11 September 2019

Closing the trade finance gap

by Brian Sturgess

Whether or not there is a deal agreed before October 31st or afterwards, British exporters will need an enabling financial environment to thrive by finding new opportunities post-Brexit. Unfortunately, despite an effective sterling exchange rate measured by the Bank of England down by 12% since the referendum, exports are not responding as well as might be expected - particularly since the start of this year. Growth has been sluggish. According to the Office of National Statistics, the value of UK exports fell by 2.2% in Q2 of this year to £161 billion after witnessing positive quarter on quarter growth for over a year. Undoubtedly, continuing uncertainty about trading conditions post-Brexit is having a dampening effect, but a serious problem facing existing and potential exporters is access to trade finance.

There is a massive global trade finance gap: it was estimated at US$1.5 trillion in 2017 based on a survey of bank-reported rejection rates for credit applications. This gap, which is particularly large in emerging markets, is damaging trade growth in developed countries. Studies show that access to external finance is even more important for exporting firms than for those concentrating on serving domestic markets.

The existence of transportation costs and the gap between shipping and payment necessitates higher levels of working capital. However, even before trading, exporters face significant sunk costs and incur search and marketing costs to find and sell in foreign markets. Furthermore, depending on the technology intensity of their products, exporters tend to spend relatively more on R&D to adapt the specifications of products to foreign markets. Finally, the legal and regulatory profile of foreign markets increases the risks faced by exporters necessitating higher insurance costs to cover contingencies. Unfortunately, there is growing evidence that, in the United Kingdom, there is not only an under provision of trade finance, but that financial shocks and disturbances in the banking system translate disproportionately into the export sector.

In theory, deeper financial markets allow many firms to start exporting, thus increasing the total value of exports, but financial depth seems to have had a more limited impact in the United Kingdom since the financial crisis. In 2009, a 3.5 per cent fall in GDP in the developed world was associated with an 11 per cent decrease in exports in the developed world. This event, known as the Great Trade Collapse, puzzles economists since the severity of the collapse in trade was far greater than the fall in demand as measured by GDP. In the United Kingdom, for example, the value of exports fell by 8.3 per cent between Q2 2008 and Q2 2009, a fall steeper than the drop in foreign demand.

The reason for the decline in export performance in the United Kingdom appears to be due to failures of banks to provide adequate trade finance. Dr Ali Kabiri of the University of Buckingham and his colleagues have researched the causes of the Great Trade Collapse using detailed firm level data and measures of bank health in the United Kingdom. They identified a significant negative relationship between banking shocks and the export performance of UK companies. Dr Kabiri found that on average a 10 per cent worsening in bank health was associated with a 1.6 per cent decrease in firms’ exports. This implies that the downturn in UK export performance could have been due to a decrease in the supply of trade finance as much or more than falls in the foreign demand for the products exported. The paper concludes:

“Persistently weak exports in the UK, post crisis means that knowing whether the credit shock inhibited new exporter firm formation, damaged existing exporters’ productivity or, if credit starvation to firms persists, are all-important areas for future research.”

This research agenda is now critical given the UK’s decision to leave the European Union and the University of Buckingham is taking preliminary steps to address the causes of and solutions to financial market failures faced by exporters.

One reason for the market failure in the provision of trade finance lies in excessive regulation causing the trade finance market supplied by the banking sector to malfunction since the financial crisis. Despite having a relatively low default risk off-balance sheet trade finance instruments such as letters of credit are treated relatively harshly by the Basel banking regulations which have been tightened in recent years. In consequence, many banks have shed their trade finance assets particularly after Basel III to bolster their balance sheets and this has widened the trade finance gap.

The existence of potential problems in the provision of trade finance has been recognised by governments in many countries for a long-time. In the United States, the Export-Import Bank (EXIM) was founded in 1934 and is a branch of the Federal Government, with a mandate not to compete with private lenders, but to offer financial solutions for transactions that commercial lenders are unwilling to assist with. In Germany, exporters can gain financial support from services provided by the state-owned KFW-Ipex bank which dates back to the Marshall plan. In the United Kingdom, the finance gap is partially met by the existence of UK Export Finance (UKEF), the government’s export credit agency which provides loans and insurance to support British exporters and is part of the Department of International Trade. In 2018-19, UKEF according to its latest report it provided £6.8 billion in loans to exporters supporting an estimated 47,000 domestic jobs and earned more than £330 million in export insurance premiums. However, given the Department of International Trade’s objective to raise the share of UK exports in GDP from the current level of 30 per cent of GDP to 35 per cent and the need to secure new markets after Brexit, these resources could well be inadequate to meet the UK’s yawning trade finance gap. Furthermore, the cost and effectiveness of state assisted export finance is controversial and can be construed as a form of government interference that could distort the market and border on mercantilism. The EXIM bank in the US, for example, has faced much criticism from both sides of the political spectrum.

In post-Brexit Britain, the market failure problem will need to be addressed sooner rather than later by re-examining the role of the UKEF, by loosening the restrictions on bank provision of trade finance to encourage low-risk profitable lending and by the employment of more innovative solutions.

Not only should banks be encouraged to expand their trade finance offerings, but a pro-export drive should also include innovative non-traditional solutions such as expanding the role of Islamic finance since trade finance is Sharia compliant. While trade finance has played an important role on the balance sheets of banks in the middle-east, its provision has been limited in the growing Islamic banking sector in the United Kingdom. Change is in the air. In October of last year the trade finance trading market place LiquidX opened its platform to the Bank of London and the Middle East (BLME), a UK licensed Islamic bank, to Sharia compliant transactions. Finally, London’s leading position in the global FinTech market needs to be harnessed to provide new efficient solutions to reduce transaction costs for exports. This will reduce the risk of lending to support start-up export companies such as Exabler.

Whatever happens after October 31st, free trade is under threat and British exporters face a more uncertain and turbulent international environment. Complacency is not an option.

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.