also anticipates that a large number of potential new counterparties - issuing banks and confirming banks - will join the TFP.

In another move, the ADB in April announced that it had expanded its Trade Finance Facilitation Programme (TFFP) to USD 1 billion in the expectation that it will generate up to USD 15 billion in trade support in Asia by the end of 2013. The ADB is also looking to boost the number of banks in developing member countries participating in the TFFP from around 60 to 100 by the end of the year. The TFFP started operations modestly in 2004 as a USD 150 million programme.

Demand drivers

Some evidence suggests that the promise of interventions in recent months is having a positive impact on the supply of credit. Reports are emerging of a resumption in the flow of L/Cs from banks to shippers, apparently backed a modest resurgence in the Baltic Dry Index, which reflects the shipping costs for a range of commodities. By the end of May it had doubled since early April on rising merchant trade, notably iron ore from China.

But L/C supply still falls short of demand, which is being stoked not just by the credit shortfall itself, but by several other drivers too. Notably, traders that were comfortable with open account terms in a buoyant economy are now questioning the financial strength of their counterparties and are asking their banks to guarantee each transaction.

One banker interviewed by DCInsight said he had seen an increase in applications from both importers wanting to open L/Cs in favour of overseas beneficiaries and exporters who have reviewed their risk control strategies and decided on methods of payment safer than open account. Another banker said he thinks strong demand will continue because L/Cs not only reduce trading risks, they also provide finance for overseas suppliers, some of which find it very difficult to access finance in their own countries.

According to a report in the Jakarta Globe, for example, Asian exporters are increasingly asking for L/Cs to guard against the increasing risk of payment defaults in the global economic downturn. The Globe quotes a Royal Bank of Scotland officer saying that "dramatic increases in disputes" between buyers and sellers and diminished levels of trust between counterparties is driving demand up. In a similar vein, an official at the Indonesian Employers Association reckons that Indonesian exporters that used to operate open account terms with known customers are now asking for L/Cs because they are shifting towards new markets and unfamiliar customers.

On other fronts, some bigger players such as JPMorgan are reportedly looking to leverage their trade finance skills to gain a share in an L/C market having substantial pent-up demand. The bank is in the midst of a USD 1 billion investment in JPMorgan Treasury Services, which includes the trade finance business.

Despite these positive developments, other banks are understandably cautious in the current economic climate and will not want to bypass due diligence in the credit evaluation process to improve their position in the market, even though demand is strong and profits can clearly be made. l

Mark Ford's e-mail is markford@gotadsl.co.uk