For many years global trade was predicated on the basis of direct relationships between emerging markets and the developed economies of the West. But as world trade has expanded, this situation has changed, with intra-emerging market trade now established as a major factor in the global economy.
A dramatic illustration of this shift is the spectacular growth in trade flow between China and Latin America. From a modest US$1.9m in 1950, annual trade flow had risen to US$343m by 1965, to US$475m by 1975, US$2.6bn by 1985, and US$6.1bn by 1995. Since then, growth has continued to exceed expectation; during a 2004 address to the Brazilian legislature, Chinese president Hu Jintao predicted that China-Latin America trade flows would hit US$100bn by 2010. In fact, they exceeded that in 2007 with a total of US$102.6bn. The new lion’s share of this trade activity is with Brazil, which in 2007 accounted for US$29.7bn of total bilateral trade with China, while Mexico remains its largest counterpart with US$31.6bn in the same period.
Yet despite this exceptional growth, the financial instruments used to facilitate this trade are relatively conventional, with tools such as supply chain finance still very much the exception rather than the rule. However, this could soon start to change as consumers in countries such as Brazil find they have both the appetite and disposable income to acquire major brand name products and relationships develop between trading partners.
Chinese Exports
While the majority of China’s imports from Latin America originate mainly from the south of the region, its export business is far more evenly distributed. For example, China imports very little from Central America but exports a large quantity of manufactured goods, such as shoes and toys, to the region. Across the whole of Latin America, there is a clear trend towards importing higher value and more sophisticated Chinese goods. As well as basic items such as clothing, companies are starting to make an impact with computer products. In addition, established Japanese and Korean brands are gradually being supplanted at the lower end of the electronics market by Chinese products. In most cases incoming Chinese electronic goods, such as televisions, are not being sold under their own name, but ‘rebadged’ with a local brand. However, with so many global brand names exporting directly from their manufacturing facilities in China, this could soon change as Latin American consumers find themselves able to afford such goods.
A number of factors underpin this growth of Chinese imports to Latin America. Most currencies in Latin America have enjoyed a period of considerable strength over the past two or three years, which has obviously further reduced the already low cost of Chinese goods in local currency terms. Another factor has been general economic growth, with many Latin American countries’ economies expanding by 5-7% per annum. While average per capita wealth is still far below that of the US or western Europe, a growing number of individuals have reached the point where they are able to afford cheap consumer items in addition to the absolute necessities. In the short term, the fact that they are as yet unable to afford major brand consumer items also plays to the advantage of low-cost Chinese imports.
Almost without exception, trading relationships between Chinese exporters and Latin American importers are comparatively new. In addition, there is not a great deal of cultural common ground and the notional lingua franca of English is not particularly common at all. As a result, virtually all Chinese exporters insist upon dealing on a letter of credit basis or requesting a down payment. In practice, more sophisticated trade finance tools might not necessarily be viable anyway, as the majority of South American markets have far more regulatory restrictions on import finance than export finance. One obvious exception is Chile, which is by far the most developed economy in the region and where trade flow represents some 60% of the total economy.
Another prominent exception is Panama, which by virtue of the large number of intermediary trading companies operating through its Colon free trade zone, plays a pivotal role in China-Latin America trade. While the Pacific coast of Latin America obviously trades directly with China, Panama is ideally positioned to satisfy demand for Chinese goods on the Atlantic coast. The lack of taxes in the free trade zone assists the activities of some large intermediaries reselling a range of goods (furniture, motorcycles, tools, televisions, etc) into the Caribbean islands, northern Brazil, Mexico, Venezuela, Colombia, Peru and Ecuador.
Chinese Imports
China’s vast appetite for commodities is common knowledge and the natural resources of many countries in South America are therefore in strong demand. Countries such as Brazil, Uruguay, Chile, Argentina, Peru, Colombia, Ecuador and Venezuela are typically very rich in commodities, ranging from copper ore to soya beans, for which there is heavy demand from large Chinese importers.
Many of the South American commodity companies are similarly large scale and often have their national government as a shareholder (e.g. Petrobras in Brazil or Codelco in Chile). South American companies of this size have access to a wide range of finance sources in both local and global capital markets, with more than a few having New York Stock Exchange listings. However, when they require short-term finance and there is insufficient time to tap the capital markets, trade is an alternative and very important way of funding their cash flow.
These large exporters of raw commodities are typically dealing with Chinese importers of similar size. As a result, the use of letters of credit (LCs) would be irrelevant, as risk mitigation is not seen as a significant factor. Trading between Chinese and Latin American entities of this scale is therefore typically conducted on an open account basis.
Typically, once a contract for supply is in place and the exporter needs financing, it will approach a bank for discount financing on the basis of its receivables. In countries such as Chile, Argentina and Peru, markets are very open and have minimal regulation, so large exporters can finance their cash flow in this manner very easily. The bank provides the discounted short-term financing and assumes the performance risk of the local company and the settlement risk of the Chinese counterparty. However, in Brazil and, to a lesser extent, Colombia, the process is considerably more complex, largely due to local regulatory controls.
Medium-sized and smaller Latin American companies are rapidly growing their export business to China. As with larger companies, a substantial part of the activity relates to food/agribusiness. However, these organisations will have far smaller balance sheets than the major mineral and agricultural exporters. In addition, their trading relationships with their Chinese counterparties are of fairly short standing and the transaction size is typically fairly small. Therefore, the possibility and costs of a dispute with a Chinese counterparty make open account trading unattractive.
As a result, such smaller exporters will almost exclusively insist on dealing on an LC basis, which allows them to raise the necessary cash to fulfill orders while insulating them from counterparty risks. However, in situations where the profit margin on a transaction is extremely tight, some Latin American exporters might be prepared to ship part of an order on open account, with the remainder being covered by an LC.
Distributor Chain Finance and Open Account Possibilities
With the exception of the major Latin American raw material producers and their large Chinese industrial customers, trading relationships between the two regions are still relatively undeveloped in terms of trust, although this has improved over the years. The lack of common cultural ground and different legal frameworks also act as something of an impediment, as does the fact that commercial reputation in both markets is something that takes a considerable period to acquire. The net result is that the use of distributor/supply chain finance is as yet virtually unheard of in these markets.
However, there are a number of factors that could change this. If economic growth continues to expand, average household wealth in Latin America will soon reach the point where a solid nucleus of consumers will be able to afford brand name consumer goods, rather than just inexpensive white-labelled items. At the same time, as Chinese acquisition of brands continue, Chinese exporters will have higher value branded products to sell. As Chinese brands gain market penetration, this raises the possibility of distributor finance solutions being provided to Latin American retail distributors.
Apart from the development of Chinese brands, established global brands could also have a strong influence on the development of supply chain finance in China-Latin America trade. Many major brands have manufacturing facilities (particularly for electronic goods) in China that produce items likely to appeal to newly affluent Latin American consumers. Distributorships for these major brands are highly valued (in supply chain terms they are ‘sticky’) which makes them an attractive prospect for banks looking to provide supply chain finance solutions. If these distributorships expand on the back of increasing Latin American sales of global brands, it seems reasonable to suppose that supply chain finance will also start to take off.
In terms of expanding the range of trade finance instruments used in China-Latin America trade, a similar situation probably applies to open account trading by smaller Latin American exporters of raw materials. If trade between the two regions continue to expand at the current rate, cultural perceptions are likely to change. The more commonplace dealing with Chinese trade customers becomes, the greater the likelihood that open account trading levels will increase – with a commensurate effect on invoice discounting and factoring activity.
Maturing Relationships
In many ways, the tale of China-Latin America trade is only half told. While the volume of activity appears impressive in isolation, it is as yet a long way short of more established trade relationships; for example, China-Europe bilateral trade in goods totalled more than €300bn in 2007. Nevertheless the pace of China-Latin America trade growth is frenetic, with 2007 volume up 42.6% on 2006, compared with a more modest 17% rise in China-Europe trade over the same period.
However, outright volume growth is only one component in the migration to more advanced and efficient methods of trade finance. Of equal (if not greater) importance are the maturity and robustness of trade relationships. Without a resilient physical supply chain – for example, where distributors of a premium brand are highly motivated to prioritise payment of the brand supplier’s invoices – a more advanced approach to the financial supply chain is impossible. However, while this ideal scenario does not as yet exist in the case of China-Latin America trade, growing consumer affluence in Latin America looks likely to propel greater demand for such premium brands and by implication more sophisticated trade finance tools.
Brazil: The Sleeping Giant?
The regulatory overhead
Brazil is the exception to most generalisations about Latin American trade and is also the country with perhaps the greatest potential for explosive trade growth with China. At present, Brazil is heavily regulated in terms of foreign currency flow, although the central bank is steadily relaxing rules. For example, exporters are now allowed to hold up to 100% of export receivables in offshore accounts. However, this does not prevent pre- and post-shipment financing of export invoices, although regulatory compliance can add a considerable process and cost payload.
All foreign exchange transactions, except those up to US$3,000, have to be registered with the Sisbacen (Sistema do Banco Central) real-time central bank system, which monitors all cross-border transactions. If a corporation approaches a bank (the corporation must be authorised to conduct international trade transactions, while the bank must be licensed to conduct foreign currency transactions) for trade finance, the bank is obliged to upload all the details of the transaction into the central bank system for the majority of finance available.
There are various different types of pre- and post-shipment finance, which can vary in terms of tenor and complexity. For example, if an extraction company wishes to raise funds on the back of a US$10m copper ore shipment to China, the bank can offer funds based on international interest rates under a range defined by the market and monitored by the central bank. If the rate is outside this range, the bank would be asked to provide an explanation why. For a long-term transaction, the central bank system has to be notified once the ore is shipped, and again when the Chinese importer makes payment (directly to the financing bank). Of the 70% of Brazilian trade flow that consists of export finance, the majority is represented by this type of tightly regulated pre-shipment finance. Even where LCs (while completely standard in other respects) are used, financing has to be registered on the central bank system.
On the import side, goods normally do not require a previous import licence unless they are subject to quotas, quality control or inspection by government institutions, etc. Imports may be financed long term and are not necessarily linked to the importer’s trade cycle.
All change?
There is a reasonable prospect that the regulatory requirements surrounding trade finance in Brazil could diminish considerably in the not too distant future. The country’s recent elevation to an investment grade credit rating is hugely significant. This has been accompanied by a major effort on the part of the government to streamline regulations with the ultimate intention of allowing the Brazilian real to become freely convertible.
If this comes to pass, the effect on Brazil’s trade volumes is likely to be dramatic. Furthermore, should trade activity increase as anticipated, the prospects for more sophisticated trade finance mechanisms will increase commensurately.