Article

by Mark Ford

Confidence may be returning slowly to the letter of credit market in some quarters, but as the world struggles unevenly out of the econo mic downturn, it looks as though the L/C sector may reemerge from the doldrums with distinctly different characteristics from those it displayed before the meltdown.

Perhaps a new order will emerge, driven by developments during the last two years of financial turmoil, including attempts by the international community to pump-prime the trade finance market and efforts by smaller L/C providers in less developed countries to bridge gaps in the market left by exiting risk-shy major banks. Other drivers include heightened risk aversion amongst parties in the mainstream L/C market, an appetite amongst banks to capture small- and medium-sized enterprise (SME) business and a spec tacular swing to L/Cs preci pi tated by the meltdown in the US housing market.

US municipal market

The sub-prime mortgage debacle brought a roller coaster ride to providers of L/Cs to the US municipal bond market. Issuers of such bonds are US cities, local governments and their agencies, state-owned airports and seaports and other public entities seeking funds, usually for capital projects.

Until the sub-prime crisis, several AAA-rated insurers routinely insured new muni cipal bonds. But key insurers turned out to be heavily exposed to the US housing market. They provided cover for complex mortgage-backed securities that turned toxic, forcing the insurers to pay up when these securities failed. Some insurers were downgraded to junk status, and the market demanded extra backing for municipal bonds. L/Cs proved a convenient way to meet the demand for additional security.

Consequently, the value of L/Cs used by US municipal bond issuers tripled in 2008 compared with 2007 as bond buyers refused to accept just conventional bond insurance cover. The value of L/Cs in the market soared to US$54.2 billion in 2008 compared with US$17.9 billion the previous year.

In 2009, the market for L/Cs tailed off, according to the Securities Industry and Financial Markets Association (SIFMA) which, earlier in 2009, called on the Obama administration to provide L/Cs or standby bond purchase agreements to shore up the troubled municipal bond market. SIFMA says sales of debt backed by domestic-bank L/Cs dropped to 5.1 per cent of issuance in the period from 13.1 per cent a year earlier. This fall, however, may have been substantially due to increased L/C pricing as banks became more risk averse.

According to data released by Thomson Reuters, the value of new municipal bonds backed by L/Cs plummeted 65 per cent to US$10.5 billion in the first six months of 2009 from US$30.3 billion during the first half of last year. The market seems to have found a level since the use of L/Cs also dropped in the nine months to September 2009, falling to US$15.4 billion of bonds compared with US$43.8 billion in the same period in 2008, again a drop of around 65 per cent. This means that the value of L/Cs backing municipal bonds was a substantial 20 per cent up on the value of such L/Cs in 2007.

This particular roller coaster may not be over. There is no sign of insurance becoming as big a player as it was in the municipal bond market. Just 10.5 per cent of new issues, according to SIFMA, carried bond insurance in the nine months to September 2009 compared with 20.4 per cent a year earlier.

Moreover, on 9 November 2009, major municipal bond insurer Ambac revealed that it had told the US Securities and Exchange Commission that it might have to file for bankruptcy protection in mid- 2011. This should serve to remind investors of the need for bonds to be very securely backed and renew the market's appetite for L/Cs to provide additional security.

Reviving international trade

Several attempts by the international community to revive trade finance are emerging in schemes born out of the G20 bailout package presented in April 2009 (discussed in some detail in DCInsight Vol.15 No 4), which included US$250 million earmarked for trade finance. Multi lateral development banks (MDBs) and export credit agencies (ECAs) will play a key role, but some schemes are only just becoming a reality.

The UK's Export Credit Guarantee Department (ECGD), for example, finally launched its L/C guarantee scheme in mid- October 2009. The scheme involves EGCD providing guarantees to five British banks of up to 90 per cent of the value of confirmed L/Cs issued by 282 overseas banks in 36 countries.

It is questionable how much difference such schemes will make. The ECGD program will not guarantee L/Cs in markets such as the US, the EU and Japan or many of the emerging markets that the leaders at the G20 summit in April appeared eager to help. Of Africa's 53 countries, the scheme supports British exports to just eight - Algeria, Egypt, Ghana, Kenya, Libya, Nigeria, Morocco and Tunisia - none of which could be described as the con ti nent's least developed countries. This group of countries may be helped by nascent home-grown initiatives, such as the new clearing system being introduced by the Common Market for Eastern and Southern Africa or schemes emerging from the International Finance Corpora tion's Global Trade Liquidity Programme and Global Trade Finance Programme, as well as initiatives by regional MDBs (DCInsight Vol.15 No 4).

Smaller providers are stepping into the breach left in Africa by big banks becoming risk averse as a result of the crisis and eschewing African business. In Botswana, the Citizen Entrepreneurial Development Agency is pushing a raft of initiatives aimed at providing more services to the SME market, including L/Cs, and aims to win more business from commercial banks and other lenders. Home-grown solutions are not con fined to Africa. Thrift banks in the Philip pines are taking up a program introduced by the country's central bank to make foreign currency L/Cs available from them for the first time.

Back to basics

The mainstream L/C market still appears much tighter than it was, despite some optimistic notes. JPMorgan's Global Trade newsletter in October 2009 noted that L/C flows have declined significantly, but report ed growing demand for L/C confirmations from exporters concerned with counterparty and cross-border risks. These sentiments are driving what some bankers are calling a "back to basics" approach, in which classical trade finance will be in demand.

In this scenario, exporters will be selective about getting confirmations for their L/Cs, preferring rock-solid banks with sound balance sheets, strong risk mitigation capabilities, an understanding of trade flows and comprehensive regional or global networks.

The "back to basics" approach has been noted in several quarters. Earlier this year, Royal Bank of Scotland Bhd's senior vice-president for Malaysia, Harm Bots, reported a shift from open account trading to documentary trading using conventional trade finance products, such as L/Cs, bills of exchange and guarantees, to mitigate risk.

SME attraction

Another trend that may shape a new order in the L/C market is the apparent attractiveness of the SME market. As well as smaller L/C providers, such as those mentioned in Botswana and the Philippines, some big players are gunning for this market.

In late 2009, Citibank announced new L/C availability for SMEs in the UAE, while financiers from HSBC have been spotted in both Singapore and India urging SMEs to use L/Cs and other risk management products in today's economic climate.

It is probably too early to say that a new order has already arrived in the L/C market. The financial turmoil of the last couple of years has wrought substantial changes, but until risk mitigation strategies and attitudes to risk - from the US municipal bond market to the international trade community - are more settled, it would be difficult to describe the L/C market as anything other than fluid.

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