The shifting landscape of financing international trade shows no sign of slowdown. Whether it’s using structured bonds to build airports in Ghana, or financing the export of computer parts from Taiwan into Eastern Europe, international trade constitutes $4.5 trillion (25%) of global trade each year. But a few problems are emerging, given recent global macroeconomic and political changes.
Deepesh Patel at Trade Finance Global (TFG) discusses the company’s expectations for 2019 and, more importantly, what businesses can do to seek opportunities for growth, manage (and hedge) risk, and optimise their trade finance lines by exploring new opportunities.
What is trade finance and why is it important?
The definition of trade finance usually confuses people but, in short, it is a broad term covering the financing of international trade and commerce. From financing new machinery into Bangladesh right through to importing widgets from Singapore to Canada, trade finance covers a wide spectrum of products. Trade finance is also relevant when looking at the sourcing of raw materials, transporting them globally, managing risk, and paying third party contractors.
The Bottom Line: How is Trade Structured?
The most important difference between most other debt instruments and trade finance, is that trade finance is generally secured on the assets which are being traded.
Historically, two parties trade on open accounts, that is, I’ll send you the goods now, and you can pay me in 30 days. Some 80% of global trade was thought to be financed like this 5 years ago, but this is reducing each year, given the significant risk and financial burden this puts on the supplier. Any large international trade contracts ought to consider trade financing structures to mitigate non-payment risks.
Letters of Credit and Bank Guarantees
Letters of Credit (LC) and Bank Guarantees are financial instruments most commonly used to allow banks to guarantee payment to the seller of goods, usually making payment at the point they’re loaded onto a ship or at a port for transport.
These financing structures allow confidence between the buyer and the seller, with pre-export finance by using LCs or the equivalent, can help alleviate cashflow or working capital strains for trading businesses. This allows companies to grow their trade lines (and ultimately increase their bottom line).
When using credit instruments, such as Letters of Credit, financiers use advising and confirming banks of the suppliers and buyers of goods to provide payment guarantees. This means that international trade in less well known jurisdictions and with unfamiliar counterparts can run smoothly..
Making cash work for your business is crucial for success. Often many businesses have unpaid invoices or receivables in their accounts, which can strain working capital and slow down growth; preventing them from competing for larger orders.
With supplier payment terms increasing (e.g. with food producers and supermarkets, now standing at roughly 90 days), invoices can be factored or discounted by a lender, allowing businesses to access up to 90% of the sales value of the invoices up front, and the remaining amount once payment is made, less fees. Flexible secure financing facilities like these are useful bolt ons for trade finance, and can help businesses grow their trade lines.
Bond Support Scheme
Various tools for exporters are available through export finance schemes such as Bond Support Schemes and Export Working Capital Schemes. In the UK, the government’s Export Credit Agency UKEF provides these programmes. The Bond Support Scheme assists a bank which is supporting a UK exporter by guaranteeing up to 80% of a Bond’s value should the exporter fail to pay back the bank.
Export Working Capital Scheme
UKEF also provides exporters guarantees through the Export Working Capital Scheme, which is distributed through a select few banks which offer up to an 80% guarantee on a UK Export related contract.
Risk, Insurance and FX
In a world of foreign exchange volatility, trade wars and extreme weather conditions, knowing your goods will get from A to B safely and at the same price, is often difficult to predict.
Of course, the biggest risk for international trade is non-payment, which becomes particularly complicated when trading in countries where legal and financial infrastructure is less sound and enforceable. This, coupled with longer payment terms, foreign exchange volatility and specialist or complex credit products being used to finance the purchase of goods is what makes international trade risky.
The credit insurance market is also changing rapidly. As the banks are selling off trade finance functions, the credit insurance broker market is becoming more visible. What does this mean? More innovation, competition, transparency and excitement in the space of trade credit insurance.
The current challenges of international trade
Firstly there are the supply chains. Supply chains are getting shorter, particularly in agricultural and food markets. There is an increasing demand for supply chains (such as for large supermarkets) to become such supply chains a more transparent, with reduced overhead costs and innovative tech driven elements. But with all this disruption, comes a much needed change in trade finance, as the processes, technology and parties involved adapt. For larger consumers and buyers such as supermarket chains, payment terms have done nothing but increase, adding to the burden on sellers and exporters; further straining working capital to meet the demands of their customers.
Payment terms are also changing, in a negative way. As a result of Basel III (and most likely Basel IV) regulation, banks have become more risk averse in relation to trade and cross border finance. They have faced increased pressure to retain liquidity and maintain strict capital ratios. The ICC have recently outlined that trade finance is a low risk asset class; (https://www.tradefinanceglobal.com/posts/news-trade-finance-low-risk-asset-according-icc-report/) looking at around 8 years of historic data – $10.5 trillion USD and 20 million trade finance transactions. Their data showed that the default rate for Letters of Credit was 0.38% or less, and lower than 0.8% for trade loans, comparable to the loss rates for large corporate lending. However, this view has not carried through to the main market and has resulted in a large trade finance gap, hurting SMEs and developing nations, as well as contributing to the decline in international trade over the last 8 years.
If banks reduce their exposure in financing documentary trades, it creates a problem for less stable economies, which will rapidly feel the negative effects. The cost of trade finance is also increasing as a result of AML, sanctions, KYC, KYG and compliance. However, if banks reduce support for trade, then they have less oversight on what is being traded, and the market turns to the alternative finance market. Although fintechs, alternative financiers and trade finance funds are stepping up to fill this gap, it’s not happening fast enough.
Macro Geopolitical Changes – is Trade on a Knife Edge?
Aside from the longer term challenges around renewable energy, global population growth and the slowdown from the rapid industrialisation that China has seen in recent years, a more imminent issue impacting trade is the current war of words.
We are currently in the middle of the global rules based system being dismantled in the US, impacting major markets such as China. As a result, many raw materials such as steel have seen huge price increases, passed on to the end consumer. This has led to an increase in infrastructure cost and a very visible affect on automobile prices to consumers.
For the markets, trade wars and friction can also be seen as an opportunity for traders, should trade routes need to change quickly.
Written by Deepesh Patel at Trade Finance Global