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"  

FDI in Retail May Not Always be Favourable to Local Farmers

A recent analysis of Nielsen data on food prices in US done by JP Morgan has found that for every 12-week period since May 14, 2011, Wal-Mart has been raising food prices faster than its competitors. So, if the consumers are not benefitting by way of lower rate of price increase, then who is benefitting from large retail chains? Certainly not the suppliers. Contrary to popular opinion, the FDI in India is not being driven by the consumers. Nor by the producers. 

The process by which capitalism has been replaced by corporatisation is being defended using the theoretical principles of competitive capitalism. However, there is no theoretical economic foundation to support the prevailing belief that a corporatised economy is capable of meeting the overall needs of society.

Corporatism is not capitalism. Corporations are designed to amass capital – to generate profit and to grow. None of the necessary conditions for competitive capitalism exists in today’s economy in India. The economy is moving away from market coordination towards a corporate version of centralised planning (supported by state-of-the-art technology). The problems of the centrally-planned economies of the communist regimes were not merely a lack of sophistication in management and planning. Central planning by government or corporation is a fundamentally wrong way to try to coordinate an economy. Had centralised planning been a result of free-market competition, it would then have been good for society. Corporatisation is not a market aligned system but a centrally-command structure with the basic flaw of growth for the sake of growth. 

Corporate agriculture is fundamentally different from the agriculture we have known in India, in the past. A corporation is a legal entity and not a person. It has no family, no community, and increasingly no nationality. The corporations that increasingly control agriculture have no commitment to India and certainly not to the farming in India. The retail corporations may help the growers get loans to buy buildings and equipment but they will abandon those growers if the contractual arrangement becomes unprofitable or even troublesome. We are in the midst of a great social experiment – an experiment being carried out by non-human entities that we have created and let loose to plunder Indians. 

Specialisation, standardisation, and consolidation are often cited as the keys to successful farming. In the past, the policy and practice in India had supported the industrialisation of agriculture by favouring those who have specialised in specific enterprises, standard production practices and operated on a commercial scale. Until recently, the industrialisation of agriculture meant advantages of the economies of scale but now it points to a situation of increased corporate control.

For the farmers, the most important strategy for surviving the next farm crisis may be to get to know the neighbours and turn them into customers. The concerted moves for dismantling the APMC market structure in the name of malpractices and corruption is directed to deny the opportunities of a decentralised free-market to farmers. 

Farmers’ markets, or cooperative marketing in any form, will provide more opportunities to bring local farmers and community members together through their common interests in sustainably produced food. Friends don’t abandon friends in the neighbourhood when the going gets tough. 

Published in The Economic Times

Trading Cos Look at New Sources of Financing after Credit Squeeze

Global trading companies’ talent and deep pockets have helped them get incredible powers. Regulators may be cracking down on big banks and hedge funds internationally but trading companies have largely remained untouched. Many are unlisted or family-run and have immense political clout. The commodities trading industry has diversified its sources of credit over the last decade as rising raw material prices have increased financing needs. However, most trading companies remain dependent on cargo-by-cargo short-term letters of credit.

Unlike commodity producers, trading firms don't just make money when prices go up. Most rely on arbitrage -- playing the divergence in prices at different locations, between different future delivery dates, between commodity qualities in different places… thus liquidity and cash flows are important.

The gains made in situations of short squeezes can often get negated if liquidity and credit squeezes have been triggered by their own banks. Global trading companies used to operate on huge liquid credit lines given by bankers. It seems that with the latest credit squeeze, trading companies are aggressively hunting for fresh lines of credit in the non-traditional geographies.

Three years ago, it was a freeze in trade lending which slowed global trade flows. Unfortunately, Europe’s sovereign debt and banking crisis is now resulting in numerous unintended consequences, especially in the commodities space. French banks such as BNP Paribas, SocGen and Credit Agricole are the main financiers of big commodity trading houses, many of which are run out of Switzerland. In recent weeks, as these lenders engage in significant asset contraction, they are reducing the availability of credit and raising its cost.

Three years ago, some of these large trading companies would have hardly glanced at alternative sources of commodity trade funding in non-traditional geographies. The scenario seems to be changing and borrowing in alternative currencies (other than US dollars) is no more exotic.

Trade finance is a huge business, with lending hitting more than US$170 billion. A drive by some banks to reduce the size of the balance sheets have aggravated the impact on commodities trade finance in light of new Basel III capital rules. While banks needed to hold capital equal to just 20% of the value of letters of credit under Basel II rules, the new agreement raises the bar to 100%, greatly increasing the cost of lending.

Trade finance, which supports US$14-16 trillion in annual global commerce, is crucial for international trade. Fewer than 3,000 defaults were observed by International Chamber of Commerce (ICC) in the full dataset comprising 11.4 million transactions. Therefore, it was argued that the increase in the leverage ratio under the new regime would not reflect market realities and may significantly curtail banks’ ability to provide affordable financing to businesses in developing countries and to SMEs in developed countries.

Following the recent consultation between the Basel Committee on Banking Supervision and World Bank, WTO and ICC, the rules for Basel III have been tweaked to promote trade with low-income countries. These alterations will reduce the amount of capital that confirming banks have to hold against letters of credit issued by lenders in low income countries.

The earlier insistence on the “sovereign floor” rule had made trade finance too expensive, even though it was extremely safe. The agreement to waive the so called sovereign floor for certain trade-finance related claims on banks using the standardised approach for credit risk will make credit more accessible in the low income countries. 

Published in The Economic Times

Just Use of Raw Material Key to Sustainable Development

Prior to the outbreak of the recent economic and financial crisis, there was a sharp increase in the demand for raw materials. Although the overheating has temporarily disappeared owing to the downturn, access to raw materials remains a highly important subject. This is because our concerns not only relate to prices but also to availability and relative prices. These factors determine industry competitiveness. Pressure will mount as soon as economic activity starts gearing up. Metals and fuels are source of our prosperity but the supply of some of these is faltering. 

At present, over 40 thermal power stations have coal stocks that are barely sufficient to meet the demand for about a week. As many as 29 projects have less than four days of coal reserves. The government has asked coal companies to step up supplies to power stations facing shortage of coal to ensure that power generation is not interrupted. 

A slew of factors, including less production from CIL collieries due to heavy rains, floods in Orissa and Telangana agitation, have hit coal supplies to power units. The threat of a strike by miners comes at a time when the power situation in the country is grim as many plants of NTPC, the country’s largest power generator, are running below capacity levels due to paucity of coal --the key raw material for generating electricity. 

Fuel prices have almost doubled over the last year and their impact on manufacturing have been worsened by the current power shortage, which has forced most local manufactures to use expensive diesel-run generators to power systems for more than the half of their production time. Any distortions in pricing and access to feedstock have a direct adverse impact on competitiveness, given that feedstock can make up a huge part of the production costs. 

Since August, the steel and allied industries in Karnataka have been facing acute shortages of iron ore, following the imposition of a mining ban in the state by the apex court. The iron ore supply crisis at JSW deepened last month when its longterm supplier NMDC stopped supply of the raw material. The state-owned company was adhering to the apex court order for selling all its ore from the state through the e-auction route. 

Industries need predictability in the flow of raw materials and stable prices to remain competitive. Policy makers should be committed to improve the conditions of access to raw materials, be it within India or by creating a level-playing field in accessing such materials from abroad. 

Our preoccupation with short-term price movement often ignores the potential of a more circular economy to increase economic resilience. Over a period of time, the pressure on raw materials will increase substantially. Therefore, we will need to use raw materials in a much more sustainable manner as the present pattern of exploitation and consumption cannot be maintained and our production process, feedstock use, consumption patterns will need to radically change to ensure sustainable development. 

Published in The Economic Times

Clearing Houses Now Accept Gold as Alternative Currency

Clearing arrangements for commodity contracts may be viewed as a process through which market participants seek to control risk. Such arrangements include both “clearing” in the sense of reconciling and resolving obligations between counterparties and “settlement” which finally extinguishes the obligations. 

One of the largest clearing houses of the world, LCH Clearnet, will begin accepting physical gold bullion (up to $200 million per member) as collateral amid growing demand to depart from the traditional reliance on cash and other securities to cover margin requirements. 

The move follows similar steps by many exchanges to increase the use of physical gold as an acceptable deposit and reinforcing the precious metal’s allure as an alternative currency. 

In October 2009, CME allowed physical gold to be used as collateral for margin requirements. ICE followed suit in November 2010. Last month, CME allowed the cap per member for gold collateral to be increased from $200 million to $500 million. 

It is important to point out a few facts that determine how clearing houses or central counterparties (CCPs) devise their margin strategies. First, it is critical to separate CCP margins into variation margin and initial margin. The variation margin is calculated on a trade-by-trade basis and offsets changes in value, whereas initial margin provides default protection and is usually calculated on a portfolio basis to allow for the offsetting of risk. There have been concerns that as the jostle for a piece of business continues, there may be temptations to relax financial standards and asset quality. That could include reducing the collateral quality instead of lowering margin requirements for members and a move which could weaken the mechanism in the event of a default. 

What is the fair price of commodity collateral? Given the complexity of pricing derivatives and the compounded challenges of calculating initial margins, there is no clear-cut solution to measure these risks. Physical commodity collateral may have a present market value of 100. However, on forced sale, the asset may be worth 60. In such situations, when a party approaches with an offer of 80 (with no other bidders in fray), should the offer be acceptable? The standard theory will say yes as 80 is more than 60. It’s a tough call for the creditors but not as tough as a forced sale. Book value may not be always the same as forced sale value. 

Clearing houses or CCP run a perfectly matched book. Every obligation to a member is matched by a precisely equal and offsetting claim against another clearing member. Therefore, clearing houses do not incur market risk. Collateral requirements do not in themselves provide adequate protection if collateral levels are not continuously monitored and related to risks incurred. 

Most clearing houses or CCP around the world conduct a routine margin settlement per day based on positions and market prices at the end of the trading day. The fund transfers associated with these margin adjustments are typically affected the following day. An essential condition for sound clearing and settlement procedures is that incentives to monitor and control risk should coincide with the capability to fulfill the monitoring/control function. The safeguard in the Indian context is that it is monitored on a real-time basis. 

Published in The Economic Times

Forex Swings Hit Commodity Values

We have seen that over the past few weeks, a number of central banks are stepping in, with a view to smoothing foreign-exchange volatility. Prices of internationally traded commodities are notoriously volatile due to market fundamentals and exchange rate movements. Commodities today are a diverse group of international markets that operate quite separately from each other. 

The value of commodities is dependent upon the currency they are exchanged for and when that currency is weak the commodity will appear to be very expensive and sometimes mistakenly very valuable. The effects of Currency Agreements as well as the Trade Agreements on the participating economies are important. Both types of agreement have multiplied in recent years. Many countries have fundamentally changed the way their currencies relate to the currencies of other countries either by adopting a common currency (Euro for EU) or through Bilateral Currency Swap Agreements where the trade settlements are done in their own currencies rather than in US dollars and finally by way of Multilateral Clearing and Payment Agreement (CPA).

While trade agreements and currency unions are often justified on the basis of the presumed effect on trade volumes, the reverse is also true. Currency agreements which lead to trade cannot be avoided. Erstwhile USSR and India used to conduct bilateral trade using an instrument called a “Rupee Rouble Escrow Account”. Boris Yeltsin unilaterally abrogated 1978 protocol without any legal or compensatory financial recourse.

China has signed Bilateral Currency Swap Agreements with Brazil, Korea, Hong Kong, Malaysia, Belarus, Indonesia, New Zealand, Kazakhstan, Uzbekistan, Argentina, Iceland, Russia, Indonesia and Singapore amounting to more than US $ 95 Billion. All these countries are important trading partners of China. In addition to border trade, ordinary trade can also be settled in both countries' official currencies. Chinese authorities are taking measured steps to internationalize the usage of the RMB (Renminbi) through a bilateral currency agreement. China which now holds large US assets is trying to diversify assets away from the US dollar.

China as per certain estimate undervalues its currency to almost 35%. China does not allow its currency, to float freely on exchange markets. This along with other subsidies and mercantilist trade policies keeps Chinese exports cheap and thus more attractive to consuming countries. Trade between India and China amount to around US$60 billion with an annual growth rate of 40%. The two countries in 2009 signed a bilateral currency swap agreement, but it has not yet been officially launched. There are also reports that some of the entities who are importing from China, are trying to tweak the existing commercial regime so they can borrow in the RMB to pay off the suppliers.

Chinese prefers to do things step by step. All the bilateral agreement should be seen as China's transitional move to make its currency RMB fully convertible and to challenge the US dollar. Eventually, wider use of the RMB outside China could redefine the balance of power as the rest of the world begins settling its bills with China in RMB instead of the US dollar.

Given the importance of China in the world commodity market, the ramifications can be significant.

Published in The Economic Times