Since December 2010, civil unrest against governments has brought disruption to lives and businesses across the Middle East and north Africa (MENA) region. Egypt, Tunisia and Libya have seen fundamental change in the political arena, but new governments have yet to be elected. Syria and Yemen continue to experience unrest which makes the political landscape uncertain.
That said, Egypt has shown significant resilience in the face of political change, and has made progress towards improving the economic and trade environment since the protests in January and February this year. This is no surprise given Egypt’s large and diverse economy. However, the rebuilding challenges that Egypt now faces give insight into what Syria, Yemen, Libya and Tunisia may also face in the coming months.
How has the political and economic volatility in the MENA region over the past 10 months affected trade flows and trade financing services?
Egypt: Focus on Trade Flows
When civil unrest began in Cairo in early 2011 there were several knock-on effects on exporters and importers operating in the country, as well as on the foreign banks that finance much of this trade activity.
The immediate response from the banks to the increased uncertainty and risk was to reduce their trade finance limits, such as letters of credit (L/Cs), which facilitate trade. Banks have also put restrictions on their cross-border trade flows until greater certainty prevails.
A second reaction was a general shortening of payment cycles. Prior to the revolution, many corporates were comfortable with payment dates of up to one year. However, in the new situation suppliers have been seeking payments as early as possible. Furthermore, trade risk pricing has increased dramatically, having peaked at almost twice the levels in the first quarter of 2011. Thanks to the uncertain European situation, prices continue to be at a high.
The fact that there was less credit available from the banks also meant that the focus had to shift towards more strategic flows. In the case of Egypt, these were commodities and oil products, rather than consumer goods; while Egypt is not an oil-producing country, it hosts essential pipelines. Egypt also is the largest wheat importer in the world.
Today, Egypt’s economy is under pressure from depleting foreign currency reserves and fiscal deficits. Tourism, which was an important mainstay of the economy (accounting for approximately 12-13% of Egypt’s GDP), as well as industrial and manufacturing activities, has been significantly impacted by the political changes. The only upside in recent news on the economy has come from Suez Canal-related activity which posted growth – a telltale sign that, on a regional basis, trade flows remain.
Challenges Facing Other MENA Countries
In Syria, Yemen and Libya, the banks’ reactions have been similar to their counterparts operating in Egypt. For example, credit became scarce, and trade finance services were reduced. This resulted in a general upsurge in price – making all imports into these countries significantly more expensive.
Despite these general similarities, each country also has its own unique challenges. For example, the EU and the US have imposed economic sanctions on Syrian oil.
The Rise of L/Cs
As the political situation in Egypt and across the MENA region deteriorated, most companies began asking their banks for guaranteed trade financing tools, such as L/Cs (and even confirmations), instead of using open account transactions. This represents a ‘back-to-basics’ approach to trade where standardisation becomes more important and customisation trend subsides. This has increased the cost of trade, as the bank is providing a risk mitigation service in addition to its role as a funds transfer conduit. While this provides banks with short-term benefits in terms of revenue, overall trade volumes are adversely affected by increased costs.
As the political situation throughout the region stabilises, corporates are expected to re-establish trade flows using open accounts transactions. However, most open account flows are currently restricted to large multinational companies’ (MNCs) subsidiaries, who typically buy from the parent company’s manufacturing facility, reducing counterparty risks.
There have been some signs of working capital rationalisation within both large MNCs and local corporates. This is due in part to the growing awareness that trade flows are recognised to be lower risk and more affordable than credit facilities, and that corporates can benefit from optimising their working capital cycles.
However, because supply chains in the MENA region were relatively less established than those in Europe and the US, companies have not fully benefited from extracting liquidity from their working capital cycles. We predict this trend will build momentum going forward.
External Factors: The European and US Debt Crises and Basel III
Various external factors are adding to the difficulty of trade financing in the MENA region, such as the ongoing debt crises in Europe and the US. Most large sovereign wealth funds from the region remain heavily invested in these markets. These are long-term investments, but can cause pain in the interim. A general, wider, global slowdown is also expected to lower oil demand and negatively impact oil price. This threatens to slow down the massive economic diversification and infrastructure expansion agenda upon which most of the countries in Middle East have embarked.
The Basel III Accord in its current form is also expected to have a predominantly depressive effect on banking activity, initially in the MENA region. Trade financing is deemed a less risky product requiring banks to allocate less capital than would be needed for a loan; however, to date, this preferential treatment is not fully reflected in Basel III. The accord will come into effect gradually over the next eight years, but banks are already preparing for the new capital allocation requirements which will be phased in from 2013. In order to comply with more stringent requirements, banks will be required to more effectively evaluate risk and maintain a higher capital ratio.
If the global banks in the MENA region are required to allocate greater amounts of capital for ‘riskier’ clients, those clients will then face significantly higher financial costs. Big MNCs with global banking relationships and strong credit ratings will continue to be supported by their banking partners, while small and medium-sized, locally-based companies will immediately start to feel the pinch. As risk perception across the globe and MENA continues to change, banks will be monitoring their exposures and returns very closely. As a result, banks will choose lower-risk profile customers or core customers, and move toward lower risk offerings such as trade financing, as opposed to traditional credit facilities such as overdrafts. This will cause increased volatility in the market as banks enter or exit specific client or product groups. The advantages of trade finance tools should create more interest in products such as supplier and receivables financing, L/C discounting, invoice-based financing, and distributer and channel financing.
Another consequence of Basel III’s capital allocation rules has been the marked increase in activity in the secondary markets. In order to reduce their exposure to higher-risk trade finance structures in the region, many banks have turned to the secondary market to sell off their trade assets, leading to more co-operation, versus competition, among financial institutions. The development of the secondary trade asset market is something which has enhanced the liquidity and portfolio management tools on the trade side of the bank’s balance sheet. This has helped banks optimise their portfolio and provide create additional capacity. For example, if a European bank finances an Egyptian entity and that entity’s risk profile changes (through increased credit, operational or political risk), then the European bank can look to sell down some exposure into the secondary market to reduce its assets and balance sheet commitment. While the secondary market phenomenon is not new, it has gained significant momentum since the 2008 financial crisis.
Alternative Financing on the Increase
The last few years have seen alternative ways of longer-term financing in the MENA markets gaining popularity. Export credit agencies (ECA), which have been playing an important role in helping to finance the export/import of capital goods, equipment and services around the globe, are now focusing much more in this region as well.
Many MENA countries are developing economic diversification agendas, in order to move away from their dependency on oil (particularly in the oil-rich states such as Saudi Arabia, Qatar, United Arab Emirates (UAE) and Kuwait). In the quest to become more global, countries are looking to attract more MNCs to the region and arrange to have companies’ longer-term financing needs met by these ECAs. Banks are also playing a key role by partnering with these agencies to provide a diversified source of financing, particularly to fill the gap created by limited option in the medium- to longer-term financing space.
The Future of Trade in the MENA Region
While the civil unrest in Syria and Libya have shut down these markets, Tunisia, Egypt and Bahrain have continued to operate – albeit with a reduced level of flows that are increasingly limited to essentials. How are upcoming developments expected to affect trade flows and financing in the region?
We feel that uncertainty around most of the countries in the region is going to prevent a quick increase in activity, and expect to see a cautious approach in the months ahead. Egypt is still some time away from establishing a new government ready to lead the country’s affairs – parliamentary elections have been pushed back to late November and the presidential elections are scheduled for 2012. Social change will be at the top of the political agenda, as well as the demand for infrastructure projects, such as housing, and power generation. It will be interesting to see how the government and international financial institutions respond to the new business environment.
However, some countries are implementing regulations to protect their own industries – leading to economic nationalism instead of globalisation. These actions are driven by politically expediency, or in some cases for economic survival (such as Algeria and Nigeria). That said, it is expected that political stability will lead to more financial security and investments returning to these countries. Internationally, governments will encourage companies to do business in the region, facilitating imports and exports where possible.
Egypt’s geopolitical position as home to the Suez Canal (which carries 8% of all seaborne global trade flows) will prove advantageous in the country’s road to recovery. Major institutions such as the World Bank, the International Finance Corporation (IFC), Organisation of the Petroleum Exporting Countries (OPEC), and Export-Import Bank of the US (EXIM) are currently supporting, or have indicated they plan to support, programmes for Egypt’s political and financial recovery. Wealthier MENA countries, such as Saudi Arabia and the UAE, have also offered support developmental programmes in Egypt, which will help to assuage the political unrest.
Conclusion
Trade flows in the region have suffered as credit has become less available and trade confirmation pricing has increased. While Egypt’s economic outlook is promising, the country’s long-term stability will hinge upon the upcoming parliamentary and presidential elections. Meanwhile, it will take some time for trading to fully recover in Syria, Yemen and Libya.
Nevertheless, corporates are using trade finance instruments to secure trade flows and payments, and banks are using these instruments to reduce risk exposure. As the region’s political environment continues to evolve and stabilise over the coming year, banks will once again enter the market, albeit with a cautious approach to their risk portfolios.