Commerce becalmed over letters of credit

Commerce becalmed over letters of credit
(The Times)
Carl Mortished, World Business Editor
November 3, 2008

The credit drought is undermining international trade in goods and raw materials with savage increases in the cost of funding for exporters. At the same time, buyers of goods are being denied access to letters of credit - the banking instruments that are the nuts and bolts of global trade.

Commentary: I love this nuts and bolts analogy as this is the exact topic I have been studying and teaching about for nearly three years.

HSBC, a leading trade finance bank, has said that the cost of guaranteeing a letter of credit, a routine instrument used for payment of goods, has doubled. Concern is growing in the shipping industry that business is foundering because of failures in trade finance, and Pascal Lamy, director-general of the World Trade Organisation, has given warning that the credit crunch is affecting global trade, particularly in the emerging markets of Brazil, India and China. He said: “Trade finance is being offered at 300 basis points above the London Interbank Offered Rate and even at this high price, it has been difficult for developing countries to obtain.”

Commentary: Other reports state these costs have tripled.

Mr Lamy has called a group of trade finance banks, including HSBC, Royal Bank of Scotland, JPMorgan and Commerzbank, to a meeting on November 12 with the IMF and World Bank to consider the trade finance problem.

Commentary: Yes it is old news but all news to me!

Lack of trade finance is having a disastrous effect on shipping. In a report issued on Friday, Maersk Broker, a subsidiary of the Danish shipping group, blamed logjams in the banking system for the slump in the dry bulk cargo market: “Banks’ refusal to offer letters of credit has resulted in very few fresh cargoes reaching the market, which is adding to the owners’ woes.”

Commentary: It appears bankers suddenly least trust other bankers at this time. It appears prudent from a cash in hand basis and those with ready cash will be largely unaffected however they only appear to represent about 10% of all global trade buyers.

A collapse in the trade of raw materials such as grain and iron ore, after years of frantic activity, is causing havoc. The Baltic Exchange Dry Index, which measures the price of voyages and the cost of chartering vessels, has plummeted. Rates for the largest transporters, known as Capesize, peaked in May at $230,000 a day. It is estimated that the daily cost of running the ships, including depreciation, is about $15,000 but at the end of last week, rates had fallen to $5,982 a day.

Commentary: It would be interesting to examine which of two factors, purchases made at record high commodities prices which were cancelled at a loss thus throwing trade credit at the top of bankers' risk assessments or the actual sudden re-evaluation of trade credit transactions consumption of bankers' short-term debt uncertainties which more heavily impacted the crash in commodities prices. Speculators might easily be blamed but how many buyers and sellers of real, tangible commodities actually participated in the speculative investments in supply costs?

According to HSBC, there has been a surge in customer requests for trade tools that can guarantee payment.

Commentary: This appears questionable and confusing as some reports state that only 10% of world trade relied on letters of credit previous to commodities price crash versus a majority which relied on sellers government guaranteed credit which in terms of Canadian exporters generally only covers 90% of the total export value. Did all of these exporters suddenly perceive 10% of their uninsured value would be lost and is that 10% often representative of their profit margin? Thus for the sake of profit margins nearly 90% of global trade has ground to a halt? Is this a fair conclusion and where and when will the public be informed of it?

Stuart Nivison, an executive in the bank’s trade finance division, said companies that two years ago might have been happy to deal on the basis of simple orders from customers are now insisting on documentary credit.

Commentary: In the Middle East it is my understanding that much of its inter-company trade has been on a cash only basis as a standard of small businesses without bank support.

Anxiety about payment was pushing companies to ask for greater security, Mr Nivison said, and in such transactions, fees were soaring. He pointed to a recent case of a shipment of industrial equipment from Britain to India, where the confirmation and discounting of a letter of credit, which would normally cost 0.5 per cent of the value of the goods, had risen to more than 1 per cent. “These are big moves and reflect the nervousness in the market. People want to be sure they are paid,” Mr Nivison said.

Commentary: If companies have rushed from government sponsored credit insurance payments perhaps it is due to sudden increased demand in commodities which perhaps have doubled in volume compared to the fifty percent drop in prices which would be impossible for most companies to fulfill?

Distrust of banks is compounding the problem. “We have received requests to guarantee the credit of top-tier banks and we have also seen cases of exporters in China saying to their UK buyers which banks they will or will not accept,” Mr Nivison said. He added: “Trade finance is the oil that keeps the wheels of commerce going. Without it, everything grinds to a halt.”

Commentary:It would appear global exporters may be trying to support higher prices for commodities based upon actual demand which has fallen out of favour as the speculators have left the building for the moment. At the same time importers may be demanding suddenly increased volumes of commodities beyond the inventory and supply capabilities of exporters. I suspect the letters of credit option is being "played" as a means to insure complete export risk coverage to maintain minimum 10% profit margins which government sponsored export insurance programs do not secure. At the same time, importers knowing this are attempting to secure lower cost letter of credit terms because 1-3% of their profit margins are suddenly being shaved off by the banks. That is the way it appears to me. Am I far off base here?