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  Date: 29th Oct 2009

 Compiled by: M Sathya Kumar  

Developments in Import and Export Finance

Corporates need to look at what method they are using for import and export financing, because what was considered an easy choice during a period of excess liquidity may not be the most economical, or even viable, model now.

What started as a crisis in the financial sector has moved aggressively into the ‘real’ economy. Within six months of the beginning of the crisis, the drop in global demand for goods and services has led to a fall in trade flows of over US$1.5 trillion, according to the World Bank. The World Trade Organisation (WTO) forecasts that trade volumes will fall 9% in 2009, the strongest contraction since World War II, as demand collapses in the biggest economic downturn in decades.

Many countries have reported double-digit drops in exports over the past few months as the recession takes hold. For example, Germany, Europe’s largest economy and the world’s top exporting nation, has seen a rapid slide in industrial orders triggered by the global crisis and, with little sign of slowing down: January’s industrial orders for engineering companies were 37.9% lower than a year before, with overseas orders down 42.5%.

In addition to the general decrease in demand that has to be seen as the main reason for the slump in order rates and export volumes there are two other factors that further increase the effects.

First, there’s obviously an increased tendency for protectionism. The strongest increase of trade barriers or tariffs, for example, is found inside the Organisation for Economic Co-operation and Development (OECD) nations.

Concurrently - or consequently, some would argue - the volume in trade finance has dramatically shrunk. The International Monetary Fund (IMF) has projected a shortfall in trade finance of between US$100-300bn and a recent IMF study found that trade financing constraints were affecting 6-10% of developing countries’ trade.

The absence of an adequate trade finance infrastructure is a barrier to trade. Limited access to financing, high costs, and lack of insurance or guarantees will hinder the trade and export potential of an economy, and particularly that of small- and medium-sized enterprises (SMEs).

Bernard Hoekman, the director of the trade department in the World Bank’s Poverty Reduction and Economic Management Vice Presidency, said that a big falloff in trade financing last fall was partially to blame for the global trade drop, but that the collapse is primarily due to the drop in demand and a reflection of the pattern of world trade and specialisation that emerged in the last 20 years, whereby businesses spread their supply chain over many countries, producing and buying components that make up a product in many countries.

Assuming that trade is affected by the drop in the availability of trade finance as outlined above, it is certainly important to have a further look into the matter and find the respective solutions.

Challenges in Import and Export Finance

The overall import and export finance situation has changed significantly in the past 12 months. Compared with 2006, when there was excess liquidity in all kinds of financial markets, such as structured commodity markets, emerging markets, etc, today the liquidity has dried up and manufacturing importers and exporters are finding it more difficult - and more expensive - to borrow the money needed to invest, for example, in equipment. Manufacturers will face even greater problems at the moment when demand starts to pick up again, as an increase in orders for their products will go hand in hand with an increased need for working capital. Thus the provision of liquidity - and not only demand for their products - will be the challenge for their future. As a consequence, for many parties, the real effect of the crisis will hit hardest when the market begins to recover. The full extent of these effects, and the number of victims they claim, will only be seen in 2010.

It is clear that the lack of trade finance is also a serious constraint for importers in a number of countries that don’t have access to the levels of working capital that they had before. Credit lines - especially with longer maturities - are no longer available at the levels needed - global banks are retreating to their headquarters and cutting credit lines that provided working capital, for example, in the emerging markets.

The banks themselves are experiencing a shortage in terms of equity and liquidity. They are therefore forced to reduce their balance sheets and an easy way to do this is to not renew a trade finance agreement. For example, international banks are not providing the previous level of working capital finance to Russian clients any longer. This decision is obviously also driven by the fact that the real risk scenario in this country, like in many others, has changed substantially.

The crisis also put a spotlight on the re-financing side. Established rules to match borrowing and on-lending in terms of underlying maturities were not really adhered to in many banking areas. For example, in Kazakhstan, many banks focussed on short-term borrowing to re-finance long-term lending. As the credit crisis hit the emerging markets, the effects came fast and hard as the short-term credit lines were cut and the price of all loans increased dramatically. In many cases companies also had a similar approach of taking short-term money to partially fund long-term investments.

In total, the evaporation of liquidity has had a devastating effect on corporates and their ability to do business. Corporates need to look at what method they are using for import and export financing, because what was considered an easy choice during a period of excess liquidity may not be the most economical or even viable model now.

Challenges in obtaining long-term financing today are not restricted to the emerging market side but also affecting the OECD markets. Thus the classic export finance focus - i.e. to support exports out of OECD markets into emerging markets - has substantially shifted. Even companies that are not domiciled within the emerging markets have to look for Export Credit Agency (ECA)-backed finance solutions because it may be the only way that they get long-term financing for their investment programmes.

The crisis draws the attention of exporters and importers to three main areas. In a time of uncertainty, corporates are more concerned about their many business relationships and look to mitigate the risks posed by these relationships through different methods of finance. Thus risk mitigation is a key aspect at the moment.

In addition, every company will have to put more emphasis on its liquidity management in order to gain more independence from external funding sources.

A third aspect, especially faced by exporters, is the complete change as the market shifted from a sellers’ market to a buyers’ market. They now have to actively use financing instruments to provide finance solutions in combination with their commercial offerings.

Returning to Letters of Credit

Up to 90% of the US$13-14 trillion in world merchandise trade is funded by trade finance, through letters of credit (LCs), which is traditionally one of the simplest and safest forms of credit. The trend towards open account transactions has been halted in its tracks due to perceived counterparty risk. LCs are only partially a credit instrument; to a larger degree, as a security instrument, they secure payments for the exporter.

Many companies feel that, due to the significant changes in the risk profile of their counterparties, they cannot trust them to pay, and so they are turning back to LCs for security reasons. But often the company additionally needs a confirmation of the LC in order to have an instrument that is acceptable from a risk perspective. In that case it turns to its bank to have the LC confirmed.

But as a result of the crisis, the banks’ lines to confirm LCs in many case have been substantially reduced and parts of the industry claimed that there was not enough credit availability in the market to receive confirmation on the LCs.

Here the ECAs either already had tools (e.g. ONDD from Belgium) or created instruments (e.g. HERMES from Germany) to improve the situation by providing specific possibilities to cover the confirmation of an LC.

So, if a bank does not have enough credit lines available to confirm their corporate clients’ LCs, the bank can apply for cover from e.g. Hermes, for example.

Reducing Risk through ECAs

Taking all the above effects into consideration, a good part of the problem can be addressed by relying on the support available from ECAs. They will grant cover for 95-100% of the covered amount. Basically, such a loan is turned into government-backed credit and is no longer a high risk for the bank. Therefore, the banking side doesn’t need much equity or a high level of risk-weighted assets to support the transaction. They are then left with the issue of liquidity. Liquidity becomes the main driver for the price, because if the re-financing rates are higher for the banking side, then it will have to charge higher rates for the borrowers. But, for many institutions, support of their exporting client base is still an important issue and banks will be prepared to allocate long term liquidity to these loans.

An ECA-covered loan will in many cases also be the only possibility to finance investments along the tenors needed from the investments’ perspective. It is an issue that - as outlined before - has by far more importance in today’s markets, as nobody likes to run a re-financing risk. Therefore, an ECA financing product is good because it matches the economics in terms of availability, repayment period, etc.

Previously, ECA-covered loans may not have been the best choice in all circumstances because of the comparably high cost, due to the exposure fee. That was when there were enormous amounts of liquidity and, therefore, very cheap money for the borrower outside of these instruments. However, the situation is now reversed and the prices have significantly increased in the finance markets. In times where, for example, Russian corporate borrowers pay all - in margins of 800 bps for medium term loans, the savings from an ECA-covered loan can be enormous.

Now ECA-covered loans are, relatively speaking, the cheapest possibility of long-term finance, even taking into account the premium paid to HERMES, for example.

Again, there is no real alternative - even if there is, the price will be dramatically higher than using ECA-covered products because these markets are experiencing extreme levels, with double digit margin figures, for example. That is not the case with the ECA finance, because the premium systems are stable, not driven by the market. As long as a country stays within the same OECD country category, the premiums will not move. Therefore, this type of financing gives a company more security in terms of the calculation.

Conclusion

The crisis has substantially changed market conditions within the financial markets and the real sector. How sustainable this development is remains to be seen. Even though some recent news suggests that things are already moving in a positive direction, I believe that markets will not return quickly to the levels seen before the crisis. Therefore, companies should be prepared to use the instruments offered by the ECAs to a much larger degree. Exporters, especially, will have to understand that they will need to provide finance solutions within their commercial offerings in order enhance their chances to secure future revenues. For many, this will require a change in their approach towards their clients, but it is a change that will be crucial for their success.

Article by Marck Wengrzik joined Commerzbank in 1995. He gained experience in different areas of corporate finance and correspondent banking before joining the bank's Export & Trade Finance Department in 1997. He is an expert in Export and import finance.

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