By providing liquidity and security to facilitate the movement of goods and services, trade finance lies at the heart of the global trading system. Indeed, as Auboin (2009) notes, trade finance – upon which some 80-90% of world trade relies – has become ever more critical as global supply chains have increasingly integrated in recent years:
“Any disruption in the ability of the financial sector to provide working capital, pre-shipment export finance, issue or endorse letters of credit or deliver export credit insurance, is likely to create a gap in complex outward-processing assembly operations. This can lead to a contraction in trade and output, and is particularly worry-some for the sustainability of global supply chain operations”.
It is no surprise then that policymakers would be concerned that, along with the rapid decline in trade during the latter half of 2008, shortfalls in the supply of trade finance might act as a contagion, deepening and prolonging the recession. Various estimates have put the size of a possible trade finance “gap” in the range of $25-500 billion, although the lack of reliable data on trade finance has made it difficult to assess precisely the scale of this “gap” or the degree to which it is simply a function of lower trade volumes or, more worryingly, of supply constraints. In any case, governments and multilateral institutions have responded with a range of trade finance programs, including a pledge by the G20 leaders at their April 2009 London Summit to ensure $250 billion of support for trade finance.
Historically, trade finance has tended to be highly vulnerable in times of crisis, as was the case in East Asia in the late 1990s. Indeed, trade finance differs from other forms of credit, such as investment or working capital, in ways that make it higher risk during crises because of the difficulty of securing and enforcing credible commitments across borders in times of turmoil. In the current crisis, it is clear that access to affordable trade finance has been constrained. A number of banks, global buyers, and firms surveyed by the World Bank are reporting to be constrained by lack of trade finance and other forms of finance, such as working capital and pre-export financing. In addition, the costs of trade finance are substantially higher than they were pre-crisis, raising the problem of affordability for exporters. SMEs and exporters in emerging markets appear to be facing the greatest difficulties in accessing affordable credit.
Yet, available information also suggest that trade finance is not down nearly as much as actual trade flows. Data from the IMF indicate that trade volumes declined about four times faster than trade finance volumes during the period October 2008 through January 2009. In short, while the contribution of trade finance to the massive decline in world trade should not be overestimated, there is evidence that a trade finance shortfall contributed to the decline of international trade and risks hindering its eventual recovery.
A critical question is whether the reduction in the supply of trade finance is the result of market and/or government failures, and, hence, whether there is a rationale for public intervention to address them. Two broad cases that would create a real trade finance “gap” would be where there is insufficient supply (i.e., “missing markets”) or where it is being supplied at prices that are temporarily too high to meet demand in the market (i.e., “overshooting markets”).
There are a number of reasons why bank deleveraging and risk-adjustment processes in response to the financial crisis might restrict the supply of trade finance more than other forms of bank credit, despite the fact that trade finance should be a relatively low-risk product line in normal times. First, there may be a temporary inability of the market to properly calculate risk – in other words, not a problem of risk per se but uncertainty, which is particularly acute in opaque and highly internationalised markets like trade finance. Second, information asymmetries in international markets have been exacerbated by a collapse of interbank trust and cash hoarding, raising the risk of interbank strategic default. Third, with the liquidity crisis forcing banks to recapitalise as quickly as possible, trade finance credit lines – the majority of which have terms less than 180 days – tend to be the first lines of credit banks cut. Finally, there may be strong political economy factors at play. As much of the response to the crisis has taken place at the national level, through central banks and governments providing liquidity and insurance to domestic banks, there is likely to be strong political pressure and moral suasion to use these resources to support domestic lending.
The largest piece of the trade finance “gap” may result not from a lack of demand or supply, but of the two failing to meet – specifically, where the prices at which banks are willing to supply trade finance are temporarily too high to clear market demand. Again, there appear to be specific aspects of trade finance that may make it relatively more prone to this form of market failure, particularly during a financial crisis. First, systematic recalibration of risk has essentially forced a downward shift in the supply curve for all kinds of credit. However, deflationary pressures in the real economy make prices for most goods sticky, giving international traders little scope to pass on these costs. Changes in regulatory regimes (specifically Basel II) may also have raised the price of trade finance to a level that is out of line with its true risk profile, due to its calculation of counterparty risk through a geographic rather than a performance lens. Third, with markets undergoing a rapid process of risk recalibration, the adjustment process may overshoot the equilibrium temporarily.
These failures – both market and government in nature – may require government interventions in the form of liquidity injection and risk mitigation to address market confidence, information provision, and collective action, as well as to manage the adjustment process. While the current economic crisis is still unfolding, a number of domestic and multilateral interventions have been launched that may or may not lead to the desired results.
Drawing on the lessons from past crises, effective public actions in support for trade finance should be guided by number of key principles. These include:
- targeting interventions to address specific failures;
- ensuring a holistic response that addresses the wider liquidity issues of banks;
- channelling the response through existing mechanisms and institutions;
- ensuring collective action in the response across countries and regions;
- addressing both risk and liquidity issues;
- recognising the importance of banks in developed countries for freeing up trade finance for emerging market exporters;
- promoting greater use of inter-firm credit and products like factoring;
- maintaining a level playing field in terms of risk weight;
- improving transparency in the trade finance market; and
- avoiding moral hazard and crowding out commercial banks by setting clear time limits and exit strategies for intervention programs and sharing rather than fully underwriting risk.
Given the substantial resources committed by G20 leaders and multilateral institutions to supporting trade finance during this crisis, it is critically important to put in place a systematic and reliable mechanism to collect data on the trade finance market. Such a system would enable monitoring of the market, not only to assess the degree to which current interventions are influencing credit supply, but on an ongoing basis, to provide a useful early warning of stress in trade credit provision.
Auboin, M. (2009). “Boosting the Availability of Trade Finance in the Current Crisis: Background Analysis for a Substantial G20 Package”. CEPR Policy Insight No. 35, June 2009, Centre for Economic Policy Research.
Chauffour, J.-P.,& Farole, T. (2009). “Trade Finance in Crisis: Market Adjustment or Market Failure?” Policy Research Working Paper 5003, The World Bank.