Malawi Conference (Lilongwe)

Conference at Lilongwe (Malawi) for Commodity Exchange Stakeholders
Group Photo with the Minister of Agriculture on 30 April, 2012 at Hotel Crossroads 

Collateralised Trade Finance

(Left to Right) Sripad Murthy Director 

Barclays Bank, Dr Anup Pujari Director

General  DGFT, Sam Pittalwala Director 

ANZ Bank & Shyamal Gupta CBO, 

NCMSL

Trade and Collateralized Trade Finance (CTF): A well-functioning collateralized trade finance system contributes to the development of trade by significantly increasing access to credit for those firms who need it the most and decreasing the cost of credit through better terms and conditions.

Collateralized trade finance framework strengthens the trade financing system in three ways:

1. Lending Opportunity: It provides banks with profitable lending opportunities
2. Secured Asset Diversification: It helps in diversifying assets held by financial institutions as collateral (other than land and building) which spreads risk more efficiently.
3. Liquidity: It improves the liquidity of assets, especially short term assets such as commodity.

Access to the Formal Trade Credit: In India, the difficulty of accessing trade credit is among the top reasons why growth has been limited. More than half of trade enterprises in India do not have any access to loans or a line of credit from the formal financial system.

Often the problem is not the unavailability of collateral required by the banks but rather the type of collateral and the inability to use valuable assets as collateral. In India, 78 percent of the capital stock of a business is typically in movable assets and only 22 percent is in immovable property like land and buildings. Financial institutions are reluctant to accept movable assets and heavily prefer land and real estate as collateral.

Securing trade transactions by working through the collateral management agencies to hold custody of the raw material and finished goods is one way to deal with this phenomenon and thus increase access of credit to the trade sector, in particular the small and medium enterprise segment.

Dual Growth of Trade Finance Demand: Research by the International Chamber of Commerce (ICC) and the International Monetary Fund (IMF) has revealed a largely mixed outlook regarding demand for trade finance products in 2012. Around 60% of the respondents indicated that the demand for trade in Asia will show improvement in 2012, while close to 50% of respondents predicted a further deterioration for the Euro area.

Based upon inputs received from 337 financial institutions responding to a joint ICC-IMF survey, the findings also show a two-speed financial system: for emerging Asia the outlook is the strongest, while the Euro area is the weakest.

Current Trade Issues in India: The merchandise trade deficit (excess of goods imports over goods exports) has remained in the range of 8-9 per cent of GDP in recent years, except in the crisis year of 2008-09 when it rose sharply to 10.4 per cent. Deficit has stood at $86 billion during the first two quarters (April-September) of financial year 2011-12 as compared with $69 billion in the corresponding period of 2010-11.

India’s receipts from what are termed “invisibles” have shrunk relative to the trade deficit. (exports of software and business services and remittances or “personal transfers” from Indians working abroad). Earlier these flows were adequate to finance much of the trade deficit, even after outflows on account of dividends and interest (which are also in the invisibles category). While it is true that the net foreign exchange earnings from services increased from $22 billion to $31 billion between April to September periods, the pace of growth of services exports has slowed.

Growth in services exports (in US$) at 17.1 per cent in the first two quarters of 2011-12 led mainly by software and telecommunications services was substantially lower than the 32.7 per cent recorded in the first two quarters of 2010-11. The current account was shored up by the fact that that private transfers or remittances that had declined by 1.1 per cent during the first two quarters of 2010-11 rose by 18.8 per cent during April-September 2011-12 driven possibly by the depreciation of the rupee.

Since 2007-08, the ratio of net invisible receipts to the merchandise trade deficit has fallen from 83 per cent to 65 per cent in 2010-11. In sum, while India’s trade deficit has risen more or less in proportion to GDP, invisible earnings have not kept pace, resulting in a doubling of the current account deficit to GDP ratio from 1.4 per cent in 07-08 to 2.9 per cent in 09-10 and 10-11.

Exports in absolute terms have been falling since July month-on-month. If the trend continues, it is most unlikely that the outbound shipments would be able to reach the government’s target of $300 billion by March 31.

Exports reached $26.7 billion in July, $24.8 billion in August and $23.6 billion in September, followed by $22.4 billion in October, $22.32 billion in November and $25 Billion in December.

Month	Exports	Imports	Trade Deficit
April -Dec 2011 (US$)	217.6 Bn	351 Bn	133.4 Bn

The message seems clear. India cannot continue to rest purely on the benefits it has hitherto derived from the exports of software and IT-enabled services. An enabling environment for merchant trade needs to be created not by way of doling out subsidy but through a better system of trade finance Access and Availability.

European Crisis: The current situation in Europe points to an extended period of low growth (if not recession). Even if recession is averted through creditors taking huge haircuts, there would be implications for countries such as India. This was mainly because of a severe crisis in the Euro zone. The 27-member EU account for around 17 per cent of the country’s exports. Thus, it is India’s largest trading partner as a bloc with bilateral trade that reached $91.34 billion in 2010-2011 from $74.45 billion in 2009-2010.

The EU accounted for nearly $ 47 billion out of India's total exports of $ 254 billion in 2010-11 – making it a larger destination than even North America ($ 27 billion). But no less important is Europe's role as a financier. European banks accounted for almost $ 148 billion out of the total foreign claims of $ 325 billion on India, according to the Bank for International Settlements (BIS) data for June 2011. The stress on their balance sheets from exposure to PIIGS countries debt may force these banks to refrain from fresh lending or even rolling over existing debt in other geographies. That could hit Indian companies in the near term as well.

China’s Easy Availability of Trade Credit: The crisis engulfing commodities trade finance is a large downside risk for raw materials prices. The tightening of credit in Europe is not the whole story. Monetary policy in China is in the process of easing rather than tightening further. Chinese commodities traders bought minimal amounts of raw materials such as copper in the first half of (Jan- June) last year and instead have run down inventories as Beijing’s drive to tighten access to credit reduced their ability to import large volumes.

Chinese buyers had been able to tap credit more easily, enabling larger purchases. Chinese buyers had been mopping up significant amounts of commodities to rebuild the depleted inventories. The rising availability of domestic credit for commodities deals in China is allowing local traders to engage in “carry trade” deals, buying copper and other raw materials for storing on the hope of higher prices in future.

Local traders are importing commodities to resell them quickly and use the proceeds during 90 days to invest in other ventures, before repaying back the loans – a practice common back in 2009. The monetary easing in China would not only have an impact on the ability of domestic commodities trading houses and importers but it is also likely to spur economic growth overall. Chinese economic growth eased in the fourth quarter (Oct-Dec) of 2011 to 8.9 per cent, down from 9.1 per cent in the third quarter (July-Aug) and 9.7 and 9.5 per cent in the first and second quarters, respectively. The growth rate was above market expectations, although was the slowest in 10 quarters, suggesting that Beijing will further ease monetary conditions in the short term.

If China provides greater access to trade credit then there are also ways by which this can be replicated in India.

Impact of Basel III on traditional Trade Finance Prodcuts: The “Basel III” rules are designed to make banks more resilient and prevent a repeat of the financial crisis, but several provisions combine to make trade finance, already a low-margin business, much less profitable. Basel III’s implementation could have unintended consequences for trade financing through the proposed leverage ratio, which would require banks to set aside 100 percent of capital for any off-balance-sheet trade finance instruments, such as letters of credit. This is five times more than the 20 percent credit conversion ratio used for trade finance in Basel II. New capital regulations would also require banks to set aside capital for one year for any instrument, even though that security may carry a maturity of under a year. Most trade finance instruments have maturities of about 90 days: this would triple the capital cost of such instruments.

European banks play a central role in emerging markets trade finance: the IMF estimates French, Spanish and UK banks account for 55% of trade finance in Asia and 59% in Latin America. As European banks pull back, this may cause temporary disruption and increased cost, but in the long run the slack is likely to be taken up by other banks.

This provides opportunities to banks in India to capture the space which they could not enter earlier by providing a more secure route of collateralized trade finance.

Trade Finance Profile: Total trade transactions estimated at US$ 16 trillion, involve a form of credit, insurance or guarantee. Trade finance covers a spectrum of payment arrangements between importers and exporters. Despite the serious impacts of the financial crisis, countries continue to trade. The availability of trade finance is critical to the sustenance of emerging markets, especially for small- to medium sized enterprises that rely on short-term trade finance for their trading activities.

Trade finance products have significantly different risk profiles, default rates and capital uses from other corporate products. Traders and producers in developing countries with weak institutions are generally more reliant on bank-intermediated trade finance than their peers in developed markets.

In these circumstances, unless the Bank is providing credit facilities, the bank will only see the clean payment and will not be aware of the underlying reason for the payment. The bank has no visibility of the transaction and therefore is not able to carry out anything other than the standard AML and Sanctions screening on the clean/netting payment. Where the bank is providing credit in relation to the trade transaction there may be more opportunity to understand the underlying trade and financial movements. Historically trade finance has not been viewed as a high risk area in relation to money laundering. This perception has changed of late and increasingly regulators and international bodies view trade finance as a “higher risk” area of business for money laundering, terrorist financing and, more recently, for transactions related to the potential breach of international and national sanctions.

Need for Collateral Management for Secured Credit:  Collateral management firms are becoming increasingly important within trade finance. Collateral managers basically "look after" collateral on behalf of a lender financing goods. By using a collateral manager, the lender can make sure that goods, such as commodities, for example, are being controlled in such a way that if anything goes wrong with the loan, such as the borrower defaulting on payments, then the bank can get its hands on the goods which are the subject of the loan, to recover monies lent. Collateral management companies serve a growing international market for trade finance, wherein money is lent based on the value of the underlying goods, rather than on the balance sheet of the borrower.

Globally the desire of bankers, borrowers and warehousemen to use the services of collateral management companies is increasing. In the absence of totally secure physical commodity storage facilities and resulting from the risks in moving commodities about, banks are obliged to find other structures for protection against physical risks. The collateral management agreement offers such solution.

Shift from Traditional Trade Finance provides new opportunity for Bank in Open A/c transaction: It should be recognized  that the majority of world trade (approximately 80%) is now carried out under “Open Account” terms. This means that the buyer and seller agree the terms of the contract, the goods are delivered to the buyer who then arranges a clean payment, or a netting payment, through the banking system. The first casualty of war is said to be the “Truth” but in financial crises, it is “Trust” that dies. While the after-effects of the recent crisis are constantly being debated, the financial crisis also brought a heightened sensitivity to risk by corporate, which has led to an increase in the relative demand for intermediated trade finance over traditional open account financing. Recent estimates indicate that the growth rate of intermediated trade finance surpassed that of open account transactions reversing a long-term trend towards open account financing. Banks can use this credit shift to its advantage by using the secured route of Collaterized Trade Finance.

Banks can expect a quantum jump in secured credit through a collateralized trade finance route as the total trade from the Indian subcontinent is increasing. The demand trade credit from the small and medium enterprise segment which does not have sufficient balance sheet strength is increasing. This issue could be best addressed by collateralizing the underlying inventory for trade credit which will serve the purpose of both the borrower and the lender.

Presented at the Seminar on "Collateralised Trade Finance"