Tradewinds of Change: Emerging Markets Drive Shift in Global Trade Patterns

Global trade is moving in a new direction – one that has emerged in the last decade. It is the shift towards a single global commercial market driven in large part by trade between emerging markets. Latin America has emerged as one of the leaders in this new world order. While still exorcising the specter of the financial crisis that impacted the region almost 10 years ago, Latin America is actively expanding and diversifying its position in the global marketplace. Diversification of the region’s trading partners and practices has led to stabilisation of demand for Latin America’s exports, spurring regional growth.

There has been rapid growth in global demand for Latin America’s agricultural products and other commodities. Brazil, Mercosur’s (Southern Common Market) biggest member, for example, has increased its farm product exports from US$20bn to US$50bn between 2000 and 2006. Uruguay, with 3.2 million people and one of the smallest Mercosur members, became the sixth largest rice exporter in 2006, with the last few years of agricultural growth outpacing that of the prior three decades.¹

A Positive Spiral: Growth Begets Growth

Destinations for Latin American exports have become increasingly diversified, with emerging markets, such as China and India, a major source of this demand. The region’s trade with China increased by 600% from 1993 to 2003² and trade with India jumped from US$6bn to US$11.2bn between 2005 and 2007.³ Additionally, there are a growing number of trade missions from other emerging markets visiting the region, such as the 30+ entrepreneurs from Vietnam who recently visited São Paulo, Brazil, to open new markets and find new suppliers.

A number of factors have contributed to the increase in trade between emerging markets. Increased demand for Latin America’s agricultural products has in part been driven by the rapid expansion of the middle class in China and India and the greater purchasing power it represents. The number of consumers in China alone is growing by 20 million a year.⁴

Demand for farm products of Argentina, Brazil and Uruguay (e.g. corn, soybeans) has been heightened by their expanded use as alternative energy sources. In addition to being the primary buyer of Brazil’s soybeans, China has also become the largest importer of metals from Latin America – not only for production of exported goods but for products for domestic consumption. Countries like Brazil, Chile, Colombia, and Peru have benefited from Asia’s economic demand – where some of their main trading partners are located on the other side of the globe.

At the same time, China, India, and other emerging markets have found a market in Latin America for their own goods. Trade between Brazil and India grew from US$488m in 2000 to US$2.4bn in 2006, with a bilateral trade target of US$10bn by 2010.⁵ Today, Brazil and Mexico – the largest regional trading partners to the US – are also China’s largest bilateral trading partners in the region. Smaller Latin American countries have also found Asian suppliers for their main provider of manufactured goods, such as cars, light trucks, electronics and home appliances. The consumer market for these imported goods in Latin America is very competitive. Given this, products from Japan, Korea, Taiwan are just as competitive as products from China.

Latin American dependence on the US as the primary buyer of its wares is decreasing – in large part to trade with China and other emerging markets. Conversely though, China also has eroded the foothold of some Latin American countries on the US market. This is the case, for example, with China’s supplanting of Mexico and Brazil on clothing and shoe exports. Mexico’s President Calderon’s visit to China in July 2008, along with the mid-July visit to China by a trade delegation from Brazil, aimed to open doors for these countries to China’s domestic market – the next step in the unfolding of bilateral trade relationships.

Beyond bilateral trade, China has been increasing its foreign direct investment in Latin America, for example investing US$150m in Brazil,⁶ as well as investing in Peru’s mining sector and Venezuela’s oil and gas sector. Still, while nearly one-fourth of China’s foreign direct investment (FDI) goes to Latin America, its total regional investment of US$22bn in 2007 was much less than that of the US.⁷

Changing Economic Tide

Global demand for Latin America’s commodities has been so strong as to reverse a downward price trend, with higher prices underwriting investment in regional development. Depending on the country, among Mercosur countries investment largely includes technology, infrastructure (e.g., roads and ports), and expansion of crop cultivation areas, all to support the continually accelerating pace of demand.

What threatens to thwart the growing purchasing power of the middle classes in emerging markets that have fuelled Latin America’s growth? It is the rise in food prices. Food accounts for 30% of consumer spend in China. The cost of surging food prices as a driver of inflation is starting to affect spending in China by lessening demand for consumer goods. The result is a shrinking domestic market for China’s factories, at the same time that China’s US market is also contracting.⁸ At the same time, the high price of metals and other commodities have increased production costs.

Paradoxically, the same dynamics that have fuelled high growth in emerging markets are now causing enough friction – economically and politically – to instigate a slowdown.

Financing Need: Small to Mid-sized Companies

Players in the Latin America arena say that credit, not price, is king. The current credit squeeze is affecting Latin America’s small and medium enterprises (SMEs) in particular, especially companies that need working capital financing but lack financial reporting transparency and may not follow GAAP financial reporting standards. Heightened vigilance by banks in following Know Your Customer (KYC) and other compliance requirements, combined with high interest rates and a lack of liquidity, has exacerbated the need for financing among SMEs, already feeling the pressure of lengthened asset conversion cycles associated with global supply chains.

These dynamics are unfolding in parallel with a push by some buyers to eliminate letters of credit (LCs) in order to reduce banking fees as a way to lower costs and enhance competitiveness. However, LCs continue to be common ground for buyers and sellers in Latin America and Asia.

LCs help new trading partners overcome three main hurdles of emerging market trading:

1. Trust: trust between trading partners develops over time, often taking several years. Trade between emerging market partners is still so fresh that many of these new partners aren’t ready to take on the full risks associated with open account trading.
2. Language: misunderstandings can occur when parties conduct business in a non-native language. The structure of an LC can help to reduce the opportunity for error by enabling buyers and suppliers to deal in a standardised language and structure.
3. Different regulatory environments: When dealing in unknown or unfamiliar countries, an LC is governed by the UCP600, an internationally recognised standard which binds LCs to a universal set of rules and regulations.

Still, even given the amount of protection they provide, some view LCs as a costly method of payment and finance. But while Latin American exporters are not willing to accept 100% of the payment risk, China importers don’t want to bear costs of issuing LCs. This opens the door for alternative financing that meets the needs of both buyers and sellers in emerging markets.

Supply Chain Financing Alternatives

Supply chain financing is emerging as a fast-growing form of open account trade financing. Unlike traditional vendor financing (e.g. factoring, invoice discounting and reverse factoring), it relies on a bank’s credit relationship with the importer to enable a bank to extend credit to exporters. An importer’s credit strength enables a bank to lend to its vendors at more attractive rates than they could get via LC financing or traditional open account lending facilities, especially in the current high-interest rate environment.

The diversification of markets and reduced cyclicality of demand for commodities – reflected in the new global trade patterns among emerging markets – make trade finance a more stable investment for banks. It makes sense, therefore, for emerging markets to tap into trade finance as a source of liquidity for working capital needs.

As an asset-based form of lending (i.e. borrowing against receivables), supply chain financing has increased in usage by 65% in the past year – attributed to the credit squeeze.⁹ Asset-based financing – rather than debt – is important when economic conditions limit access to liquidity and working capital, as is happening in the current global credit crunch. The quality of asset-backed trade financing is distinguishable from asset-backed lending associated with investments like mortgage-backed securities, both in the short-term nature of repayment and in price transparency related to asset valuation. Investors are more comfortable distinguishing between strong credits such as receivables versus sub-prime mortgage debt.¹⁰

New technology platforms enable buyer, sellers, banks, and other supply chain members to gain visibility of the flow of goods and related information. Visibility enables a bank to better evaluate and assume risk, and, therefore, intermediate with pre- and post- shipment financing solutions. These solutions work well in emerging markets, where unencumbered by legacy systems, companies can adopt the latest technology.

Open account solutions, such as supply chain financing, may not become a norm in emerging markets for some time. Already there is increased acceptance, for example, by Chinese exporters in some sectors. Increasingly it is an attractive option for Latin American exporters, offering them a less costly financing option in a scarce credit environment.

Towards Open Account

Rising interest rates, slowing growth and other signals of global economic slowdown cast a shadow on the recent round of WTO trade talks. But despite the apparent dislocation, this disturbance in conventional practice reflects an underlying shift in global trade patterns with more permanent effects.

In tough economic times, market contraction is inevitable. Even in those industries where open account is the trend, current economic conditions are causing some vendors to ask for the reinstatement of LCs. Longer term, though, the broader trend is towards open account, with banks intermediating to enhance the working capital efficiency of the supply chain. The latest WTO trade negotiations, despite points of contention, reflect the increasingly global nature of the commercial ecosystem. Today’s emerging markets are playing an integral and vital role in the development of a more complex, less cyclical, and integrated market.

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