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Whether or not the December summit of European leaders found a sustainable solution to the Eurozone crisis, which was still uncertain as of this writing, it was already clear in 2010 that the repercussions were negatively impacting letter of credit business far beyond Europe.

Three questions now seem critical: how much worse could the crisis grow, what processes can be hatched to resolve it and what discrete solutions can be employed to help keep L/Cs flowing across the globe? Answers to some of these questions are difficult to discern. There are many ways the crisis could go, but at least the root problems of global L/C business are reasonably well-defined.

European banks have traditionally played a key role in financing between 70-90 per cent of global trade, but they need the greenback to do this, and they are struggling to raise US dollars. Meanwhile some European banks, including BNP Paribas and Société Générale, have already reduced trade lending as they scramble to maintain capital requirements. It will be a tough year for L/C business in 2012.

Global impacts

Evidence of the negative impact on L/C business emerged more than a year ago. According to Bloomberg, imports to Europe from China plummeted by nearly 40 per cent in the three months to the end of November 2010.

A sales manager for an export-oriented toy manufacturer in mainland China told DCInsight that his company started to refuse L/Cs issued by Greek banks in March 2010. Since that time, Greek importers have had to pay a 33 per cent cash deposit on all new orders.

The general recessionary effects of the crisis have taken their toll as well. Sales to Europe overall were around 25 per cent down during the pre-Christmas buying season in 2011 compared with 2010. A US-based importer of products from China said some suppliers she had previously dealt with on L/C terms were now asking for cash on shipment.

With 2.5 million acres of forestland in North and South Africa, Brookfields Timberland, has also signalled the seriousness of the downturn. Through the third and fourth quarters of 2010, it saw the availability of L/Cs "dramatically reduced," according to managing partner Reid Carter.

In Australia, bankers have repeatedly warned about a shortage of L/Cs from Europe that usually provide an essential tool facilitating Australia's international metals and minerals trades. One banker pointed out that the 2008-09 L/C shortage caused Australia's coal and iron ore exports to collapse so spectacularly that it scuppered BHP Billiton's takeover offer for Rio Tinto.

BHP Billiton chief Marius Kloppers warned that the availability of trade finance could dry up if the European debt crisis worsens. He said that in November 2010 BHP was already seeing European conditions impacting on L/C availability, though he played down the impact this might have on BHP.

Emerging markets

But just as in the last L/C shortage, the emerging markets of Africa and Latin America might come off worst. There may be somewhat less impact in Asia, where Europe's banks are significant L/C providers.

There have already been clear signs of retrenchment. Société Générale mulled curbing export loans and other credits. Germany's Commerzbank cut credit extended to markets outside Germany and Poland.

The Asian Development Bank (ADB) is not optimistic about the situation in Asia, but, as in the 2008-09 crisis, it is the development banks that could at least help sustain global L/C flows. The ADB says it is responding to what it sees as a potentially deep and prolonged recession in both Europe and the US, possibly affecting seriously on emerging East Asia.

In the second half of 2011, ADB saw demand for its L/C-oriented Trade Finance Programme (TFP) increase more than 25 per cent. The bank's head of trade finance, Steven Beck, said it was "difficult to see how we won't be in a serious credit crunch in 2012, one that will hit trade hard." The International Finance Corporation (IFC), a World Bank subsidiary, also reported sharply increased demand for its similar initiative, the Global Trade Finance Programme (GTFP), which provides L/C guarantees in emerging markets worldwide.

Some emerging markets may be hit harder than others. One IFC official said very difficult markets, such as Afghanistan and Pakistan, would be the first to suffer from a lack of global trade finance. A London-based trade financier said that he anticipated other banks stepping in as European banks' backed out of Asia, but doubted whether other banks would fill gaps that appear in the tougher markets in Africa and South America.

Moreover, even where trade finance is available, the cost of it has often substantially increased. One Australian banker told DCInsight in December 2011 that the cost of trade financing Asian deals had doubled in just a few weeks.

What next?

So far, the Eurozone crisis has not led to such a spectacular collapse in trade finance as it did three years ago. The Baltic Dry Index - a bellweather for L/C flows in the last crisis - has not crumbled the 94 per cent it did in fewer than six months in 2008. For 90-day L/Cs issued by emerging and developing countries, a spot check in early December 2011 revealed a spread of 42.29 basis points (bp) for selected L/Cs - high compared with a normal range of 10-16bp, but not as scary as the massive opening of 250-500bp in the last crisis.

One discrete area that could be addressed is the scramble for banks to meet the Basel Committee's capital adequacy requirements. ICAP, the shipbroking arm of the world's largest dealer broker carrying out transactions for financial institutions, is concerned that this could lead to global trade facing "the most dangerous scenario of all" if European banks limit access to trade finance, thereby stemming the flow of L/Cs to commodity traders.

While development banks and export guarantee schemes such as those launched in the wake of the last crisis may help sustain L/C flows in emerging markets, this is unlikely to be enough, and solutions for the whole crisis have yet to be found.

Wider awareness of the importance of L/C flows may be of some help. Even commentators usually focused on other aspects of the global finance seem fully aware of the need to keep L/Cs flowing. Jeremy Siegel, a US financial guru, best known for his commentary on stock markets, pointed out that European financial institutions had already become hesitant to issue L/Cs and other trade credits. He advocates a bigger role for the European Central Bank (ECB), saying the Bank should provide guarantees to Europe's financial institutions, thereby ensuring that European banks remain liquid.

Siegel's reasoning appears sound. Somehow a mechanism for maintaining European banks' liquidity is needed to maintain global trade flows, even if it is not down to the ECB to provide the means to do so. But as DCInsight went to press, how this mechanism will be designed, implemented and sustained remained as unclear as it has been for months.

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