5 July 2019

Trade finance: oiling development

by Brian Sturgess

Over 80 per cent of international trade is financed by some form of credit, but despite its importance the trade finance market has attracted little attention from trade economists until relatively recently. This changed after the Great Financial Crisis of 2008-2009 when global liquidity dried up and the impact on the availability and price of trade credit was particularly severe.

Data from the World Trade Organisation shows global merchandise trade reached US$16.2 trillion in 2008 before plunging by 22.3 per cent to US$12.6 trillion the following year as a direct result of the banking crisis. Furthermore, despite a recovery in global GDP, international merchandise trade growth has been weak since 2012 with the recovery in 2017 into the first half of 2018 threatened this year by events such as President Trump’s tariff war with China. A more insidious threat to trade growth, however, is the malfunctioning of the trade finance market after the crisis. Despite having a relatively low default risk off-balance sheet trade finance instruments are treated harshly by the Basel III banking regulations which have been tightened since the financial crisis.

The Asian Development Bank (ADB) has estimated that there was a global trade finance gap of US$1.5 trillion in 2017 based on a survey of bank-reported rejection rates for trade finance applications, with a shortfall of over US$120 billion in Africa. This gap acts as a drag on international trade growth and represents 35 per cent of the bank provided global trade finance market estimated by the International Chamber of Commerce (ICC) at around US$4.6 trillion in 2017.

Data on proposed and rejected applications shows that emerging markets suffer the greatest shortfalls. Micro and Medium-sized Enterprises (MSMEs), drivers of growth and employment in the developing world, typically faced a greater problem accessing trade finance than large firms. Responding banks to ADB survey reported that 74 per cent of rejections were to MSMEs and midcap firms.

There are two main external sources of working capital used by companies to facilitate international trade: traditional trade finance (TTF), intermediated by banks which lend money to supply working capital to bridge trading cash flow gaps to clients engaged in international trade at risk-adjusted competitive interest rates. Lenders competing in this market offer their customers profitable trade credit at rates related to payment or default risk: Letters of Credit; Guarantees and Documentary Collections. Secondly, trade can be financed through non-bank guaranteed inter-firm credit contracts between importers and exporters. This includes open account transactions where goods are shipped and delivered before payment is due and cash-in-advance transactions where payment is made by buyers before goods are shipped. Open account trade finance involves exporters offering payment terms to importers after delivery and acceptance of the goods or services traded usually with 30,60 or 90 day payment terms. This is advantageous to importers in terms of cost and working capital requirements, but not to exporters. The risk of non-payment in open account trade transactions can be mitigated by the purchase of another trade finance instrument such as export credit insurance which is also used by banks to hedge payment risk. Berne Union data shows that export credit and investment insurers underwrote US$2.5 trillion of new business in 2018.

If the cost of payment insurance is too high or not available exporters can take advantage of alternative trade finance products such as factoring or variants of supply chain finance (SCF), a growing financing processes linking parties in a transaction —buyer, seller, and financing institution with the aim of lowering financing costs and improving efficiency. Supply chain finance provides short-term credit that optimises working capital for both the buyer and the seller.

Unfortunately, despite its importance to the international economy there is not a comprehensive, consistent data source to measure the global size and composition of the trade finance market by country, by commodity trade flow or by instrument. The first serious attempts to monitor the market date are subsequent to the GFC so there is no historical data more than a decade old. Data on trends in the international trade finance market are available from the annual surveys which have been carried out by the ICC but only since 2009. The 2018 ICC Survey found that in 2017 the total value of TTF instruments provided by responding banks was US$4.6 trillion. The Asia-Pacific region generated the largest share at 47.1 per cent of global bank provided TTF with a supply of US$1.2 trillion, followed by Western Europe with US$823 billion, or 18.0 per cent and by North America with US$524.2 provided or 11.5 per cent of the global total.

The ICC Survey provided information on the breakdown of the trade finance market by products offered by banks. The data indicates that LC accounted for the largest share of transactions at 60 per cent, followed by Collections at 24 per cent and guarantees at 16 per cent. The LC segment breaks down into standard LCs at 49 per cent and standby LCs at 11 per cent. The ICC Survey also found that contrary to market growth trends, the value of TTF supplied by responding banks was still nearly six times greater than total SCF provided standing at US$813 billion.

Trade Finance Market by Region (Source: ICC, 2018)
Trade Finance Market by Region (Source: ICC, 2018)

The opportunity cost of high rejection rates is of course lost trade and 60 per cent of responding firms reported that they failed to execute the transaction when their application for trade finance was rejected. This implies that trade finance shortfalls can restrict economic growth while the remaining 40 per cent of firms were able to complete the sale without bank-intermediated trade finance.

Trade Finance Market by Product (Source: ICC, 2018)
Trade Finance Market by Product (Source: ICC, 2018)

The problem of collecting reliable data in order to promote trade growth and to monitor financial stability is being exacerbated as the trade finance sector is undergoing rapid structural change with innovations such as paperless transactions, the employment of block chains and securitisation that attempt to minimise bank capital and balance sheet usage. Recently the industry launched the “bank payment obligation” – a payment method that offers a similar level of payment security to that of L/Cs, but without banks physically handling documentary evidence and supply chain finance is a growing area of banks’ trade finance activities. An analysis of the penetration of these new instruments and the market dynamics are held back by data gaps at both the global and the national levels. Economists interested in trade should address these issues as soon as possible before the next trade volume recession hits global growth whether it is sparked off by tariffs or banking problems.

Brian Sturgess

Brian Sturgess is Managing Editor and Chief Economist at World Economics, and worked as a consultant to the Competition Directorate of the European Commission.