While financial market stability and regulation may be the overarching theme of the G-20 summit in Pittsburgh, there is one unglamorous aspect of finance which needs equal attention ? trade finance. During the last summit in April this year, the G-20 agreed to ensure availability of funds to the extent of $250 billion for trade finance. The package made certain that availability of finance for trade purposes did not dry up and ensured efficient functioning of international trade markets.
Trade finance oils the wheels of global trade. Although precise figures are not available, estimates of annual trade financing amount range between $10-15 trillion. Commercial banks are the most important providers of this form of financing and have a market share in excess of 90%. It is among the safest form of financing because it is short-term so the risk undertaken by the bank is for considerably less time than, say, loans. Moreover, this is collateralised by the merchandise. Yet, trade finance credit was not available freely in the crisis months of last year.
In the aftermath of the credit crisis, banks had been reluctant to provide any kind of financing. Firstly, banks were unwilling to take counterparty risk in many countries. Secondly, as the banking crisis unfolded, banks were using capital to shore up their weakened balance sheet rather than commit more funds for traditional businesses. Thirdly, the new Basel guideline imposed a higher capital charge on trade financing to developing countries. The banks in turn passed this higher cost to their customers. And finally, banks sometimes faced liquidity concerns because of which their cost of funding too went high. This too was passed on to their clients. This resulted in an increase in the cost of financing ranging from 0.25% to 3%. When the developed nations realised that the banking crisis was affecting even the safest and non-exotic forms of financing, they committed to package so that the inefficiencies prevailing then did not affect the already dwindling international trade.
Let us understand the trade package and how it is being made available. The package involves a commitment of $250 billion to be provided over a two year period. Now, unlike in a bailout, the G-20 does not have to pump in that amount of new money to make it available for trade finance. The actual quantum of money that may be deployed would be of the order of $50 billion. Due to the short-term nature of the financing, $50 billion can be rotated in the system to provide financing of up to $250 billion over two years. Of this, $50 billion only 40% is to be contributed by governments of developed nations and by international institutions such as the International Finance Corporation and Asian Development Bank. The remainder 60% is supposed to come from commercial banks. The 40% contribution by governments and supra-national agencies would also get routed through banks because they are the most efficient way to deliver the package. For instance, in June this year, the London-based emerging market bank, Standard Chartered, took a $500m credit from IFC. In turn, it committed to make $1.25bn available for trade finance in emerging markets over two years. At the end of two years, the loan would be repaid by Standard Chartered to IFC.
Various estimates have put the size of possible trade finance gap in the range of $25-500 billion. The package announced in the London summit made sure that the banking crisis did not affect international trade severely. But, since the G20 meeting, the market has not gone back to normal. There has been an increase of payment defaults.
The rise in casualties in what would normally be a relatively safe market is still creating an abnormally high aversion to risk and thereby increasing the financing gap. Customers in developing countries are still facing difficulties in opening of new letters of credit. Even among developing countries, perception of risk varies depending on assessment of the sovereign risk. For instance, India is considered among the best counterparty risks, yet the premium is currently at about 1.50% over normal levels.
During their deliberations in Pittsburgh, the member nations would do well to increase the trade package to at least $400 billion. This was something that the G-20 had agreed in London?that if need be the extent of assistance would be increased. To make sure that the trade flows stabilise and that trade volumes start to increase again, it is imperative that another timely injection of funds be done to remove frictions in international trade. Compared to the bailout package doled out to financial institutions last year, the quantum of money to be allocated for this package is much lower and the benefits accrue to a larger group of developing nations.
The author, formerly with JPMorganChase?s Global Capital Markets, trains finance professionals on derivatives & risk management