The role of bank guarantees in international trade

Tim Schmidt-Eisenlohr, Friederike Niepmann 26 November 2014

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International trade is a risky activity – importers may not pay after receiving the goods and exporters may not deliver if they are paid in advance. To reduce the risk of international commerce, banks offer specific trade finance products, the most prominent being letters of credit (LCs). In recent years, policymakers have become increasingly concerned that there may be a shortfall in the supply of trade finance. On the one hand, they worry that banks may stop issuing and confirming LCs during times of financial distress.[1] On the other hand, they perceive a systematic lack of trade finance in the smaller and riskier destinations.[2] These concerns have led to a set of actions. For example, the G20 agreed to increase its support of trade finance by $250 billion over a period of two years in the midst of the 2008/2009 financial crisis. Many development banks run large trade finance program today; the International Finance Corporation, a part of the World Bank Group supports the confirmation of LCs with about $5 billion per year with a particular focus on the least developed countries.

Despite the large policy interest, little is known about the relevance of LCs and similar trade guarantees for exporting, mainly due to a lack of data. Academic research has shed some light on the link between finance and trade in recent years but with a focus on general bank links and the role of credit for exporting firms. Amiti and Weinstein (2011), for example, showed that, in Japan, firms linked to under-performing banks reduced their exports.[3] The effects of reductions in the supply of trade-specific financial products, such as LCs, which do not mainly address firms' financing needs but lower the risk of international transactions, have not been investigated.

What is a letter of credit?

Figure 1 illustrates how an LC works. A bank in the importing country issues an LC and sends it to the exporter. With the LC, the bank commits to paying the exporter if he presents a set of documents, including the invoice, a certificate of origin and transport documents. Because there remains the risk that the issuing bank will not pay in the end, a bank in the exporter's country typically confirms the LC and thereby underwrites the payment. Thus, an LC represents a guarantee of payment for the exporter. At the same time, the LC increases the importer's incentives to pay since he only obtains the documents from his bank after paying, which he needs to fully employ the goods. Moreover, the importer sometimes has to deposit cash with his bank or provide collateral to obtain the LC.

Figure 1. How a letter of credit works

While letters of credit are not common in domestic transactions, they are a key tool in international trade.[4]  According to data from SWIFT (the Society for Worldwide Interbank Financial Telecommunication), about 9 percent of U.S exports are settled with letters of credit. Firms are more likely to use this instrument when trading with risky destinations. While LCs are barely used by U.S. firms that ship to Canada, Mexico or Germany, for example, 30 percent of U.S. exports to China employ letters of credit. Other destinations for which LCs are central include Korea, Turkey, Pakistan and India.

What are the alternatives to a letter of credit?

If trading partners do not use a letter of credit, they have several other options. The exporter can ask to settle the transaction on cash-in-advance terms, which implies that the importer pays for the goods before the exporter produces and delivers; in reality, this is often difficult because the importer may not have the funds to pre-finance the purchase or he may doubt that the exporter will deliver the goods in the end. Alternatively, firms can trade on an open account, in which case the exporter delivers the goods and the importer pays after receiving them. Selling on an open account is common but the exporter may need to bear a great deal of risk. He can transfer the risk to a third party by buying trade credit insurance. However, trade credit insurance is often very costly or not available for high risk destinations. This discussion underlines that letters of credit represent a unique instrument to reduce the risk of an international transaction that cannot easily be substituted for. If firms cannot obtain LCs, they may trade less or not trade at all.[5]

Letters of credit are crucial for international trade

In a recent paper (Niepmann and Schmidt-Eisenlohr 2013) we exploit a unique dataset from the Federal Reserve Board to analyse the role of letters of credit for US exports. The dataset has information on the trade finance activities of all large US banks from 1997 to 2012. Based on these data, we construct a measure of the supply of trade guarantees by US banks for various export destinations and test if this measure predicts US exports.

Our empirical analysis follows a two-step estimation procedure.[6] First, we estimate by how much each bank in the sample changed its supply of trade guarantees from quarter to quarter. In a second step, we exploit the fact that banks specialise in the provision of LCs for different countries. If a bank reduces its supply of LCs overall, this should affect exports to countries more in which the bank takes a larger share of the trade finance market. By weighing and summing the bank-level supply changes over all banks that serve a US export destination, we obtain a country-level measure of the supply of LCs.

Our analysis reveals that changes in supply of letters of credit by US banks have a causal effect on US export growth. If the supply of LCs to a destination declines by 17% (one standard deviation) from the previous quarter, US exports to that country fall on average by 1.5%. Effects double in times of financial distress and are stronger for exports to small and poor countries. During a crisis episode, the same decline in LC supply reduces US exports to small and poor countries by 5.8 percentage points. This is probably because firms are less willing to trade without an LC when shipping to high risk destinations and when uncertainty in the economy is high. At the same time, firms may find it harder to obtain an LC from other banks when their home bank does not provide the service; these may be less willing to take on additional risks and may have a harder time refinancing letters of credit on capital markets.

Large banks can have effects in the aggregate

The trade finance business is highly concentrated. In 2012, the top 5 banks held more than 90% of all trade finance claims in the US. Several counterfactual experiments illustrate the implications of this extreme market concentration.  If a large US bank reduced it supply of trade finance by 42.6% (which is a large change but not the largest observed in our data), aggregate US exports would decline by up to 1.4 percentage points.

Table 1 shows what would happen with US exports to different world regions if two different US banks cut their supply of trade finance to the same degree.  The example is based on the actual distribution of market shares in the trade finance data. A reduction in the supply of LCs by Bank A would reduce exports to Sub-Saharan Africa by 2.86%. The same cut in supply by Bank B would have a much smaller effect on this region but US exports to South Asia would be much more affected. This shows that individual banks do not only matter for the level of trade but also for trade patterns.

Table 1. Letter of credit supply shocks of two large US banks

Implications for the Great Trade Collapse

Researchers are still debating the factors that caused the Great Trade Collapse in 2008/2009. Our research suggests that trade finance had a non-negligible effect. While trade finance was probably not of first-order importance for trade between large and developed countries, firms were substantially constrained in their exports to poorer and smaller countries due to a lack of trade finance. Thus, through trade finance, financial distress may have spilled over to countries that were at the periphery of the initial financial turmoil. In light of these findings, the focus of development banks on small, poor and risky destinations and the public provision of trade finance during times of financial distress seem reasonable.

References

Ahn, JaeBin (2013), “Estimating the Direct Impact of Bank Liquidity Shocks on the Real Economy: Evidence from Letter-of-Credit Import Transactions in Colombia”, mimeo.

Amiti, Mary and David E. Weinstein (2011), “Exports and Financial Shocks,” The Quarterly Journal of Economics, 126 (4), 1841–1877.

Amiti, Mary and David E. Weinstein (2013), “How Much do Bank Shocks Affect Investment? Evidence from Matched Bank-Firm Loan Data,”Working Paper 18890, National Bureau of Economic Research March.

Antràs, Pol and Fritz Foley, “Poultry in Motion: A Study of International Trade Finance Practices,” Journal of Political Economy, forthcoming.

Greenstone, Michael and Alexandre Mas (2012), “Do Credit Market Shocks affect the Real Economy? Quasi-Experimental Evidence from the Great Recession and Normal Economic Times,” MIT Department of Economics Working Paper 12-27 November.

Niepmann, Friederike and Tim Schmidt-Eisenlohr (2013), “International Trade, Risk,and the Role of Banks,” Staff Reports 633, Federal Reserve Bank of New York.

Paravisini, Daniel, Veronica Rappoport, Philipp Schnabl, and Daniel Wolfenzon (forthcoming), “Dissecting the Effect of Credit Supply on Trade: Evidence from Matched Credit-Export Data,” Review of Economic Studies.

Schmidt-Eisenlohr, Tim (2013), “Towards a theory of trade finance,” Journal of International Economics, 91 (1), 96 – 112.

Working Group on Trade, Debt and Finance (2014), “Improving the availability of trade finance in developing countries: an assessment of remaining gaps,” Note by the Secretariat, World Trade Organization.

Footnotes

[1] One reason is that these instruments are short term and can be unwound quickly to improve banks’ liquidity conditions.

[2] See, for example, Working Group on Trade, Debt and Finance (2014). Maintaining a network of correspondent banks is costly for individual banks and elevated due diligence requirements have reduced banks’ incentives to work with foreign banks.

[3] Another paper, Paravisini et al. (forth.) found that reductions in the supply of credit to firms in Peru led to lower exports. Ahn (2013) also studies LCs in Colombia but focuses on the relationship between bank balance sheets and LC supply.

[4] Data provided by SWIFT reveal that about 91% of all LCs are used for cross-border transactions. See Niepmann and Schmidt-Eisenlohr (2013a) for more details about the use of letter of credit in US exports.

[5] For more details on the trade-offs that firms face when choosing between different payment contracts in international trade, see Schmidt-Eisenlohr (2013), Niepmann and Schmidt-Eisenlohr (2013a) and Antras and Foley (forthcoming).

[6] It builds on and extends the approach proposed by Amiti and Weinstein (2013) and Greenstone and Mas (2012).

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Topics:  International trade

Tags:  Letters of credit, Trade finance, US exports

Economist, International Finance Division, Federal Reserve Board

Economist, International Finance Division, Federal Reserve Board

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