Trade finance
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Acknowledgements
This publication is the result of a joint effort of the IFC and the WTO and was prepared under the guidance of Susan Lund Vice President of Economics at the IFC and Ralph Ossa Chief Economist of the WTO. Nathalie Louat and Denis Medvedev of the IFC and Marc Auboin of the WTO provided leadership for the research. Marcio Cruz Maty Konte Francesca de Nicola Alexandros Ragoussis and Trang Thu Tran of the IFC and Eddy Bekkers and Alexei Timofti of the WTO managed the project teams across the two organizations. Working team members included: Karlygash Dairabayeva Milagros Deza and Gianluca Santoni of the International Bank for Reconstruction and Development (IBRD); Stephanie Annijas Gbenoukpo Robert Djidonou Sarah Hebous Ibrahim Nana Alexander Vanezis and Ariane Volk of the IFC; and Kirti Jhunjhunwala Saptarshi Majumdar and Ruoyi Song of the WTO.
Foreword
The expansion of trade depends on reliable adequate and cost-effective sources of trade financing which help to fill the time gap during which goods are produced shipped and paid for. Trade finance is routinely supplied to exporters and importers by banks and other financial intermediaries which mitigate the financial and payment risk involved in crossborder trade. While developed countries can often rely upon large and advanced economic sectors mobilizing sophisticated trade finance instruments such as supply chain finance significant shortages exist in developing countries. These shortages can have many reasons both international (inflation availability of correspondent banking relationships country risk) and local (level of development and expertise of the financial sector cost access to finance by local firms).
Restoring Trade Finance During a Period of Financial Crisis
The paper discusses the efforts deployed in 2008 and 2009 by various players Governments multilateral financial institutions regional development banks export credit agencies to mobilize sufficient flows of trade finance to off-set some of the “pull-back” by commercial institutions in the period of acute crisis that has characterized the financial sector in the past two years. Given that 80 to 90% of trade transactions involve some form of credit insurance or guarantee one can reasonably say that supply-side driven shortages of trade finance have a potential to inflict further damages to international trade. As an institution geared towards the balanced expansion of world trade the WTO had been concerned with occurrences of market tightening throughout this period. While a number of public-institutions mobilized financial resources for trade finance in the fall of 2008 this has not been enough to bridge the gap between supply and demand of trade finance worldwide. As the market situation continued to deteriorate in the first quarter of 2009 G-20 leaders in London (April 2009) adopted a wider package for injecting additional liquidity and bringing public guarantees in support of $250 billion of trade transactions in 2009 and 2010. Ahead of the Pittsburgh Meetings experts reported that more than the targeted amount had been mobilized. In the meantime through the summer and the fall of 2009 the market situation seemed to have eased – although in many countries access to trade finance by the smaller traders had become either significantly more expensive or had simply disappeared. One can expect the trade finance market to have its up and downs for some time because lending for trade is a function of the general lending situation of commercial banks. The paper discusses longer-term initiatives aimed at improving the resilience of the trade finance market to short-term and longer-term shocks.
Improving the Availability of Trade Finance in Developing Countries: An Assessment of Remaining Gaps
While conditions in trade finance markets returned to normality in the main routes of trade the structural difficulties of poor countries in accessing trade finance have not disappeared – and might have been worsened during and after the global financial crisis. There is a consistent flow of information indicating that trade finance markets have remained characterized by a greater selectivity in risk-taking and flight to "quality" customers. In that environment the lower end of the market has been struggling to obtain affordable finance with the smaller companies in the smaller poorer countries most affected. In an area where statistics are difficult to find this paper looks at recent available information and provides background on the persistent and significant market gaps for trade finance in developing countries notably in Africa and developing Asia. It discusses various initiatives in which the WTO and partner institutions are involved to alleviate in part this situation.
The Impact of Basel III on Trade Finance
Trade finance particularly in the form of short-term self-liquidating letters of credit and the like has received relatively favourable treatment regarding capital adequacy and liquidity under Basel III the new international prudential framework. However concerns have been expressed over the potential” unintended consequences” of applying the newly created leverage ratio to these instruments notably for developing countries’ trade. This paper offers a relatively simple model approach showing the conditions under which the initially proposed 100% leverage tax on non-leveraged activities such as letters of credit would reduce their natural attractiveness relative to higher-risk less collateralized assets which may stand in the balance sheet of banks. Under these conditions the model shows that leverage ratio may nullify in part the effect of the low capital ratio that is commensurate to the low risk of such instruments. The decision by the Basel committee on 12 January 2014 to reduce the leverage ratio seems to be justified by the analytical framework developed in this paper.
Boosting Trade Finance in Developing Countries
The paper discusses the efforts deployed by various players mainly multilateral financial institutions regional development banks export credit agencies to mobilize greater flows of trade finance for developing countries with a view to help them integrate in world trade. As an institution geared towards the balanced expansion of world trade the WTO is in the business of making trade possible. Its various functions include reducing trade barriers negotiating and implementing global trade rules and settling disputes on the basis of the rule of law. The WTO is also interested in strengthening the "supply-side" of developing countries so that they can respond to new market opportunities. To this end it supports various initiatives aimed at improving the "trade infrastructures" of developing countries ranging from the ability to meet international product safety and sanitary standards to run efficient customs or to participate effectively to the multilateral trade negotiations by training public servants. The WTO carries out various initiatives with other partners (public and private sector institutions) in the context of its own technical assistance program or in the context of multi-agency projects such as the Integrated Framework or the Aid-for-Trade Initiative. Since more than 90% of trade transactions involve some form of credit insurance or guarantee one can reasonably say that trade finance is the lifeline of trade. Producers and traders in developing or least-developed countries need to have access to affordable flows of trade financing and insurance to be able to import and export and hence integrate in world trade. From that perspective an efficient financial system is one indispensable infrastructure to allow trade to happen. In line with the above initiatives the WTO has been following actively and at times directly supporting initiatives to boost the availability of trade finance in developing and least-developed countries wherever it was needed. Since the WTO is not a financial institution it has been supporting in the past few years partners engaged in this effort such as international financial institutions export credit agencies large banks and regional development banks. Initially the WTO has been asked by its members at several points in recent years to examine the issue of availability of trade financing – as a key infrastructure needed by developing and leastdeveloped countries to integrate in world trade. Paragraph 36 of the Ministerial Declaration of Doha requested WTO Members to examine and if necessary come up with recommendations on measures that the WTO could take within its remit to minimize the consequences of financial instabilities on their trade opportunities. In the context of the newly created Working Group on Trade Debt and Finance (WGTDF) the interruptions of the flows of trade finance in emerging markets during the Asian and Latin American financial crises were quickly identified as concerns by Members as well as the chronic difficulties of low income Members to secure more affordable flows of trade financing in the long-run. These concerns were channelled to the WTO Ministerial Meetings in Cancun (2003) and Hong-Kong (2005).2 During this period of examination the Heads of the IMF World Bank and the WTO agreed at the General Council Meeting on Coherence of 2002 to form an expert group including all interested parties multilateral and regional public institutions export credit agencies private banks to examine what went wrong in this segment of financial markets and how to create an enabling environment in local markets to provide adequate flows of trade finance on a on-going basis. In chairing one of these meetings the Director-General of the WTO defined the role of the WTO in this area: encouraging liberalization of this type of financial services under the financial services agreement being a regulator of export credit and guarantee subsidies under the ASCM and serving as a forum to discuss WTO-compatible ways of providing support to developing countries. Conclusions by the Working Group were presented at the WGTDF and later at the General Council. WTO Secretariat work on this topic up to 2003 in particular its contribution to the WGTDF and to the expert group was summarized in WTO Discussion Paper 2.4 While the liquidity in financial markets improved from 2002 until the recent turmoil created by the crisis of the sub-prime mortgage markets trade finance remained an issue for concern for WTO Members in particular the poorest which do not have access to international financial markets or for emerging markets which remain prone to changes in market sentiment and hence credit rating. Despite the rapid development of "trade finance facilitation" schemes developed by regional development banks and the IFC with immediate success in low income countries the issue of availability of trade finance came back among other "supply-side" constraints identified by the Aidfor- Trade Task Force after the WTO Ministerial Meeting in Hong-Kong. While the mandate of the WTO under the Aid-for-Trade is essentially one of evaluation and monitoring it may be in cases one of advocacy. Based on the work being carried out since 2002 and after consultation with partners (regional development banks multilateral institutions export credit institutions...) input by the WTO Secretariat to boost the availability of trade finance for developing countries under the Aid-for-Trade umbrella was welcomed by Members. Lack of trade financing and guarantee infrastructures were identified as one of the barriers to integration of low income countries in world trade by each of the three regional Aid-for-Trade Reviews. It was acknowledged that the current Aid-for-Trade Initiative could provide the extra leverage to convince WTO partners to deliver more plentiful of trade credit and guarantees to WTO members that need it the most. This paper provides background on the difficulties of some countries and traders to access affordable trade credit and finance on the growing divide between these low income countries and economically advanced countries in handling modern trade finance instruments and on the joint reflection undertaken by the WTO most recently under the Aid-for-Trade programme and previously under the umbrella of the WGTDF and the Coherence Mandate to help strengthen developing countries' capacities in this area.
International Regulation and Treatment of Trade Finance
The paper discusses a number of issues related to the treatment of trade credit internationally a priori (treatment by banking regulators) and a posteriori (treatment by debtors and creditors in the case of default) which are currently of interest to the trade finance community in particular the traditional providers of trade credit and guarantees such as banks export credit agencies regional development banks and multilateral agencies. The paper does not deal with the specific issue of regulation of official insured-export credit under the OECD Arrangement which is a specific matter left out of this analysis. Traditionally trade finance has received preferred treatment on the part of national and international regulators as well as by international financial agencies in the treatment of trade finance claims on grounds that trade finance was one of the safest most collateralized and selfliquidating forms of trade finance. Preferred treatment of trade finance also reflects the systemic importance of trade as in sovereign or private defaults a priority is to "treat" expeditiously trade lines of credits to allow for such credit to be restored and trade to flow again. It is not only a matter of urgency for essential imports to be financed but also a pre-condition for economic recovery as the resumption of trade is necessary for ailing countries to restore balance of payments equilibrium. The relatively favourable treatment received by trade finance was reflected in the moderate rate of capitalization for cross-border trade credit in the form of letters of credit and similar securitized instruments under the Basel I regulatory framework put in place in the late 1980s and early 1990s. However as the banking and regulatory communities moved towards internal-rating based and risk-weighted assets systems under the successor Basel II framework a number of complaints emerged with respect to the treatment of trade credit – particularly in periods of crisis. Issues of pro-cyclicality maturity structure and country risk have been discussed at some length in various fora including in the WTO at the initiative of Members. Part of the issue was that Basel II regulation was designed and implemented in a manner that in periods of banking retrenchment seemed to have affected the supply of trade credit more than other potentially more risky forms of lending. With the collapse of trade in late 2008 and early 2009 the regulatory treatment of trade credit under Basel II clearly became an issue and was discussed by professional banking organizations regulators and international financial institutions. A sentence made its headway into the communiqué of G-20 Leaders in London in April 2009 calling upon regulators to exercise some flexibility in the application of Basel II rules in support of trade finance. As the issue of removing the obstacles to the supply of trade finance spread became part of the public debate discussions with respect to the regulatory treatment of trade finance in the context of the making of "Basel III" rules are now raising political attention. Part of the underlying problem regarding the design of regulation of trade finance is that banking regulators may not have enough understanding of the way that trade and trade finance operate in practice. In turn the banking community has made insufficient progress in explaining these issues to regulators and in providing evidence about the high level of safety and soundness of their activity in collecting statistical information and even in defining clearly what comprises trade finance. This paper aims at clarifying such issues. The WTO in its role as an "honest broker" is trying to help the parties concerned and has been asked from time to time to act as a go-between between the two communities in order to clarify issues. Section 1 looks at the overall Basel framework and its evolution over time with particular emphasis on the regulation of trade finance. Section 2 looks at issues raised in the WTO context by the trading and trade finance communities be it by WTO Members or by experts and how this has helped to clarify some of the disputed issues. Section 3 raises a number of questions which need clarification from the trade finance community for regulators to be able to better capture the reality of trade finance operations and allow them to regulate with full understanding of its implications.
Trade Finance in Periods of Crisis
This paper reviews a number of initiatives taken by public and private institutions aimed at minimizing the impact of the on-going crisis of the financial sector on its ability to supply trade finance to support trade at affordable rates. In doing so it draws a few policy lessons. One of them is that a relatively stable segment of the financial industry is now regularly hit by the contagion of financial crises with potentially very harmful spill-overs on global trade through a dry up of its financing. Specific policy measures to restore confidence in this otherwise safe market required a good level of coherence and dialogue between national governments and international and regional development organizations. Lessons from the Asian and Latin American financial crises of the late 1990's have been learned and academia provided input by developing understanding on a previously under-rated topic in the literature. Learning-by-doing and leadership have also been features of the policy response which altogether had some successes. Still longer-term challenges remain such as addressing the structural gaps in the availability of trade finance in low-income countries - ad hoc programs have been designed to fill the gap between the perceived and actual risk of extending trade credit to traders in these countries. Moreover regulation of the trade finance market needs to continue to take into account its low-risk character the absence of leverage and its impact on development.
Why do Trade Finance Gaps Persist
Trade finance shortfalls now appear regularly. Does this matter for trade expansion and economic development in developing countries? Global trade finance has resumed following the 2009 global financial crisis. However the pattern of recovery has been uneven across countries and categories of firms. The recovery has been robust for the main routes of trade and for large trading companies. By contrast access to trade finance remains costly and scarce in countries which have the strongest potential for trade expansion. We introduce new data from a global survey of firms to argue that real shortfalls are exacerbated by perception gaps in a way that has enabled market failures to persist. This has troubling implications most directly through its effect on the ability for small firms to benefit from the reallocation of production and investment within global supply chains.
Fiscal Policy Cycles and the Public Expenditure in Developing Countries
The paper studies empirically the fiscal policy instruments by which governments try to influence election outcomes in 24 developing countries for the 1973-1992 period. The study finds that the main vehicle for expansionary fiscal policies around elections is increasing public expenditure rather than lowering taxes and public investment cycles seem particularly prominent. Institutional mechanisms which constrain discretionary expenditure policies and which strengthen fiscal control are therefore worthwhile considering to prevent opportunistic policy making around elections.
Can Trade Policy Help Mobilize Financial Resources for Economic Development?
The linkages between trade and resource mobilization are complex and not well defined in theory. To what extent does trade policy affect resource mobilization and what are the mechanisms? We argue that trade policy is a key factor of influencing the domestic fundamental balance between aggregate savings and investment. The main effect of trade policy on resource mobilization stems from its contribution to static and dynamic gains from trade. But the effect of trade policy on the supply of financial resources also operates through several channels including through linkages of trade policy with foreign investment government revenues income distribution foreign aid. The paper looks at direct and indirect channels and makes a distinction between short and long term effects of different trade strategies. We also briefly review trade barriers in goods and services affecting developing countries and the potential gains from further liberalization. The long term gains from trade liberalization are substantial but they may have to be set against short-term adjustments costs. The latter could and should be reduced by effective institutional and tax reforms.