Pandemic spells change for trade finance
The pandemic has been a health and humanitarian crisis of historic proportions. Our understanding of the full extent of its impact continues to develop. As we went into a global lockdown to control the spread of the virus, international supply chains have had severe disruptions, on an unprecedented scale. With these disruptions, there has been a material impact to corporates involved in global trade, as well as to banks who support them with trade finance arrangements.
People movements may have been restricted during the various lockdowns, but imports and exports continued. Trade in essentials has even increased, with a deeper appreciation for necessities required to endure the pandemic – food supplies, staples, medical equipment, PPE (Personal Protective Equipment) and even consumer electronics as more people work from home. Trade volumes have dropped as expected, as non-essential or larger trade transactions were deferred. This is similar to what was observed during the global financial crisis, when WTO data showed global trade volume declining by around 12 percent. However, the post GFC rebound in global trade volumes was swift. We expect a similar rebound with a return to normalcy once the pandemic eases.
According to Bank for International Settlements estimates, trade finance directly supports about one-third of global trade. The key instrument is the letter of credit (LC), which continues to play a material role in enabling trade with developing economies. Over the years, trade finance has provided clients with benefits such as risk mitigation and working capital financing. Digitalisation is one area where trade finance has lagged, though that may be set to change.
Risk mitigation is a commonly cited benefit of trade finance – for example the role of an LC to ensure that a seller / exporter will eventually be paid for a product shipped to another country. LCs are typically used for exports to developing countries – as the risks of non-payment from a developing country are statistically higher. Analysing SWIFT data on LCs issued globally, the top 15 countries include Bangladesh, Pakistan, Vietnam, Sri Lanka and Nepal. Despite this – International Chamber of Commerce (ICC) data from 2008 to 2018 shows extremely low default rates for LCs – 0.37 percent for import LCs and 0.05 percent for export LCs.
Against this backdrop, we’ve noticed some changes since the start of pandemic – both to global supply chains, as well as usage of LCs. LCs are also often used by exporters with first time customers or new trading relationships, where the risks of non payments are higher than a historic trading partner. Furthermore, we have experienced tremendous innovation in supply chains – for example auto companies repurposing assembly lines to produce ventilators, or a broad range of industries now adapting to produce PPE.
LC based trade vs open account: Over the past several years – while global trade has increased annually, the number of LCs issued globally has tended to decline. As counterparties become more familiar with each other, a higher percentage of trade was occurring on open account basis. The immediate impact of the coronavirus has been a short-term reversal in this trend. Several exporting corporates now require a higher portion of sales to be covered by an LC, to guarantee payment from their buyers. Coronavirus induced supply chain disruptions are forcing new trading partnerships, as buyers seek alternative sellers. Exporters will typically require LCs from new buyers, especially in developing markets. We will need to wait until the return to normalcy in a post-pandemic environment to determine whether this effect is long lived, or the extent to which these drivers of incremental LC demand will outweigh lower trade volumes.
New LC markets for risk mitigation: Given the increased need for risk mitigation, several corporates have implemented policies requiring a higher percentage of exports to be protected by LCs. We have also seen increased requests to confirm LCs issued by banks in relatively developed market in the EU and Asia – including Italy, Poland, Malaysia and even South Korea. It’s possible with further sovereign downgrades, the role of trade finance in providing risk mitigation expands to a broader range of countries.
Trade as a source of working capital finance: Trade finance is also commonly used as an instrument for short-tenor working capital finance– financing the gap between input costs and getting paid for sales. This is clearly an area that the recent pandemic has put under strain.
A broader range of trade finance instruments can be used for such short tenor financing – LC discounting, electronic bankers draft discounting (E-BAD) in China, invoice financing (with recourse), trade receivables purchase and payables finance solutions. We have seen a number of corporates that previously only used trade finance for risk mitigation, now also using trade finance for working capital finance, for example by asking us to confirm and discount an LC. Across financing instruments, the self-liquidating nature of trade has lead to continued demand as corporates have sought to raise cash to weather the storm, and in many cases utilise trade instruments to support strategic supplier relationships in the supply chain.
Trade is an extremely paper-heavy activity with a wide array of required documentation, such as bills of lading, LCs, certificates of origin, customs papers, invoices and many more. Trade finance transactions often rely on hard-copy paper documentation to process payments and ultimately clear the release of goods to buyers. In many countries, electronic trade documents are either prohibited or their legal status is unclear. There has been a trend towards digitalisation of trade finance, though given certain complexities, this has lagged other parts of banking such retail or financial markets.
The recent pandemic has created certain challenges for market participants as sales and operations staff have been required to work from home, reliability issues in courier services have slowed the movement of documents, which has in turn has risked delays in shipment.
A broad list of participants of trade, such as exporters, importers, logistics companies, customs authorities and banks, have been evaluating digital solutions for some time. The disruptions from the pandemic have underlined that traditional trade finance techniques and practices are ripe for reform. As such, the pandemic may have actually accelerated this trend. In the short term, this has already increased acceptance of electronic signatures. In the medium to longer term, we may an further usage of digital trade platforms.
It is encouraging to see the ICC show a strong desire to accelerate digitalisation to ensure trade continues. For example, the ICC provided guidance to market participants, regulators and governments alike to temporarily void legal requirements for paper-based documentation. As the trade finance community recovers from the pandemic, it’s possible that many countries will continue to accept electronic documentation. This would also be a huge step toward digitalising trade finance.
The pandemic has been unprecedented in its scale, changing our approach to many aspects of our lives and how we conduct business. Exports, imports and the trade finance required to support these activities are no exception. The global sourcing patterns continue to shift, with underlying principles of diversification and agility in supply chains remaining as important today as ever before. Similarly, the pandemic has shown the criticality of trade finance towards facilitating the movement of goods around the planet. It is in times of stress and dislocation that that this role becomes even more important.
Deepan Dagur is managing director, regional head Asia and Middle East, transaction banking, Commerzbank AG