Article

by Michael Quinn

Until 2008, when the music stopped for global trade, the first decade of the twenty-first century could be described as the Roaring Two's. World GDP grew at better than 3.4 per cent per year, with trade in goods and services enjoying 9-12 per cent growth annually.

As trade surged, liquidity flooded the international markets, and in the rush to keep pace with rapidly growing trade flows, traditional risk mitigation techniques took a back seat to getting deals done. Participants were confident of anticipating problems and taking steps to remediate issues long before settlement came due.

Banks with limited trade finance experience joined the fun and became international financiers overnight. As was the case in all other asset classes, the money chasing investment opportunities led to reduced due diligence and falling returns. And as returns fell, players became even more aggressive, financing deals with limited knowledge and even less expertise.

Bad times

In mid-2007, real estate values flattened and began to fall in some US and Europe markets. Commodity prices, which had fueled the absolute dollar value surge in global trade, began to flatten too.

By the end of 2008, a massive deleveraging was sucking all liquidity from the markets. Balance sheet strength was not enough to prevent financial institutions from being buffeted by the storms racking global markets. Governments were forced to intervene, using both monetary policy and direct intervention to calm the waters.

The global economy entered its deepest recession since World War II. Global trade ran aground as economic retrenchment took hold and reduced demand for goods and services. Uncertainty about the economic viability of trading partners prevented engagement in any meaningful commerce. Where viable transactions did exist, there was no financing available for them: the primary and secondary markets froze completely and risk appetite was literally at zero.

Although aggressive actions were taken by central banks and multilateral agencies, breaking the cycle would take nearly 15 months. Liquidity was made available in hopes of stimulating minimal levels of trade. Trade finance facilities were made available by local Export Credit Agencies and the financing arms of global multinational organizations. Banks not as dramatically affected by the downturn loaned aggressively - primarily to financial institutions that had been their traditional trade counterparties - not only to help facilitate trade, but to help sustain their own viability.

Recovering

In 2010, year-on-year trade growth is forecast to be 9-10 per cent against an extremely low base, with restoration to pre-crisis levels still projected as a 2012 event. Commodities have stabilized and there are signs of increasing demand and higher prices. Some regions have bounced back from the crisis more quickly than others. Asia fared best because, while overall trade fell, intra-regional trade continued to demonstrate strength. Latin America has borne up well this time, with Brazil demonstrating particular resilience. Turkey has proved a regional standout and functions as a gateway between Europe and the Middle East and Maghreb emerging markets.

Surviving financial institutions have been recapitalized through the markets or direct government intervention. Profitability has been restored in most financial markets, and there is new willingness to lend. Secondary markets are reviving, albeit at only at 60 per cent of pre-crisis levels. The price of risk, which peaked in the first quarter of 2009, has begun to fall and in some markets has returned to pre-crisis levels. Well-capitalized customers continue to have access to the capital and debt markets, but access to capital remains problematical for lower middle market and sub-investment grade borrowers.

In this "back to basics" business environment, highly structured and securitized transactions have declined significantly as accounting rules and investor scrutiny have forced bankers to return to transparent structures. Financing is linked more tightly to the ultimate source of repayment. Documentation standards have been raised to include stronger terms and conditions.

Rebounding

What do we think the future holds? My crystal ball shows global trade rebounding. During the next 12-18 months, trade volumes will likely claw their way back to the levels seen pre-crisis, with accelerated growth continuing in 2013 and beyond. As supply and demand return to their natural balance, markets will resume globalization, and we will probably once again experience the optimism and vibrancy of the early 2000s.

The explosion in global trade over the past decade created globalized, intrinsically linked economies whose interdependencies were as evident in the collapse as they were in growth cycles. These interdependencies cannot be reversed, even if isolationism and protectionism rear their heads in certain countries or regions. We have learned over the years that such restrictions cannot be sustained. Entrepreneurs will find ways to circumvent those barriers in order to make the best product at the best price. Capital flows will continue to seek the best returns, regardless of local legal and regulatory challenges.

Intermediation of country risk had been losing importance pre-crisis and will continue to decline in the post-crisis era. Businesses become more comfortable with cross-border risk as they globalize. While still an impediment to trade, local legal and regulatory regimes are increasingly transparent and can be managed with the appropriate mix of information and people on the ground. Country events, like the political upheaval in Thailand and natural disasters in Pakistan, may temporarily disrupt trade, but alternative channels will develop quickly and efficiently.

The price compression we have seen in the industry will no doubt continue. Customers view plain-vanilla L/C processing as a commodity and will take any competitive bid. With the development of capital markets in emerging economies, suppliers are much less dependent upon the L/C as a credit enhancement for packing loans or pre-export financing.

Letters of credit or other documentary trade products will continue to be utilized when parties involved in a cross-border transaction are new to each other, or when one of the parties is domiciled in a "tough" or highly regulated country. The robust and time-tested body of rules and regulations governing transactions under these instruments will continue to preserve the rights of the various parties and provide consistency in outcomes. Also, as noted in the most recent crisis, the cyclical nature of economies will drive usage depending upon the severity of the downturn.

Crisis as opportunity

"Don't let a perfectly good crisis go to waste" is good guidance in our current circumstances. This recovery is when the future of trade can best be defined.

As they envision the next wave of trade, banks should focus on customers holistically in order to gain understanding of their end-to-end business. This new kind of relationship changes the traditional trade bank's role - "only dealing in documents" - to a new concentration on underlying commercial transactions. From J.P. Morgan's perspective, it means focusing on the customer's supply chain and finding the means to integrate financial and physical activities.

Partnership paradigm

By focusing on the supply chain, we gain visibility to business processes and understand at what point responsibilities begin and end among the parties and when there is contractual or process-driven "commitment" to pay. Looking at commercial risks provides better understanding of when mitigants are required and how they can best be applied as a by-product of the commercial transaction. Success in global trade lies not only with buyers and sellers, but also with servicers and other parties whose coordinated effort is required to deliver value to the end user/consumer. Full knowledge of their interdependencies helps further reduce risk.

The success of integrating finance and commerce is measured by its impact on the parties' bottom line. Optimizing working capital is the end game, and winning means effective management of all aspects of payables, receivables and inventory. Financiers need the ability to leverage the strongest credit in various points of the supply chain to inject liquidity at the right time and in the right place. In the absence of traditional trade instruments, risk mitigation, liquidity and settlement capabilities must be available to the right parties at the right time and at the right price. Value comes to the provider from leveraging technology platforms that support visibility to the transaction through data management. In this new world, trade bankers need to extricate themselves from the paper-handling morass and instead confirm compliance with L/C terms by leveraging supply chain information.

Globalization is now all about outsourcing, alliances and leveraging centers of excellence in ways that are mutually beneficial. Trade banking customers have learned to capitalize on high-quality skilled resources wherever they reside. Banks need to recognize their own weaknesses and partner with firms that help them add value by collaborating to solve problems for the customers they share. In the pre-crisis world, we saw some ill-prepared banks entering trade finance with little more than a fat wallet. In the new world, these participants can provide liquidity in their home markets in conjunction with a facilitator with deeper experience of global markets and supply chains.

Banks must find a niche within their customer's ecosystem. Why shouldn't they become an extension of their customers' business processes and provide value in multiple stages? The customer's payables process increasingly blurs the line between international and domestic settlement. Banks must be able to intermediate both within a single business process. Banks excel at reconciling and controlling processes. Isn't it reasonable to think they can eventually take over the customer's order-to-cash cycle from shipment through collection and invest the resulting proceeds? This is the thinking of the futurists who are focused on flourishing in the future of trade. And the future, as we would probably all agree, starts tomorrow.

Michael Quinn is Managing Director, J.P. Morgan Global Trade. His e-mail is michael.f.quinn@jpmchase.com