Article

IFC: shoring up trade finance in emerging markets

by Bonnie Galat with Rajdeep Salooja

With current market uncertainties, how do banks mitigate payment risk without interrupting trade transactions vital to the health of businesses worldwide and, more broadly, to continued economic development across the globe, particularly in the emerging markets?

The International Finance Corporation (IFC), a member of the World Bank Group, fosters private sector investment in developing nations. A shipment of vegetable oil from Malaysia to Niger is a recent example of a transaction that utilized the IFC's Global Trade Finance Program ("GTFP") to address this concern. With a letter of credit for just over USD 1.4 million issued by Ecobank in Niger, GTFP provided a guarantee to a major US confirming bank, to cover 100 per cent of the transaction amount.

Current situation

During a meeting of the World Trade Organisation (WTO) held in November to address the current crisis, WTO Director- General Pascal Lamy noted that "the market for trade finance has severely deteriorated over the last six months." His observations touch upon the difficulties experienced by banks, as highlighted by Roger LeBaron, Senior Advisor to the GTFP Program, who attended the meeting. According to LeBaron, "Banks are struggling to operate on a reduced capital base and this comes at a difficult time because of the transition to Basel II standards. In addition, bank mergers are also reducing capacity in trade financing, tenors are shortening and investment appetite in the secondary market for trade credits and packaged trade finance has virtually disappeared."

As ICC and the International Trade Center (ITC) have warned, the increased due diligence applied to letters of credit during difficult times must not be used to avoid or delay financial obligations. The assistance of multilateral and regional trade finance programs such as the GTFP is critical to mitigating counter-party bank risk at a time when confidence among parties has eroded. Trade finance has become one of the central pillars of what IFC is supporting in a significant way during this critical period.

Program growth

As a result of the drastic change in market conditions and a growing number of participating banks, the GTFP program limit was increased to USD 1.5 billion in October 2008 and is under consideration to be doubled in the coming month. The program will execute a greater strategic focus in its operations to maximize the role IFC can play in stabilizing the banking market, specifically with regard to shoring up the capacity for banks to work with other banks to facilitate trade from and to emerging markets.

The recent increase to the program enhances the counter-cyclical role the World Bank Group is expected to play during adverse economic and financial periods. History shows that when a country experiences a liquidity crisis, banks quickly manage their exposure down as a defensive measure, most easily accomplished by pulling or reducing short-term trade lines. Under the GTFP, IFC can guarantee the payment risk of the issuing bank up to the full value of a transaction. This enables the continued flow of trade credit into the market at a time when imports may be critical and the country's exports can generate much-needed foreign exchange.

Challenging trade flows

GTFP's development impact is rooted in the greater access to finance it offers participating banks. Banks in the program have access to a broad number of international banks which have joined the GTFP network to transact trade. This network, in conjunction with risk mitigation provided by IFC, has resulted in first-time trades between bank counter-parties, new correspondent relationships, increased bank lines and released cash collateral requirements. Improved financing availability has enabled the client base of small local banks, largely small- and medium-sized enterprises ("SMEs") importers and exporters, to reach new markets under competitive terms. Seventy-five per cent of the number of guarantees issued in 2008 has been for less than USD 1 million with the median at USD 180,000, reflecting support for shipment sizes consistent with small businesses.

New trade routes

Through trade finance, GTFP supports trade to and from nascent markets. To date, the program has facilitated trade across more than 500 distinct trading routes, supported imports into over 115 developing countries and promoted exports from 80 emerging markets, thereby expanding trade links across regions. Thirty-five per cent of the dollar volume of guarantees issued by the program in FY2008 supported flows between emerging markets or "south-south" trade; fiftyone per cent has been issued to facilitate trade with the poorest developing countries (as classified by the World Bank according to GDP); and forty-one percent has supported flows to sub-Saharan Africa, among which include first engagements with post-conflict countries such as Angola, the Democratic Republic of the Congo, Rwanda, Liberia and Sierra Leone.

Stabilizing role

In addition to its developmental impact, the program has been a stabilizing force for trade transacted and pricing movements in markets undergoing sudden or sustained events that disrupt the normal extension of inter-bank trade credit. IFC has maintained its support for the Lebanese banks since the turmoil of 2006 and, more recently, in Kenya and Mauritania in 2008. In the wake of the conflict affecting Georgia, IFC quickly established a trade line on an urgent basis for a prime private sector bank.

Going forward

In addition to increasing its program ceiling to better respond to the current economic turmoil, the program is expected to activate risk-sharing partnerships with other Development Finance Institutions ("DFIs"), which will assist IFC in leveraging its lines and managing headroom exposure constraints, as well as serve to build trade capacity among other multilateral development banks.

Partnerships with ICC

Shortly after the launch of the GTFP in 2005, GTFP began a partnership with ICC to enhance the functioning of trade and the training of the trade professionals around the world.

In October 2008, IFC's trade program held its Second Annual GTFP Bank Partners Meeting, an event attended by 150 bankers. In conjunction with the event, IFC and ICC sponsored a joint workshop, "Rules and Tools of Trade." While in Paris, IFC members were able to attend the ICC workshop while ICC members were able to take part in the GTFP Bank Partners Meeting. The exchange of knowledge and networks, as part of this partnership, will benefit both organizations going forward. The IFC/ICC partnership will be an important alliance in furthering the capacity of banks to transact trade in a confident, professional manner. Together the two organizations have supported the training of bankers in a number of developing countries to ensure that UCP rules and other trade conventions are understood and put into practice with standards that represent international best practice.

Bonnie Galat is Global Head, GTFP Marketing & Distribution at IFC; Rajdeep Salooja is an Analyst in the GTFP. For more information about country coverage and contacts, the IFC GTFP website is www.ifc.org/GTFP

Secured transactions and the future of trade banking

By Michael F. Quinn

In the current economic crisis, the world of documentary trade continues to shrink. In order to drive down banking fees, corporate customers are moving away from documentary instruments as a means to effect payment and create liquidity in their supply chains. And despite a temporary respite, bankers still face an ongoing challenge: staying relevant within customers' supply chains while avoiding "risky business" on behalf of their firms and shareholders.

Given the globality of today's physical and financial supply chains, banks have to be intimately aware of their rights and obligations under local laws in jurisdictions far from their head offices. Without a globally accepted set of rules and practices like UCP 600, which governs documentary trade, banks risk putting themselves out of business - either because they cannot serve their customers, or because they have undertaken risks that prove unsustainable. In lieu of uniform rules for the open account space, the global banking community needs a means to understand and act under local law and requirements.

Time will tell

As I write, some of JPMorgan's major importing customers in the US and Europe are moving a significant proportion of their international supplier base to open account - in spite of restrictive credit markets, increasing economic instability in both developed and emerging economies and a general loss of confidence among counterparties. Is this foolish? Only time will tell. Our customers tell us they believe they have sufficient information and relationships of trust with their suppliers to effect this change with minimal risk. Intimacy with these suppliers has been enhanced by advances in telecommunications, access of information via the Web and the ability to be physically anywhere in the world from any starting point in 24 hours or less. Increasingly, the countries our customers source from are maturing rapidly, with rules of law and transparent financial markets supporting the generation of capital and secure movement of funds.

Having invested heavily in "extended" supply chains that span the globe, major customers are very focused on the "end-to-end" impact of changes or disruptions on the players and their performance. Information is exchanged among participants, suppliers, suppliers to suppliers and various functional intermediaries who play key roles in moving goods and providing services along the way. Continual honing of the supply chain has facilitated effective cost control and "speed to market". Given energy cost volatility and a new sensitivity to the importance of emphasizing "green" supply chains, many customers are attempting to shorten their supply chains without forsaking the flexibility of their original footprint.

To perform this balancing act, customers rely even more on their ability to nimbly change their supply chain configuration without disrupting their ability to meet their own customer and shareholder expectations. Customers who are successful can vary the length of their supply chains - viewing the strategic importance of the product against the screen of cost and risk parameters.

International v. domestic

Compared to the international variety, domestic supply chains run like well-oiled machines. Common language, single legal regime and the increased likelihood of some level of data exchange or integration make for a simpler and more controlled process. Settlement is effected through well-defined payment instruments: checks, ACH, GIRO and funds transfers. Evaluation of counterparty risk is augmented by publicly available resources (D&B; rating agencies) and can be monitored in a more timely way, since settlement terms are predominantly 30-45 days.

Proprietary supplier-payer networks developed in the US, such as Xign and Ariba, foster electronic ordering and invoicing conversion. Although they still represent a small percentage of commercial settlements, their use continues to grow rapidly. Similarly, the European Union is encouraging member companies to migrate to electronic invoicing (E-Invoice). Success has been limited, though, since the struggle to achieve standardization of messaging formats and interchange requirements remains problematic. However, as global organizations such as the International Standards Organization (ISO) begin to influence regional initiatives, adoption is expected to grow rapidly as well.

The role for banks

International trade is still tied to paper. The traditional paper-based "three-way match" of purchase order, invoice and evidence of shipment remains prevalent among settlement processes, because it provides the necessary internal controls and audit trail to support compliance with SOX and other regulatory requirements. The complex documentary requirements for cross-border trade are driven by the need to secure transit through multijurisdictions using multiple modes of transportation while being subject to multiple tax regimes.

Global supply chain leaders do leverage technology to increase the efficiency of their supply chain, promoting the exchange of critical data elements rather than documents to integrate among the disparate service providers. Documents are still committed to paper at key junctures of the supply chain, where documentation serves a legal or regulatory purpose or where a supply chain participant needs more than data elements to perform. Documentary trade has traditionally thrived at these junctures, but today it is being diminished as customers migrate from traditional trade instruments and continue to drive automation and supply chain efficiency.

Customers migrating from traditional documentary trade instruments still require assistance from financial intermediaries. Within these increasingly automated and ideally paperless supply chains, the need for efficient and secure settlement processes, risk mitigation and sufficient liquidity among the supply chain participants is critical. Financial institutions of varying size and presence have roles to play in the non-documentary environment, but need to adapt swiftly or lose their seat at the table to other intermediaries. Of most concern to customers in this time of economic uncertainty is maintaining an uninterrupted flow of goods and services through ensuring supply chain liquidity. Without universally acknowledged debt instruments, traditional bankers are challenged to respond to this need.

Old world, new world

When documentary trade predominated, financing was available and relatively inexpensive. Local banks could take a view of either the exporter or importer - or equally, the issuer of a documentary instrument - and make a credit decision based in part on the presence of a debt instrument with which they were comfortable. These physical documents gave comfort to all parties that there were tangible goods behind the transactions and that those goods could not be released from party to party in the chain without being scrutinized by the bank. Payment could be effected and financing provided to the holder of the document or goods based upon their own creditworthiness or that of their counterparty. The underlying instruments were enforceable under local law and global practice and had a "value" which could be articulated to any party.

In the era of the modern supply chain, however, where electrons represent the goods, the parties and the values, the rules of the game either change dramatically or are completely absent. In the old world, the goods were tangible and saleable in their existing state. In the new, they are often pieces of a whole which have a value but are more valuable postassembly than in their current state. Even "finished" products' absolute value is undeterminable until they reach their final market and have weathered the changing valuation common in supply and demand economies. "Final" payment is made closer to the end user; intermediate payments have to be made "final" based on the strength of the end user's payment. This phenomenon has given rise to the global use of supply chain financing techniques to provide trade finance within the open account environment.

Financing the supply chain

Supply chain financing will always lack the traditional characteristics of trade finance, but it can and should be relatively inexpensive and safe. To accomplish this, supply chain finance providers must know and understand their rights in the trade receivable. Which country's laws apply to that receivable as it travels around the world? By what means can providers enforce their claim in the right jurisdiction in a cost-effective manner? When securing interest in a receivable, there needs to be clarity as to what constitutes that receivable. In many jurisdictions, it may not be limited to an invoice, but may be reflected in other commercial documents or in actions of a party (i.e., delivery of product creates an obligation to pay). Does the transfer of the rights have to be subject to local law, or can parties agree to subject the transaction to foreign law?

Today there are no effective means of identifying local law requirements for payment obligations. Formal requirements, such as notification to a governing body or a local registry in order to make the transaction effective, vary from country to country. When considering more effective means of raising low-cost funds, banks typically turn to the securitization market. In order to use this market efficiently, receivables obligations need to be aggregated across multiple obligors to create "bundles" of risk that will be acceptable to investors. The bundling of receivables must be practically and legally achievable. These and a number of other issues must be addressed and harmonized in order for financing of open account transactions to be effective.

Good news, bad news

There is good news on this front. Among its member states, the United Nations has published for ratification the "UN Convention on the Assignment of Receivables in International Trade." Additionally, The Organization of American States is promoting its "Model Law on Secured Transactions," which closely mirrors the UN Convention. Both bodies provide clear, consistent rules for dealing with trade finance in the open account world.

There is also bad news. The ratification rate is painfully slow. As of this writing, only four countries have signed the UN convention and are harmonizing local laws to conform. Similarly, the Model Law has been ratified by only one Central American country, with three others actively considering it. Although the US has not ratified either, its laws as embedded in the Uniform Commercial Code are already consistent with the Convention. Clearly, without some form of globally accepted law and practice, the ability to provide financing within sophisticated supply chains will continue to be more expensive and riskier than it needs to be.

An ICC role?

ICC's Banking Commission has recognized the importance of providing effective trade finance to customers in the evolving open account trade landscape. Having been the leading authority on the documentary instruments that support trade finance today, the Commission is also seeking ways in which members can demonstrate leadership in open account. Though not finally decided, there have been recommendations to establish a task force to gather country level information through ICC national committees. The goal would be to understand what laws, if any, have been enacted in each country to address secured transactions; or if there are actions being taken in the legislature to either draft new laws or adapt the UN Convention. Based on that feedback, the task force could make available to the Banking Commission membership a current overview by country of secured transaction law, and make a recommendation to the Commission as to the future role that it could take.

My personal view is that only through an organization like the ICC Banking Commission, representing key stakeholders in trade finance, can a global effort to support law and practice in the new trade finance environment be successful.

Michael F. Quinn is Managing Director of J.P. Morgan Global Trade Services in New York. His e-mail is michael.f.quinn@jpmchase.com