In the 1950s, the vast majority of world trade was conducted on letter of credit (L/C) terms, while today trade is predominantly done on open account terms. As trade volumes have grown dramatically, fuelled by globalisation and the rise of emerging markets, the L/C still remains a very relevant instrument. However, corporates are attracted to the efficiency and simplicity of open account trade. While the L/C offers more security and the credit support of a bank, buyers and suppliers have become more familiar with each other over time and therefore more at ease on an open account basis.
Despite the decline in use of L/Cs as a proportion of global trade, trade finance instruments are now seeing something of resurgence. In certain pockets, the L/C remains very important, for example in the commodities sector, where sustained high transaction values continue to drive demand for these instruments. For all companies, working capital management is now more important than ever, and trade finance instruments, particularly those that serve open account, are seen as an important lever in the process.
Post 2008: Boosting Working Capital through Supply Chain Financing
Since the credit crunch of 2008, company priorities have changed and many corporates are increasingly concerned about counterparty risk and working capital management in their supply chains. As a result, banks are now offering financial supply chain products that provide benefits similar to those of L/Cs, such as liquidity and counterparty risk mitigation. These products are a more automated and efficient way of delivering those same benefits.
As the capital markets have become a less reliable source of financing, at least in times of stress, trade finance instruments are now seen as a more viable component of a company’s working capital tool kit. Whether that is through supplier-financing structures or traditional L/Cs, companies are looking for ways to boost their working capital cycle through flexible and affordable financing. However, financial supply chain (FSC) is really the area where there is dramatic take-off, and the US is one of the leading regions in this renaissance.
US Corporates Leading Trade Finance Growth
Large US corporates were among the first to move away from L/Cs to open account, but have also been at the forefront in terms of realising the importance of trade finance in managing working capital. Post-2008, there was a small uptake of traditional L/Cs, as companies took refuge in the safety of documentary guarantees. Now these same companies are looking to the FSC side of the trade finance business and are leading innovations in this area. For example, treasury departments are seeking to speed up collection of their customer receivables – their days sales outstanding (DSO) – while at the same time seeking to extend payments to suppliers. By delaying their days payables outstanding (DPO), companies can make considerable improvements to their cash flow.
To avoid damaging suppliers with delayed payments, the bank provides financing so the supplier is paid on day one (and at an advantageous rate reflecting the better risk of the buyer), while the corporate client (the buyer) can improve their working capital by paying after 60 days. The supplier receives payment sooner, while the buyer has the flexibility of paying later. As a result, managing working capital and risk through FSC (around DSO and DPO) is now a key, strategic activity for large US corporates.
The new capital adequacy rules of Basel III will mean, however, that providing these supply chain services has new challenges for banks. They will have to reassess their risk measurement methodologies and manage their own balance sheets in a more dynamic manner through distribution and capital market activities.
While companies continue to find value in the L/C business, there is also potential for L/Cs to become more automated. SWIFT’s Trade Service Utility (TSU) and the bank payment obligation (BPO) are initiatives that offer more automation for trade finance services. The BPO, for example, delivers the same benefits as the L/C, but for trade on open account terms and on a more automated basis. The BPO has been in development for some time with the establishment of rules to be endorsed by the International Chamber of Commerce (ICC) and it stands a greater chance to achieve the critical mass needed to make this initiative a success over the medium term.
Trade Finance in Latin America
Trade finance products, including L/Cs, haven’t seen as much of a decline in Latin America as has occurred in other more developed markets, such as the US. In fact, trade finance products have continued to be the backbone of much of the financing in Latin America. In many Latin American countries there are special regulations for trade finance instruments, sometimes giving them certain beneficial treatment under taxation and insolvency laws. Taxation is a major factor in Latin America with its rapidly-changing regulation and taxation environment. Some of these instruments include export pre-payments, L/Cs, stand-by L/Cs and short-term trade finance instruments. These are highly traditional trade finance instruments, which are predominant in Latin America and differentiate the market from the US.
Certain core countries, including Brazil, Argentina, Venezuela and Colombia, still have strong appetites for traditional trade finance. Meanwhile, other countries, including Chile and Mexico, have a similar dynamic to the US, where clients are using more sophisticated FSC products. Mexico is a key manufacturer and supplier for the US, so production there is very much interlinked with the US market. For example, if a company manufactures washing machines in Mexico and sells them to US retailers, the Mexican company becomes integrated into the supply chain of the US retail market. Chile, on the other hand, is one of Latin America’s wealthiest economies, with a GDP of US$14,311 per capita and an A+ rating from Standard & Poor’s (S&P). Its high credit rating means that trade financing is cheaper and sophisticated structures are more in demand from large companies based in the country.
Latin America’s export markets are prospering and this is a key driver of trade finance. The commodity export boom is primarily driven by Asian growth – for example, iron ore is used in construction and auto manufacturing in China. The increase in consumer buying power in China is also driving food commodity exports. So far the European crisis and US downturn have had little impact on the Latin American economies, with the exception of Mexico (due to its heavy exposure to the US). Basel III will most liklely also have an effect on banks’ capabilities and services in Latin America.
Brazil: Largest Market in Latin America
The Brazilian market is opening up slowly, with Brazilian multinationals such as Petrobras, WEG, Embraer and Vale emerging in recent years. These companies and many more like them are now trading globally, so they need access to global treasury services, including global cash management products, payment factories and financial shared service centres in Asia and Europe. Brazil already has a very sophisticated trade finance market, but there is huge potential for further FSC products to develop.
Brazil is Latin America’s biggest exporter of commodities. For example, it is one of the biggest soya bean exporters in the world (used for livestock feed in Asia and worldwide). It is also a leading exporter of orange juice, coffee and iron ore, while other products such as sugar, pulp, paper, oil and petroleum are also key exports. Brazil also exports specialised industrial products such as aircrafts.
Two upcoming global events in Brazil are also driving investment: the Olympic Games in 2016 and the World Cup in 2014. These events are boosting trade finance business, which supports the import of services and equipment. Brazil is also investing in infrastructure such as stadiums, roads, ports, oil refineries and transport for the Olympic Games.
Choosing Your Trade Finance Bank
When choosing a trade finance bank, whether in the US, Latin America or another region, there are certain key requisites to consider. . Corporates should assess potential trade finance banks for the following attributes:
- Choose a bank with which you already have a relationship. FSC structures are relationship-oriented services, built on essentially long-term partnerships.
- Choose a bank with a strong track record in trade finance services, including L/Cs and FSC. It’s a specialised activity and requires a lot of expertise.
- Choose a bank with a global branch network: do they have trade finance operational capabilities in the countries where your supply base or distributor base exists?
- How robust are the bank’s platforms and processes? They need to have broad functionality, user friendly interfaces, and to be able to connect to your corporate systems – and those of your trading partners – in a very effective way.
The Future of Trade Finance
Some 15 years ago the L/C was a well-established trade finance instrument, but today 85% of trade is done on open account. The L/C still plays a vital role, but there has now been a real renaissance in the way banks support companies in trade finance and in the FSC. This is driven by the corporate need for flexible financing and risk mitigation.
While many local banks no longer have the expertise or critical mass to support trade finance on an international scale, many larger banks have invested in global platforms, specialised products and expert staff to provide services to large, sophisticated corporate clients. Overall, trade finance instruments have improved and are now an increasingly important way for companies to manage their working capital through their supply chains. FSC can take great pressure off the working capital cycle by reducing counter party credit risk and by freeing up liquidity.
Ten years ago, companies didn’t consider trade finance to be an important part of their working capital and supply chain tool kit – that has changed. Further development of FSC services and more automated traditional trade finance instruments will ensure that trade finance remains an important working capital and risk management resource for corporates across the globe.
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