Column : No safety in finance

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: One surprising thing about the period of extreme financial markets turbulence in September 2008 was the speed and extent with which it translated into an economic slowdown. The proximate cause had become clearer over the past couple of months, a shutting down of credit lines across geographies and products. And one credit facility in the direct line of fire was trade credit. Just as the current slowdown in India seems to have emanated largely from a deep export slowdown, the source of the sharp drop in economic activity in emerging markets is a collapse of trade, shown by the plummeting of the Baltic Dry (Bulk Goods) Freight Index (BDI), down more than 92% in November 2008 from its earlier highs in May (see graphic).

Global trade is currently of the order of $14 trillion annually, and has been growing at over 9% annually over the last three years. Trade is about a quarter of the world’s 2007 GDP of $54 trillion. This growth is reported to have come down to around 6% in 2008 and is projected to shrink by 2% in 2009. WTO sources estimate that 90% of this trade is based on some kind of trade finance—letters of credit, guarantees or insurance.

LCs pay a large role in credit. A well-structured LC provides an established framework that the exporter and its customers can use to manage the entire trade cycle from purchase order receipt to export financing through to payment. The basics of the way it works is this. Say company A in the US wants to import from Company B in India. They draw up a sales contract for a specified amount. Company A goes to its bank in the US and applies for an LC for this amount, with Company B as its beneficiary. This LC is either a loan underwriting or funded with a deposit and an associated fee. The US bank sends the LC to the Indian bank, which in turns informs Company B that it will pay when the terms of the contract are met (normally with the receipt of shipping documents).