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).
India?s 29% compound annual growth of merchandise trade from 2003-08 has been matched by a 45% CAGR in LCs, with the resultant off balance sheet exposure of banks at end-March 2008 being over $148 billion. Export credit outstanding had increased from $4.6 billion at end-March 2004 to $10.4 billion at end-March 2008. Though this amount looks small in terms of total trade, remember that a lot of this is short term in nature and keeps rolling.
Overall trade related credit increased from $4.1 trillion in 2004 to $44.6 trillion in 2008.
The WTO reports that there might have been a shortage of $25 billion in trade credit, arising out of both a shortage of liquidity and a rise in counterparty risk aversion. Trade financing is normally considered one of the safest lines of credit, due to its short term nature, its backing with documents and the underlying collateral of the consignments and the comfort of the bank issuing the LC. The credit freeze, however, had increased counterparty risks to the extent that many banks were reportedly refusing to honour LCs. At that point, no institution, global or domestic, was considered a safe credit risk.
This latter aspect has resulted in the collapse of many of the ancillary activities relating to the primary credit. Secondary markets in trade credits have also vanished, in line with the collapse of these markets based on other syndications. Anecdotal evidence suggests that costs of trade credit have sometimes risen six fold, making financing of exports completely unviable.
This current episode of the drying up of trade finance is not new. A very similar situation was observed during the Asian crisis, when trade credits to emerging markets had dried up. The paucity and delay in official response then had led to a prolonged stagnation of trade till early 2003. This lesson seems to have been learnt this time around.
Global multilateral lending and export credit agencies have responded to the current shortage. The International Finance Corporation has tripled the ceiling, to $3 billion, of the trade finance guarantees available under its Trade Finance Facilitation Program. National Export Credit Agencies have reportedly increased their business by more than 30 percent in 2008. Many national governments have also actively backed this increase. Global Dollar swap facilities opened by the Federal Reserve with some emerging market central banks has also served to ease some of the shortage.
As the World Bank notes, the global credit crisis is likely to affect private investments and capital flows hard, being the most cyclical and prone to risk aversion. A quick and relatively large Indian response, already on the anvil, in coordination with global measures, might serve to blunt some of the adverse impact.
The author is vice-president, business & economic research, Axis Bank. These are his personal views