Access to Trade Finance in Times of Crisis
Chapter 10. Trade Credit for Crisis Countries: The Role of Export Credit Agencies
- Jian-Ye Wang, and Márcio Valério Ronci
- Published Date:
- February 2006
- Glen Hodgson 53
Developing countries in financial crisis appears to be a recurring feature of the international financial system. For the purposes of this chapter a “crisis country” is defined as one that is unable to service its external debt obligations as scheduled and is experiencing other forms of severe economic stress (for example, a sharp currency devaluation, reserve depletion, fiscal and macroeconomic disequilibrium, etc.). While a framework has emerged for providing financial assistance and relief to crisis countries in an orderly fashion, with the IMF (and to a lesser degree the World Bank) at its center, it is certainly possible to consider enhancements to that framework. Maintaining or restoring access to trade credit is one possible enhancement. This chapter identifies institutional and economic policy constraints faced by export credit institutions when a crisis country needs trade credit. It points to transaction-based action that could be taken by external lenders and insurers to restart the flow of credit to crisis countries, and concludes with some observations on how multilateral policy changes could make the flow of trade-related credit to developing countries more sustainable.
Changing Face of Trade
Global trade in recent decades has grown much more rapidly than global GDP, reflecting the combined forces of increased economic integration and greater disaggregation of production. Economic integration is the result of the greater trade liberalization that has occurred multilaterally and regionally since the 1980s. Since trade barriers are lower, companies are increasingly disaggregating production through global supply chains. They are breaking their products into smaller components, focusing on what they do best, and purchasing inputs internationally. Foreign direct investment is used to build global supply chains and is thus an integral part of trade today.
Some developing countries are reaping the economic benefits of trade integration and globalization—China is a stellar example, as are other East Asian economies. In contrast, many other developing countries are still largely engaged in more traditional forms of trade—the international buying and selling of goods. But one need virtually all developing countries have in common is for trade finance. In most cases, that means accessing credit from external sources, since few of these countries have a financial system that is sufficiently mature to meet all their trade finance needs.
What Is Trade Credit?
Trade finance covers three broad categories of credit that can be used to facilitate international trade. First, credit can be provided to domestic buyers to purchase imports, especially for those used as inputs when making exports. Second, exporting firms normally require domestic working capital to pay operating costs prior to shipment of and payment for the export. And third, credit can be extended to foreign buyers of exports to facilitate the completion of the export sale. A wide variety of specific financial and insurance instruments have been developed to extend credit for trade, but all these instruments perform one of these three basic functions.
A distinction should also be made between short-term trade credit of a year or less for normal trade in goods and services, and medium- and long-term credit for capital goods and projects. For crisis countries, the loss of short-term trade credit can exacerbate the situation by choking off the capacity to export. Medium- and long-term trade credit is less critical in immediate crisis situations, but can play an important role in crisis prevention and crisis recovery by supporting a sustainable pattern of trade and investment activity.
Constraints Faced by Export Credit Agencies
Export credit agencies (ECAs) face a number of constraints to maintaining or restoring trade credit for crisis countries.
The first constraint is the nature of export credit agencies themselves. These institutions were never intended to act as international crisis managers; that role belongs to the IMF, World Bank, and the regional development institutions. In addition, ECAs are not homogeneous, even though state-owned ECAs generally have a mandate to foster national trade and advance national interests. There are significant differences between individual ECAs in philosophy and financial underpinnings that lead to major differences in behavior and performance. Finally, ECAs are in a constant state of evolution, and the differences may be increasing, not shrinking. In sum, ECAs are generally limited from the outset in what they can do to fill credit gaps for developing countries in crisis.
We have already noted the distinction between short-term trade credit for normal trade, and longer-term (i.e., over two years) insurance, guarantees, and financing used for capital goods and projects. Through privatization, the public sector has largely exited the short-term credit insurance business. Japan and Canada are the only Group of Seven countries with a public sector institution offering short-term credit insurance as a core product. Very few other industrial countries have any material public sector, short-term export credit insurance capacity. While there are valid questions as to whether governments should have abandoned the short-term credit insurance field so completely, that bridge has largely been crossed. 54
Private export credit insurers have no public policy mandate and operate for profit. For developing countries in the midst of a financial crisis, private insurers generally have little interest in preserving existing levels of cover or extending new cover—except by cherry-picking the very best commercial credits. Yet because of privatization of their short-term export credit businesses, creditor governments have little or no capacity today to re-open in a crisis country on a shorter-term basis and then gradually extend longer credit terms once a positive payments track record had been established. Therefore, the current state of the credit insurance market is a fundamental constraint to restarting trade credit for crisis countries.
Constraints also exist with respect to medium-term credit. Export credit systems differ widely, reflecting very different operating philosophies and underlying financial conditions. No two creditor-government export credit systems are exactly alike. Compare, for example, the financial conditions for the U.S. Export-Import Bank, which is based on a lender-of-last-resort concept backed by annual budgetary appropriations from Congress, with that of Export Development Canada (EDC), which has government capital originally invested in its balance sheet, is expected to grow through profits and retained earnings, and must take responsibility for all its credit decisions. Countries like France, Germany, and the Netherlands have engaged private insurers that act as agents for the state, but with governments taking the core credit decisions and the risk. These complex institutional arrangements make it very hard to generalize about how export credit institutions providing medium-term credit might play a more prominent role in countries in crisis.
Finally, the practices of individual ECAs along with the international rules governing official export credit—formally known as the “The Arrangement on Officially Supported Export Credits” of the Organization for International Cooperation and Development and commonly called the OECD Consensus Arrangement—create additional constraints to effective cooperation between the public sector and private market and can make it more difficult to unlock trade credit in times of crisis. The Consensus Arrangement rules defining “official support” were designed for another era, the 1970s. Their principal objective is to minimize trade distortion in the use of medium-term trade credit by establishing a level playing field among OECD governments, even if that level field creates an implicit or even explicit subsidy. Issues such as creating the right incentives to encourage greater use of private, medium-term trade credit by developing countries have not been taken into consideration. Not surprisingly, most OECD official export credit systems are therefore not designed to “crowd in” private credit by working cooperatively with the private sector on a shifting risk-sharing basis. For the Consensus Arrangement, market failure is a binary choice; the official market starts where the private market stops, with little if any transition.
In terms of the current debate on trade finance for crisis countries, there are two consequences flowing from these rules. First, the rules may subtly undermine efforts at crisis prevention in developing countries by encouraging countries to allocate scarce foreign exchange and domestic resources to transactions and projects, supported by official credit, where the financial return is below market-based yields—allowing less efficient transactions with low expected financial returns to proceed. And second, since most official export credit systems are designed to be lenders of last resort, many ECAs have only limited experience with the innovative structuring and risk mitigation practices of the private sector. They also see only a subset of the potential transactions in a given country’s pipeline; hence they cannot even cherry-pick deals that might still make financial sense in a crisis setting.
What is the end result of all the preceding institutional factors? If a developing country experiences a financial crisis that turns off short-term trade credit, foreign private investment and medium-term debt financing, most export credit institutions simply do not have the capacity to step in quickly and fill the gap. To cite work done for the IMF by Malcolm Stephens, 55 ECAs are not a “Sleeping Beauty” that can be awakened with a kiss each time a crisis appears. For many, privatization of their short-term business has removed the technical capacity to provide short-term credit in times of crisis. As for medium-term credit, the existing international rules and practices have left ECAs without the necessary experience and knowledge base to act quickly if private credit dries up.
It should be noted in passing that EDC is one of the few institutions that offers short-term trade credit insurance, has the capacity to operate in both the official and commercial medium- and long-term trade credit markets, and understands the disciplines of both markets. The EDC can potentially help to bridge the private-public gap, which conceptually would be one means of restarting trade credit to countries that have experienced a financial crisis.
Country Risk Assessment and Management
Heightened country risk is an obvious second constraint to new trade credit for crisis countries. When a country has been through a crisis, it likely will have been downgraded within any credit institution’s risk-rating system. A downgrade invariably reduces the country limit while raising the minimum risk premium to be charged for doing business in that country. If arrears build, or even if existing exposures are rescheduled, a large share of the country limit can be tied up for many years to come. Capitalization of interest as part of a rescheduling simply adds to the problem.
Country risk also comes in many forms, with transfer risk arguably the most prominent issue in times of crisis. Uncertainty about both the foreign exchange regime and the actual exchange rate is a serious constraint on the capacity to extend new credit—to paraphrase Alan Greenspan, risk can ultimately be priced, but uncertainty cannot. If a country’s foreign exchange regime is in a state of flux (like Venezuela today), we have little basis on which to judge whether foreign exchange commitments to creditors will be honored, and at what cost to the local counterparty.
A final constraint for ECAs emerges from the fundamental nature and practices of multilateral financial institutions and how they relate to export credit institutions. One set of relations is through the management of existing ECA exposures in developing countries. The Paris Club of creditor governments is increasingly being treated as the residual balance of payments gap-filler in IMF-supported programs. In recent years, there has been a shifting boundary line for sovereign debt rescheduling and debt reduction, with a growing list of countries being considered for exceptional treatment— Serbia, Pakistan, and Indonesia to name three specific cases.
Looking ahead, the introduction of the Evian Approach heralds a fundamental shift in Paris Club thinking from a rules-based approach (e.g., Houston terms, debt forgiveness for countries participating in the Heavily Indebted Poor Countries initiative) to a judgment-based approach based on an evaluation of sovereign debt sustainability in each case. The Evian Approach may eventually help to provide clarity on the financial criteria for the recovery and/or forgiveness of sovereign debt, but only when creditor governments have sufficient experience on which to base decisions about the likelihood of future debt service payments from sovereigns. In the interim, uncertainty about the status of sovereign debt restructuring or forgiveness means that trade creditors may be far less inclined to step up and offer new cover for countries that have been through a payments crisis. It bears repeating: you can price risk but you cannot price uncertainty.
Another set of relations exist around new credit and the lending practices and preferred creditor status of the multilateral institutions. Large exposures for the IMF, World Bank, and regional banks may crowd out new ECA activity. Trade credit institutions are well aware that in a few cases, a significant claim that cannot be rescheduled has already been made on future foreign exchange earnings. In other cases, the existing stock of multilateral debt may not be a problem, but the inflexibility of preferred creditor status for multilaterals may leave little scope for true risk sharing on new lending among multilateral lenders and trade finance institutions. This refers specifically to the private sector windows of the development banks.
Conceptually, the International Finance Corporation and the other private sector windows of the development banks should be ideal partners for trade credit institutions in re-opening a crisis country’s access to foreign credit—both can fill financing gaps when there is market failure. In practice, however, trade creditors do not receive pari passu treatment with the multilaterals, and thus are structurally delegated to second-tier creditor status—which could further impair their appetite for new credit.
Export Credit Agencies and Crisis Response
Notwithstanding the constraints described above, a number of approaches can still be taken by export credit agencies, consistent with their mandate, to help unlock new trade financing for countries that have experienced a payments crisis.
Start Short Term
The ideal commercial practice would be for trade credit institutions to start by extending credit on a short-term basis, allowing the country to re-establish a repayment track record, and then extending longer terms. This is how EDC often approaches a crisis market in an effort to rebuild a positive credit record. However, as already noted, there is limited scope among ECAs for this commercially oriented practice due to the privatization of most state-owned, short-term export credit businesses a decade ago.
Price to Risk
A second best practice is pricing to risk. Pricing to risk brings rigor and discipline to lenders and borrowers, forcing both to set priorities where capacity is scarce. This is certainly the risk-pricing concept at EDC, where transactions are evaluated using commercial risk assessment methodologies. In contrast, the failure to price to risk eats up scarce institutional capacity, can distort or spoil a developing-country market, and can contribute to future debt service problems if nonpriority transactions are allowed to proceed. Pricing to risk may be a challenging concept in a postcrisis situation, since risk is even harder to estimate in times of greater uncertainty, but the underlying principle is fundamental to good practice.
Use Risk Mitigants
Trade credit institutions should make use of all available risk mitigants when considering new credit in order to help avoid crises and unlock new credit for countries in crisis. These mitigants include:
Giving preference to transactions that generate net foreign exchange for the country in question;
Using offshore accounts to capture project or transaction earnings, thus reducing or eliminating transfer risk, and using third-party guarantees from foreign entities;
Extending credit in local currency to eliminate foreign-currency transfer risk. However, local currency lending requires a source of domestic savings that can be tapped by banks or export credit institutions that are direct lenders, which in turn depends on the depth of local financial markets;
Focusing on those risks where cover is possible—e.g., there may be appetite to cover the risk of expropriation, but no appetite for transfer or terrorism risk.
In addition to risk mitigation techniques, export credit institutions could make greater use of highly structured or project financing techniques wherever possible. Projects in resource-extractive industries are prime candidates for structured financing, and one obvious area where export credit institutions can potentially operate in a crisis country and contribute to strengthening the country’s exports and debt service capacity. Institutions that focus on support for foreign investment may also have greater opportunities to restart the flow of capital to developing countries.
However, it must be noted that there is limited ability in most developing countries to use asset-backed financial structures, since the requisite legal foundations are inadequate or do not exist. Work has been done to establish an international convention on asset-backed financing, but a conclusion remains far off.
Assess All Risks
Finally, there are “new” risks that have attracted considerable attention in recent years— those related to the environment, human rights, social impact, and corruption. An assessment of these risks must be part of any list of good practices. However, it also raises the question: can crisis countries meet the emerging international standards for these risks? All too often, countries that have been in crisis are least equipped to satisfy the requirements of export credit institutions in these areas of corporate social responsibility or reputation risk, and thus may lose opportunities to re-access foreign credit. The multilateral institutions have a special role to play in building the institutional capacity of countries in crisis and other developing countries to deal with these new risks.
Earlier, this chapter mentioned some areas where multilateral policy action could be taken to improve crisis countries’ access to trade credit. There is no silver bullet or magic solution, but policy action is possible on a number of fronts.
Agree on Guiding Principles
An obvious place to start is for all external creditors to agree on a common set of guiding principles aimed at making trade credit sustainable for developing countries. While setting the overall framework for crisis prevention and resolution is not the purpose of this chapter, Box 10.1 sets forth four possible guiding principles for sustainable trade credit: first, start with a common definition of trade credit; second, focus on crisis prevention; third, if crisis occurs, take a systematic approach to its management; and fourth, seek a level playing field among providers of exceptional credit. A serious international discussion on guiding principles may well lead to consideration of ways to reduce some of the constraints to ECA action that were identified earlier.
Box 10.1.Guiding Principles for Sustainable Trade Credit
1. Include the entire trade credit chain
• Credit for imports used in exporting
• Working capital for exporters
• Credit to foreign buyers of exports
2. Prevention first
• Macroeconomic policy design and implementation
• Health of financial sector, including central bank
• Openness of the economy—capacity to manage shocks
• Terms and structure of external credit and obligations
• Trade credit that is not distorting and uses risk mitigants
3.If crisis occurs, take a systematic approach to its management
• Objective: restore commercial credit as quickly as possible
• Coordination: reach a shared diagnosis of the problem
• “No harm” concept for intervention: goal of exceptional trade credit is to sustain and restart commercial credit, not crowd it out
• Decide who is best placed to do triage of exceptional trade credit:
∘ Expect demand to outstrip supply; political constraints on full risk pricing
∘ Use domestic financial system as much as possible
∘ Next option is local public sector, usually led by the central bank
∘ External players as a last resort
• Use objective criteria for triage of exceptional trade credit:
∘ Determine priority export sectors based on:
■ Market shares
■ Pricing power
■ Import dependence of exports (in crisis, lower is better)
■ Cyclicality of exports
∘ Determine exporting firms in priority sectors based on:
■ Sustainable business model
■ Financial strength
4. Seek a level playing field among providers of exceptional credit
• Multilateral leadership normally expected
• Optimal state: pari passu treatment among public sector providers
• Commercially-based pricing to minimize distortion and crowding out
• Bias in favor of private creditors committed to the market/country
• Risk-sharing with public sector would encourage self-selection
A More Seamless International Financial Market
Conceptually, all emerging markets would benefit from reducing the barriers between multilateral creditors, export credit institutions, and the private market to creating a more seamless international financial market. From an aggregate or “top-down” viewpoint, most immediately see the advantage—it would mean that all sources of funding could be considered when assessing how to close a crisis country’s balance of payments funding gap and speed it on the path to recovery.
In contrast, the international financial market is remarkably segmented at a transactional or “bottom-up” level when it comes to new credit. Relatively hard boundary lines have been created, either inadvertently or by design, between multilateral credit, official support from ECAs, and the commercial market. These hard boundary lines appear as differences in risk pricing, repayment terms and structure, and lender security. They generally frustrate innovation, discourage risk sharing, and lead to inefficiencies. They may well result in funding gaps emerging for specific transactions and can delay or even preclude some bankable deals from being completed. Anyone interested in unlocking new credit for crisis countries should therefore want to make the boundary lines between market segments more flexible and overlapping.
What does this mean in concrete terms? One policy option worth examining is the scope for true, pari passu risk-sharing between the multilateral development banks, especially their private sector windows, and export credit institutions. There will always be circumstances where the multilateral development banks should be the preferred creditor, especially when they are acting as the funding source of last resort for the government of a country in crisis. But there is no compelling reason why preferred status must apply in all circumstances.
Consider, for example, a country that has suffered a devaluation shock and has been pitched into a resulting external payments crisis, as was the case during the Asian crisis or, more recently, in Argentina. Existing external creditors are at risk of not being paid on time and are therefore obviously reluctant to provide new credit. Yet the country may have unexploited natural resources that could generate sufficient foreign exchange to cover any new external credits if sufficient funding capacity were to be mobilized to develop the off-take of those resources. Foreign exchange risk is not high, since the devaluation shock has already taken place. Under these circumstances—which are often found in crisis countries—the real need is financing capacity, not just a preferred lender of last resort. A multilateral financial institution that acts as a partner to a group of ECAs by bringing risk-taking capacity on a seamless or pari passu basis could play a valuable public policy role, mobilizing foreign credit to expand the country’s exports without taking undue risk.
Shifting away from absolute preferred creditor status to a more relative or selective use of such status would require a more granular assessment of circumstances, credit risks, and competencies among the various institutions that provide trade credit, since some may be better positioned to take certain risks than others. Here the historical example is of the Multilateral Investment Guarantee Agency (MIGA), the political risk insurance arm of the World Bank. The MIGA traditionally has had a less-than-absolute status as a preferred insurer and consequently has been seen as an integral and integrated player in the political risk insurance market.
The same overlap concept should apply to official export credit agencies and the commercial market. Much of the resistance to market-based practices by ECAs seems to be rooted in a history of win-lose competitive subsidy in trade finance among major industrial countries. Yet ECAs that can also be market players, taking the same terms and conditions as the private sector, have greater capacity to fill gaps when the market boundary line recedes in a crisis country. ECAs that are engaged with the private market on comparable credit terms would have more room for innovation and adaptation, and thus more scope to add to the capacity of the private market.
The challenge of restoring trade credit for countries emerging from crisis makes it abundantly clear that the time has come to take a more objective look at how ECAs can maximize the benefits to all stakeholders, including developing countries. Maintaining or justifying the status quo no longer suffices. Rather than continuing with a Consensus Arrangement guided by the lowest common denominator—a level playing field that constrains trade finance subsidies among OECD governments—a fundamental rethinking of the rules governing official support could help unlock trade credit for countries emerging from crisis, or trying to avoid it. Imagine an arrangement among OECD governments that would create incentives for attaining the highest common denominator—market-based medium- and long-term trade credit for developing countries—in order to encourage improved access to private credit. Change the objective of the exercise and the outcome might look very different.
Crisis-Country Policy Design
The third area for action involves macroeconomic policy design and implementation, which must remain the core of any crisis country’s stabilization and recovery. Export creditors would benefit from improved clarity on the IMF’s advice and expectations with respect to foreign exchange regimes in crisis countries. At a time when the slogan “Washington Consensus” is much used, it is striking just how little consensus there seems to be on a sustainable foreign exchange regime for developing countries—one in which creditors could have long-term confidence.
To encourage the restart of export credit, creditor institutions would also benefit from more explicit IMF support for the best-practice risk mitigants and other innovative approaches outlined earlier. The IMF should be prepared to acknowledge and even encourage risk mitigants like offshore accounts linked to specific projects. While such accounts may channel foreign exchange away from central bank access, the projects they underpin can help to strengthen and diversify the productive capacity of a crisis country, with fiscal and other economic spin-off benefits. Similarly, a priority focus on financial deepening in developing countries would help to underpin local currency lending.
A final area for policy reconsideration is the Paris Club and its underlying practices. It makes sense that the Paris Club has progressively relaxed and expanded its practices to increase the scope of possible sovereign debt relief, since certain classes of debtor sovereigns clearly suffered from a debt overhang that had to be reduced. However, on recent occasions, the baby has been thrown out with the bath water—rescheduling or debt forgiveness terms have been offered that exceeded the actual needs of the sovereign in question.
The move to Evian terms represents a fundamental shift from a rules-based approach to a judgment-based approach stemming from an evaluation of sovereign debt sustainability in each case. What is now needed is multilateral agreement on the methodology for calculating debt sustainability, since that methodology is critical to determining the boundary line for eligibility for debt reduction and exceptional treatment. Without greater clarity on the new operating rules for the sovereign debt management game, new export credit flows will be discouraged. This is of particular importance to middle-income countries that have the potential to re-establish creditworthiness relatively quickly—in months or years, not decades.
Export credit agencies have comparable mandates to promote national trade, but they are not all guided by the same financial objectives—one size does not fit all. There are institutional and practical limitations to what can be done in crisis countries, especially for short-term trade credit. Nevertheless, there also are a variety of innovative underwriting and structuring practices available to ECAs that could help to unlock new trade credit, earlier, for countries that have come through a financial crisis. Conceptual and policy changes could also be made by the international financial community that would improve the functioning of the international trade credit system, to the benefit of many developing countries. Are official export credit agencies equal to the task?