Easing trade finance crunches could lessen severity of crises
IMF Survey: What prompted you to examine trade finance?
Gilman: Bank-financed trade credits declined by as much as 30–50 percent in Brazil and Argentina in 2002, about 50 percent in Korea in 1997–98, and over 80 percent in Indonesia during the Asian crisis. Sharp declines in trade finance were also observed in Russia, the Philippines, and Thailand in 1997-98 and in Turkey in 2000–01. The scale of the collapse appeared to be out of proportion with the level of risk. After all, trade finance usually takes the form of short-term credits secured against goods that earn foreign exchange, and the default rate on this category of financing has traditionally been very low.
What concerned us is that a collapse in trade finance meant that a country’s ability to export—and therefore to increase export earnings to help it get out of a crisis—could be seriously compromised. We wanted to determine whether there was any general pattern or common thread among these collapses. Another concern was whether something could have been done, in retrospect, to limit the extent of the collapse or mitigate its impact.
IMF Survey: What drove the cutbacks in trade credit—a reduction in demand or a shortfall in supply?
Gilman: Indications are that supply-side factors were primarily responsible for the sharp decline in trade finance. In recent crises, in line with perceptions of heightened risk, banks raised interest rates, shortened maturities of credit lines, and charged higher fees for confirming letters of credit. In Brazil, for example, interest rate spreads on bank-financed trade facilities increased from about 1 percentage point to 6 percentage points over LIBOR and maturities fell from 360 days to as little as 30 days. Also, insurance, when it was needed, became more difficult to obtain as trade insurers tightened their coverage policies.
Banks, being leveraged institutions, are sensitive to perceived changes in risk and tend to reduce asset exposure to a crisis country to avoid large losses and potential insolvency. Ironically, trade credit lines are among the first to get slashed despite the fact that they are usually the least risky assets. Under pressure from shareholders, the nonrenewal of trade credit is the easiest, quickest, and cheapest way of reducing country exposure. In a market facing a crisis, participants engage in herd behavior—they all rush for the exit together.
IMF Survey: What are the main consequences of this sharp decline in trade credit?
Wang: When firms involved in foreign trade are faced with a sudden loss of liquidity—that is, when they no longer have access to relatively low-cost, foreign-currency-denominated working capital, it is hard for them to maintain their production and trade activities. These adverse effects on the trade sector may extend to the wider economy. Many firms involved in trade must then turn to the spot foreign exchange market to make payments and service their debt. This increases demand in the foreign exchange market. The decline in trade credit may also reduce the supply of spot foreign exchange because, as trade activity declines, foreign exchange earnings from exports also drop. The resulting pressure on the exchange rate can compound the country’s external debt and payment difficulties and increase country risk, leading to further cutbacks in all funding, including trade finance. Finally, the scarcity of trade credit may blunt the stimulus to expand exports stemming from the exchange rate depreciation that typically accompanies a crisis. This impedes economic adjustment and recovery.
IMF Survey: Are crisis-induced collapses in trade finance a more serious problem now than during the 1980s debt crisis?
Gilman: In some ways, yes, although I qualify that by saying that we need to get a better handle on the data to make that determination. The annual volume of international trade financed by commercial credits is in the trillions of dollars, but these transactions are so routine and taken for granted—outside of crises—that there has not been an international effort to collect systematic data on trade credits. We are trying—with the help of commercial banks, multilateral development banks, export credit agencies, and other international financial institutions—to piece together the existing data to get a better handle on what happened. Having a solid empirical base, of course, is also important to determine what can be done to prevent future trade finance collapses.
With that caveat, we can surmise that the collapse in trade credit has become more serious in modern capital markets. Traditionally, export credit agencies, particularly in the industrial countries, played an important role in trade finance. And this was still the case in the 1980s. At the same time, banks were in the business of providing firms with both long-term finance and short-term trade finance. This meant that banks’ interests were aligned with those of countries in crisis to the extent that they had incentives to provide trade credit to limit the scale of economic dislocation and thereby protect the value of their long-term claims.
But the world has changed since the 1980s. With the development of international capital markets and global banking networks, export credit agencies now have only a marginal role in providing short-term lending. In addition, long-term finance is now provided predominantly by bondholders rather than by banks, and banks’ incentive to maintain trade credit lines in difficult times has been significantly weakened.
Wang: Also, in the 1980s, many countries still had exchange controls. To qualify for exemptions from these controls to export and import, firms would have to have their trade-related transactions monitored by banks through documentation relating to shipping, customs, and financing. In the 1990s, with the widespread liberalization of capital movements, international banks moved away from such documentary credits and, instead, began providing revolving lines of credit to banks—and even enterprises—in emerging markets.
These changes have made it more difficult to distinguish between trade credit and other types of short-term finance, which, in turn, reduces international banks’ confidence that payment priority would be granted by a crisis country to trade credit over other types of short-term financing. In addition, with the removal of exchange controls and the liberalization of capital movements in many developing countries, trade finance has become more vulnerable to surges of capital flight and changes in investor confidence.
IMF Survey: Were any successful steps taken during the recent financial crises to deal with collapses in trade finance?
Wang: Several initiatives were launched. For example, in Korea, Indonesia, and Brazil, country authorities—with the support of official bilateral creditors in the case of Korea and Indonesia—provided funding directly or through the domestic banking system to exporters and importers to alleviate the shortage in trade finance when international banks reduced their trade credit lines. In Indonesia, where the domestic banking sector was weakened by mounting nonperforming loans, the central bank deposited $1 billion of its international reserves in 12 foreign banks. This money served as a guarantee for letters of credit issued by Indonesian banks for the financing of imports by export-oriented firms. This measure was deemed to be helpful; no claim was made on the central bank’s deposit.
Multilateral development banks intervened by providing financing to government agencies for on-lending to the private sector and to private sector financial intermediaries for on-lending to their corporate clients. In some cases they provided guarantees as a means of reducing risk perceptions. For example, during Brazil’s financial difficulties in late 2002, the IFC [International Finance Corporation] extended loans to Brazilian banks that were major players in the country’s trade finance sector so they could continue to provide pre- and post-shipment export finance to their clients. The IFC loans were complemented by loans syndicated among several dozen international banks, as well as the Inter-American Development Bank. Through this initiative, the IFC mobilized private sector financing of about $1 billion or so and helped facilitate Brazil’s recovery.
IMF Survey: What actions should policymakers take to avert shortfalls in trade financing in the future?
Gilman: Above all, the focus needs to be on implementing the right economic policies and institutional reforms to strengthen the legal and regulatory framework for international transactions, foster competition in foreign trade and trade finance sectors, and deepen local capital markets. Better banking supervision could also help mitigate the decline in credit during a crisis. Certainly, removing policy uncertainty early on would go a long way toward reducing perceived risks.
To help induce a quick resumption of trade finance by the private sector, the authorities in crisis countries could, for example, make foreign exchange available for appropriately documented trade finance transactions. They could also facilitate risk sharing among private and public, domestic and foreign creditors and insurers.
Even in the presence of a sound macroeconomic reform strategy, however, there may be circumstances in which targeted support to the trade sector could be useful to mitigate a generalized loss of access to trade finance and prevent a liquidity crisis from becoming a solvency crisis. Such financing could be provided by a country’s central bank with resources from multilateral creditors or official bilateral creditors. As Jian-Ye just mentioned, recent experience suggests that the trade finance facilities of multilateral development banks can be effective in mobilizing additional private sector funding during a period of heightened risk aversion. Such support could include direct provision of financing or guarantee of financing to government agencies and intermediaries for on-lending to the private sector. A more coordinated approach by export credit agencies could enhance the effectiveness of external support.
Finally, the involvement of private sector trade credit providers can help facilitate a rapid return to confidence and financing. Such participation could be in the form of a formal or informal agreement between the country authorities and international commercial banks to maintain these banks’ trade credit exposure to the country.
IMF Survey: Is the IMF in a position to help in its capacity as lender or policy advisor?
Wang: Certainly, the IMF can help countries assimilate lessons from the past. We could also play a supporting role in facilitating a country’s efforts to address a decline in trade finance. In situations where the authorities have sought IMF financing in support of an economic adjustment program and there are concerns about the loss of access to trade finance, IMF staff could facilitate authorities’ efforts by exploring ways to encourage the maintenance of trade finance. IMF-supported programs could also build in the flexibility to accommodate the use of external resources and foreign exchange reserves in support of well-designed trade finance schemes.
The full text of “Trade Finance in Financial Crises—Assessment of Key Issues,” prepared by the IMF’s Policy Development and Review Department in consultation with the International Capital Markets and Monetary and Financial Systems Departments, is available at http://http://www.imf.org/external/np/pdr/cr/2003/eng/120903.pdf.