Restart Trade Finance: Rebooting the Engine

Article excerpt

Finance is a crucial component of the world economy, underpinning some 80% to 90% of world trade. As a result, the tightening of trade finance market conditions, which has been steadily worsening since the beginning of 2008, is particularly concerning. Public-backed institutions have responded rapidly in the course of 2008, but still their efforts have not been enough to bridge the gap between supply and demand of trade finance worldwide. Recognizing the need for further action, the G20 has pledged another US$250 billion in support of trade finance.

1 Why does trade finance matter?

One of the reasons for the collapse of world trade is insufficient trade credit financing. The global market for trade finance (credit and insurance) was estimated to represent approximately 80% of 2008 trade flows, valued at US$15 trillion. The World Bank estimates that a fall in the supply of trade finance has contributed some 10% to 15% of the decrease in world trade since the second half of 2008.

Despite the overall fall in trade transactions, quantitative and qualitative surveys confirm a general increase in trade credit prices, as banks demand risk premiums often far in excess of loans made to other banks. This has led to a mismatch between supply and demand for credit.

Two arguments are often put forward to explain the presence of trade finance gaps. The first relates to market failure arising from the inability of private sector operators to avoid herd behaviour when credit and country risks become highly uncertain (e.g., existence of rumours of sovereign default). Secondly, on the regulatory side, commercial bankers have long complained about the implementation of Basel II rules, which are regarded as having a pro-cyclical effect on the supply of credit. Under poor market conditions, trade finance would be unfairly treated as capital requirements are significantly increased, particularly for counterparty risk with developing country customers. In addition, the system of rating agencies does not help, as such counterparty risk tends to be biased against developing countries, according to reports from several developing countries and, in particular, the World Trade Organization (WTO) Working Group on Trade, Debt and Finance.

2 WTO's involvement in trade finance issues

Trade finance is generally considered a very secure, short-term and self-liquidating form of finance. Nevertheless, the reluctance of many lenders to finance short-term credits confirms that trade finance markets have not been immune to the present crisis.

The current credit crunch is having a direct negative effect on trade due to reduced access to trade finance. The same scenario was experienced by emerging economies in the 1990s. According to market specialists, demand for trade credit is far from being satisfied, and prices for opening letters of credit far outweigh the normal reassessment of risk, particularly in developing countries.

Changes in the general perception of the commercial risks related to trade finance derive from increasing doubts about the creditworthiness of banks, a rise in country balance-of-payment risks, and the presence of large exchange rate fluctuations. An expected increase in payment defaults on trade operations in the second part of 2008 meant that some banks were unable to meet the demand from their customers for new trade operations, leaving a 'market gap' estimated to be around $25 billion in November 2008. In addition, the price of transactions increased sharply. A re-assessment of customer and country risks and the lack of liquidity - which has spread to the developing country money markets - is making it difficult to back up loans.

The institutional case for the WTO to be concerned with the present scarcity of finance is clear. The experience of the Asian financial crisis led to the establishment of a group of trade finance experts in 2003 by the heads of the WTO, International Monetary Fund (IMF) and World Bank - under the umbrella of the Marrakesh Mandate on Coherence - to examine the causes of the financial crisis and prepare contingencies. …