Emerging Markets Trade Finance | Special Report
Although barriers to trade have declined, gaining access to trade finance is challenging in some markets.
Emerging markets’ firms are ever more central to world trade. In 2012, trade in developing countries accounted for 38% of global flows—up from 14% in 1990, according to the McKinsey Global Institute report, “Global Flows In A Digital Age,” published in April. But unmet demand for trade finance capacity in emerging markets is making it difficult for small and medium-size enterprises to meet their financing needs, which may stymie their ability to grow.
Trade finance backs global flows by offering importers and exporters the ability to obtain much-needed funding while mitigating counterparty risk. A report published by the Bank for International Settlements in January estimates that trade finance directly supports about a third of global trade and is “primarily used to finance trade involving emerging markets economies (EMEs), particularly in Asia.” The report states that in China, for example, trade finance backs 47% of merchandise trade.
The lack of clear regulation… is leading to unintended consequences and is increasing the market gap for trade finance—which ultimately results in less trade and less economic growth.
~ Steven Beck, Asian Development Bank
Sam Sehgal, EMEA head of trade finance and commodities at Citi, identifies several long-term trends that will affect the development of this area over the coming decade. “Without a doubt, the most important trend is globalization,” he says. “As companies’ trade activities become more international, banks are likewise having to make their products more global and scalable. On a related note, banks which are looking to service their clients holistically also need to provide solutions which go beyond US dollar-, renminbi- and euro-denominated trade and also focus on exotic currencies.”
“A few years ago, people were talking about the decoupling of the East and West—but this isn’t the reality,” observes Simon Constantinides, regional head of global trade and receivables finance in Asia Pacific for HSBC. “We live in a global economy: The world moves rapidly and daily, and so does trade. The barriers to trade have been reduced, and companies are a lot more comfortable setting up their manufacturing operations all around the world.”
Sehgal notes that there is increasing investment in infrastructure by some emerging markets economies, as well as growing demand for commodities as expanding populations become more affluent, thereby consuming more. Both of these trends are driving EM growth, which in turn is a key driver of global growth. A report published last year by Ernst & Young, “Hitting the Sweet Spot: The Growth of the Middle Class in Emerging Markets,” predicted that the global middle class will expand by three billion people in the next 20 years, with most of this growth coming from emerging markets.
WORKING CAPITAL NEEDS
But it is unclear whether banks will continue to be able to finance that growth through their balance sheets. “Clients are increasingly looking for off-balance-sheet solutions,” says Sehgal. “Basel III will force banks to make choices for the scarcer capital they have, which as a result will mean less lending to the corporate sector. Corporates will therefore have to find intelligent and indigenous ways to extract working capital requirements from their own operations, rather than relying on bank debt. Often this means having a robust, end-to-end supply chain finance solution, i.e. a robust mechanism to pay suppliers, leaner inventory management and market-leading receivables financing capabilities.”
Banks are increasing investment to these areas. Constantinides says HSBC is focusing on the shift from traditional trade products, such as letters of credit, to open account terms. “We’ve been building out to support open account with our receivables finance and payables finance structures and have been putting new technology and solutions into the market with that,” he says.
IMPACT OF REGULATORY CHANGE
The last year has seen some positive developments for banks in terms of regulation. Concerns had been raised that Basel III would have an adverse impact on the pricing and availability of trade finance, in turn affecting global trade flows. In January, however, bank and corporate lobbying paid off, with amendments to the leverage ratio providing more-favorable treatment for letters of credit—namely, applying a credit conversion factor of 20% rather than 100%.
However, regulation continues to affect the availability of trade finance in emerging markets. Steven Beck, head of trade finance at Asian Development Bank (ADB), says that financial crimes compliance is a key concern. “Particularly after 9/11, a plethora of regulatory requirements came into play around anti-money-laundering (AML) and know-your-customer (KCL) compliance,” he notes. “But over the past few years, these regulations have developed differently in different jurisdictions, making it difficult and costly for banks to comply with them. At the same time, much of this regulation is unclear, so banks do not always know exactly what they are supposed to comply with.”
Corporates will… have to find intelligent and indigenous ways to extract working capital requirements from their own operations, rather than relying on bank debt.
~ Sam Sehgal, Citi
With many high-profile fines levied on financial institutions in recent months, Beck says that financial crimes compliance is associated with a significant fear factor, with many financial institutions exiting relationships with other banks as a result. A survey published in July by the International Chamber of Commerce (ICC), “Rethinking Trade and Finance 2014,” found that 68% of respondents had declined to do transactions as a result of KYC and AML concerns; 31% had closed down correspondent (banking) account relationships for the same reasons.
These factors are contributing to a gap between supply and demand for trade finance around the world. The ICC’s survey found that 41% of respondents believed there to be a global shortfall where trade finance is concerned. And research published by the ADB last year found that there is unmet demand for trade finance to the tune of $1.6 trillion—with $425 billion of that figure relating to developing Asia.
While top-tier multinational corporations are unlikely to suffer as a result of this shortfall, some organizations may struggle to access the finance they need, Beck points out. “This is affecting small and medium-size enterprises (SMEs) and emerging markets in a disproportionate way, with corporations struggling to access the finance they need to do business,” he observes.
The ICC’s survey identifies SMEs as being particularly at risk of being unable to access trade finance: “It remains clear that SMEs, particularly in emerging markets, continue to rely on loans in local currency or overdrafts to finance their international trade activities with the consequent restriction on their ability to trade at optimum level during these challenging times.”
“Financial institutions certainly don’t want to support financial crime,” says Beck. “But the lack of clear regulation in this area is leading to unintended consequences and is increasing the market gap for trade finance—which ultimately results in less trade and less economic growth. As an industry, we need to obtain hard data so that we can continue to make a convincing argument to regulators and demonstrate these issues.”