Squeezes of trade finance have been among the factors responsible for the recent collapse of trade. Those squeezes should be seen in the context of an overall “introspection” of banking activities that has been sparked as an aftermath of the financial crisis. The prospects and strength of recovery in the global economy will depend on policy reactions to those issues.
1. Squeezes of global trade finance as a sign that this is no business (cycle) as usual
Shipping costs – as measured by the Baltic Dry Freight index – nosedived in mid-2008, falling by 90% in the latter part of the year, in tandem with the commodity bust (Chart 1, right side). In its turn, global trade plunged during the final months of last year and world trade volumes are forecast to shrink in 2009 – something not seen since the beginning of the 1980s – in a close association with the tumble of OECD real retail sales of durables (Chart 1, left side).
Shrinking trade as a direct result of the economic contraction and the global credit crunch accentuated since mid-September is of no surprise. Perhaps less expected was the intensity of trade impediments directly caused by harder conditions at trade credit flows. The particularly deleterious consequence of the unavailability of trade finance is that it eventually harms production despite the existence of demand for it, affecting thus otherwise sound companies and making economic recovery more difficult.
Trade finance is a lubricant to trade taken for granted under normal circumstances. It is “at the low-risk, high collateral end of the credit spectrum. (…) Some 80% to 90% of world trade relies on trade finance (trade credit and insurances/guarantees), mostly of a short-term nature” (Auboin, 2009). Trade finance operates with strong collateral and documentation requirements, based on long-held underwriting practices and procedures established by banks and traders. Not surprisingly, the business navigated well along the financial turbulences of 2007 and first months of 2008, but the overall liquidity squeeze started affecting the supply of trade credit along the year, until a seizure of re-finance took place immediately after the September events. According to Auboin, 2009: “Spreads on short-term trade credit facilities soared to 300 to 600 basis points above LIBOR, compared to 10 to 20 basis points in normal times”
Most of the complex, global supply chains of production that have been built along the last decades depend on the availability of trade finance. If higher costs and harder access remain for long, some retreat of the outsourcing and offshoring process that has been at the basis of the integration of emerging economies is expected to occur. In the meantime, a negative feedback between developed and developing economies, aggravating the crisis, may also result from a dearth of trade finance, even if the latter is of a temporary nature.
The disruptive implications of a trade finance squeeze go beyond the realm of firms that face the disappearance of low-cost foreign-currency-denominated finance. At a macroeconomic level, the shortfall in foreign credit tends to lead to a higher demand for foreign exchange at the spot market, as well as to a higher demand pressure on domestic substitutes as suppliers of credit and insurance/guarantees. As a consequence, economic recovery may become harder to obtain as finance costs increase and the exchange rate may suddenly devalue.
2. Emerging economies are especially affected by the banking introspection in course
The global squeeze on trade finance was of course one dimension of the seizure taking place at interbank markets in the US and other developed economies last year. Heightened risks of insolvency as perceived by counterparts, in the context of a deep crisis of confidence and flight to the hyper-safety of US Treasuries, led to liquidity hoarding at banks’ headquarters. Interbank interest rates skyrocketed, and have not returned yet to pre-crisis levels (Chart 2). Emerging economies were affected both directly through a “systemic sudden stop” that encompassed all kinds of foreign finance, but also indirectly through a contagion effect on their domestic banking systems (Canuto, 2008).
There is overall a process of “introspection of finance” in course, something that goes beyond simple deleverage of portfolios abroad through redemption or fire-sale of foreign equity and bonds (Larsen & Tett, 2009). Banking activity itself has reflected both market and political forces in favor of privileging domestic business, which has led to a retrenchment in cross-border credit (The Economist, 02/07/09). Banks at developed countries have been forced to shrink their balance sheets and cope with their shortness of capital, for which abandoning non-core activities abroad becomes a natural choice. Because of Basel-related capital charges on emerging-market assets, the scarcity of capital favors even more retrenching from them. Decisions to signal lower risks of bankruptcy at home and/or to exhibit strong war-chests of liquidity have also led those banks to liquefy assets abroad and repatriate proceeds and dividends. Furthermore, a “home bias” derived from better acquaintance with domestic credit risks has also been in effect. On top of those market factors, there is the “financial protectionism”: “moral suasion” toward increasing domestic lending exercised by political agents responsible for bailout packages, when such a commitment to increase lending at home does not come openly as an explicit obligation attached to state support.
Deserved attention has been given to the forecast of net capital flows to emerging market economies in 2009, released by The Institute for International Finance (IIF) last January 27 (Chart 3). Net private flows are expected to be 65% shorter than last year, and less than 20% of what they were in the peak year of 2007. The retrenchment of credit by commercial banks is particularly striking. Such a shrinkage of capital flows reflects the “Great unwinding” of global leveraged positions still in course, a generalized heightened risk aversion, as well as the deterioration of economic prospects in emerging economies. The point we want to make here is that the “introspection” of banking activity in developed economies may carry implications in addition to such reduced external funding – of which the challenges regarding trade finance are just one case.
The World Bank’s “Global Development Finance – GDF” report last year brought an analysis of the changing and augmented role acquired by international banking activity in development finance since the early 1990s: “the secular growth in lending exposure, a shift from cross-border to local-market delivery of financial services, and substantial foreign investment through cross-border acquisitions and establishment of local affiliates” (p.84). Although occasionally the growth in international banking was halted during moments of credit contractions and economic downturns, it went along a sustained upswing from 2003 until the beginning of the global financial turmoil in mid-2007. It mirrored the process of tremendous creation of global liquidity, large-scale securitization, and cross-border banking sector consolidation (see box 3.1 in GDF).
The increased role played by foreign banks in many developing economies brought with it a series of benefits, but also a higher exposure to a new range of risks. For instance, according to the GDF:
“Preliminary econometric investigation establishes a statistically significant relationship between international bank lending to developing countries and changes in global liquidity conditions, as measured by spreads of interbank interest rates over overnight index swap (OIS) rates and U.S. Treasury bill rates. A 10 basis-point increase in the spread between the London Interbank Offered Rate (LIBOR) and the OIS sustained for a quarter, for example, is predicted to lead to a decline of up to 3 percent in international bank lending to developing countries.”
No wonder thus that the seizure and skyrocketing costs of interbank activity depicted in Chart 2 above also paralyzed banking activities with emerging economies, including trade finance. Now, if banks’ difficulties and corresponding “introspection” remain for long in developed economies, one may infer that their retreat in developing economies will open an agenda regarding how to make sure that the gateways “through which corporations, sovereigns, and banks transfer funds abroad, borrow in short and medium terms, and conduct foreign exchange and derivatives operations” (p.81) are kept open.
3. Bounded capacity of response to squeezes in trade finance and banking introspection
The individual capacity of emerging market economies to respond to the trade finance crunch and to international banking retrenchment has varied in accordance with two variables: level of foreign-exchange reserves and domestic banking capacity to occupy voids eventually left by exiting banks. Reserves matter as a basis for funding, through e.g. repurchasing agreements with banks or directly with corporations. Domestic banks in turn may be a requisite depending on how “homeward-bound” foreign banks behave.
South Korea, South Africa, India, Indonesia, and Brazil are examples of countries in which central banks have used foreign-exchange reserves in order to engage in pledges or repurchase agreements with the private sector. For instance, in the case of Brazil, since October 20, six auctions of US$-credit lines for the finance of Advances on Foreign Exchange Contracts (“Adiantamentos de Contratos de Cambio” – ACC) operations have been made by the Central Bank, amounting to US$9.5 billion. ACC volumes remain below those prior to last September (Chart 4), including as a consequence of decreasing exports. However, those auctions have mitigated the effects of the shrinking in inflows of private credit lines for foreign trade operations that has taken place since November and so far not been reversed.
On the other hand, many developing countries are not currently equipped with a war chest of reserves. In addition, many among them will have to cope with the challenge of reinvigorating domestic banking capacity.
Multilateral development banks – IFC, IDB, EBRD, and ADB – have recently enlarged their trade facilitation programs. “This has brought [their] total capacity to US$7 billion on a roll-over basis, financing potentially some US$30 billion or so of trade involving small countries and small amounts (US$250,000 on average by transaction)” (Auboin, 2009). Noteworthy as well has been the launching by the IDB of a US$6-billion liquidity facility in order to support government provision of liquidity to the private sector through local commercial banks in Latin America and the Caribbean.
Notwithstanding the prompt reaction by those institutions, the issues at stake will require a scale and a range of actions that still remain far from achieved. Proposals of strengthening the IMF capacity of response, e.g., should also address an adaptation of its instruments so as to make possible its support to the private sector, even if through sovereign-guaranteed operations.
There has also been a move by bilateral export credit agencies, especially directed at short-term lending of working capital and credit guarantees targeted at small and medium enterprises. By the same token, regional agreements on reinsurance cooperation, currency swaps and the like have also been announced. All this, however, does not preclude that an effort be made at the global level, in order to mitigate the risks of a regional fragmentation of international finance as an aftermath of “financial and banking introspection”.
4. Payments frictions as an oft-forgotten driver of the Great Depression
There is a broad acknowledgement that, whatever may have originally led to the Great Depression in the 1930s, trade wars and the ensuing trade collapse helped to ensure that the crisis lasted as long as it did. The same level of attention however may have not been given to the role played by payments frictions following the unraveling of the Gold Standard at the time.
This is at least what can be inferred from the systematic quantitative approach of the evolution of world trade volumes over the period 1870-1939 developed by Estevadeordal et al. (2002), where the authors found that: “(…) controlling for changes in the scale of world economic activity, [they] can explain most of the rise and fall of world trade. In contrast to traditional explanations that focus only on obvious goods markets frictions, such as transport costs and commercial policy, (…) a large part of the change in trade volumes can be explained by a ‘common currency’ effect, related to the rise and fall of the gold standard” (p.2).
If one is to use History as a guide for policy responses to the global economic crisis in course, those findings should be kept in sight. Much attention has recently been dedicated to current potential and actual practices of trade protectionism. However, as we tried to highlight, travails at global financial markets are in themselves already bringing harmful consequences to international trade and growth. And unless appropriate policy responses are taken, finance-originated disruptions of trade may well lead not only to a slower global economic recovery, but also to a retreat of globalization as we have known it in the last decades.
(*) Presented at the “V Symposium on International Trade”, Woodrow Wilson Center – Brazil Institute, Washington, 20 February 2009, and to appear at www.rgemonitor.com.
Canuto, O., “Emerging markets and the systemic sudden stop”, http://www.rgemonitor.com/latam-monitor/bio/otaviano2/otaviano_canuto, 14 November 2008.
Credit Suisse, “Brazil highlights”, 19 February 2009.
Estevadeordal, A.; Brian, F.; Taylor A.M. (2003) “The Rise and Fall of World Trade, 1870-1939”, Quarterly Journal of Economics, Vol. 118, No. 2, 2003.
Larsen, P.T.; and Tett, G., “Wary lenders add to introspection”, Financial Times, 29 January 2009.
The Economist, “Homeward bound”, 7 February 2009.
World Bank, “Global Development Finance 2008”, Washington, June 2008.
Otaviano Canuto is the Vice-President for Countries at the Inter-American Development Bank (IDB)