EconSouth (First Quarter 2009)

Credit Storm Sinking Global Trade

Once a mainstay of worldwide economic growth, international trade is foundering in the rough financial seas now engulfing the world. As credit costs soar and private credit providers are less willing or able to fund trade financing, governments and multilateral organizations are having to support credit to help keep world trade afloat.

Photo of a cargo ship sinkingDuring the past several decades, the world economy grew rapidly, raising living standards and promoting development. This growth was driven in part by an even more dramatic increase in international trade. In the United States, the share of international trade (the sum of all imported and exported goods and services) rose to around 30 percent of gross domestic product (GDP) in recent years, up from a mere 10 percent four decades ago. International trade also accounted for about three-quarters of U.S. economic growth between the first quarter of 2007 and the third quarter of 2008.

International trade, especially in developing countries, depends to a large degree on the availability of credit to finance activities in the stream of trade. For instance, exporters often require financing to manufacture products before receiving payments from their buyers. Meanwhile, importers need credit to buy goods, such as materials and machinery, from other countries.

Globally, international trade of goods amounts to about $14 trillion annually, and, according to the World Trade Organization (WTO), 90 percent of these transactions involve trade financing. Trade-related credit is primarily issued by banks via letters of credit, whose purpose is to secure payment for the exporter. Letters of credit prove that a business is able to pay and allow exporters to load cargo for shipments with the assurance of being paid.

Related Links
On the site:
A Tempestade de Crédito Está Afundando o Comércio Global
On the Web:
World Trade Organization
Export-Import Bank of the United States
International Monetary Fund article about trade finance

A simple example demonstrates how trade-related credit typically works (see the flowchart). Company A, located in the Republic of A, wants to buy goods from Company B, located in B-land. The two companies draw up a sales contract for the sale price of $100,000. Company A then applies to its bank, A-Plus Bank, for a letter of credit for $100,000, with Company B as the beneficiary. (The letter of credit is either issued through a standard loan underwriting process or funded with a deposit and an associated fee). A-Plus Bank sends a copy of the letter of credit to B Bank, which notifies Company B that its payment is available when the terms and conditions of the letter of credit have been met—normally, upon receipt of shipping documents. Once these documents have been confirmed, A-Plus Bank transfers the $100,000 to Bank B to be credited to Company B.

Photo of manufacturing in china
The scarcity of trade credit and slowing global trade are disrupting industrial production in China, where many manufacturers depend on imported materials and on financing to obtain those materials. Some Chinese companies already operating on thin profit margins are going out of business.

Exporters and importers left high and dry by credit drought
Since the financial storm hit the world full force last year, the price of credit has risen significantly, especially for emerging economies. For example, the cost of a letter of credit tripled for importers in China, Brazil, and Turkey and doubled for Pakistan, Argentina, and Bangladesh, according to Bloomberg News. What's more, news stories from various regions of the world report that some banks have been refusing to honor letters of credit from other banks, leaving cargo ships stranded at ports.

Exporters and importers in emerging economies may be particularly vulnerable since they rely more heavily on trade finance. A WTO study on financial crises' effects on emerging economies in the 1990s shows that, in some countries, private markets' failure to meet the demand for short-term trade finance affected imports and exports, at times halting trade completely.

Since about 40 percent of U.S. exports are shipped to developing countries, the inability of the importers in those countries to finance their purchases of U.S.-made goods may have a negative impact on U.S. export industries, which are already suffering from falling foreign demand as the global economy slows. As testament to the current condition of global trade, the Baltic Dry Index—a daily average of prices to ship raw materials that serves as an indirect gauge of international trade flows—plummeted more than 90 percent since its peak in June 2008 (see the chart). This drop can be attributed not only to decreased global demand but also to the reduced availability of trade financing needed to meet the demand that remains.

In Brazil, which is considered a major emerging export power, exporters are experiencing hardships in obtaining credit to finance their businesses, according to the Wall Street Journal. Some Brazilian firms need dollar-denominated credit to be able to trade, but the cost of credit is now so high that it exceeds profit margins and companies are not able to do business. For Brazil, which ships everything from wholesale beef to jets and whose exports totaled an estimated $300 billion in 2008, a credit crunch this severe can have serious implications for economic growth.

Letter of Credit Process
Image of the process for Letter of Credit

China's economy, which has already surpassed Germany's as the world's third-largest, is also suffering from the lack of access to trade finance. In nominal terms, exports from China have been declining in recent months after growing about 20 percent for most of 2008. While the primary cause of this decline is slowing global demand, the tough conditions for securing trade credit is hindering Chinese exporters that would otherwise be able to meet the existing demand. The chief executive of China Export Finance, a major financing company, estimates that letters of credit accounted for about 70 percent of Chinese trade finance in 2007; that share is now only 30–40 percent, partially because of eroding confidence in the international banking system.

The scarcity of trade credit and dampening global demand are now having a significant negative effect on China's stalwart domestic economic development. Slowing global trade is disrupting industrial production because many manufacturers depend on materials supplied by foreign countries. Some Chinese suppliers who are already operating on thin profit margins are going out of business. The Li & Fung Group, a supply chain management company that deals primarily with factories in China and retailers in the United States and Europe, estimates that 10,000 of the 60,000 factories owned by Hong Kong interests in China have closed or will close by early 2009.

Public agencies throw a lifeline
Public institutions, such as state-run export credit agencies, often step in to improve export financing, assuming credit risks that the private sector is unable or unwilling to accept. Over the past year, export credit agencies have increased their business considerably. According to the WTO, this increase is backed by the governments of some of the world's largest exporters, such as Germany and Japan.

The Export-Import Bank of the United States (Ex-Im Bank) is the government's official export credit agency, whose mission is to assist in financing the export of U.S. goods and services to international markets. For example, in November 2008, the Ex-Im Bank announced that it will provide up to $2.9 billion in credit insurance for Korean financial institutions. In fiscal year 2008 Ex-Im Bank authorized $14.4 billion in loans, guarantees, and credit insurance worldwide, which were estimated to support $19.6 billion of U.S. exports.

In Brazil, the country's development bank began to offer the same guarantee instruments offered by export credit agencies as well as financial support to businesses to promote Brazilian exports. In addition, Brazil's central bank has used billions of dollars in reserves to help banks provide dollar-denominated credit.

Baltic Dry Index
Chart of Baltic Dry Index
Note: This index is a daily average of prices to ship raw materials.
Source: Bloomberg

The severity of the financial crisis has led to increased global cooperation, including in the area of trade finance. In November 2008, the WTO convened a meeting of representatives of private banks, international financial institutions, and export credit agencies, who all concurred that the market for trade finance had severely deteriorated. To alleviate the problem, the World Bank announced that it would triple the ceiling, to $3 billion, of the trade finance guarantees it provides. A second meeting is scheduled in March at the WTO to take stock of the situation and consider additional resources.

In December 2008 the United States and China agreed to jointly provide a total of $20 billion through their export-import banks to support exports of products from the United States and China to emerging economies. The program will be implemented in the form of direct loans, guarantees, or insurance to creditworthy banks. The two countries expect these efforts will generate total trade financing for up to $38 billion in exports over the next year.

Breaking the cycle
According to the International Monetary Fund, world trade volumes are expected to decline for the first time since 1982, mostly as a result of a near collapse of import demand from developed countries. As trade finance conditions tighten as a result of the global financial crisis, governments and multilateral institutions are stepping in to provide export financing where the private sector is no longer willing to extend credit. In the words of WTO President Pascal Lamy, "the world economy is slowing and trade is decreasing. If trade finance is not tackled, we run the risk of further exacerbating this downward spiral."

This article was written by Galina Alexeenko and Sandra Kollen, senior economic research analysts in the Atlanta Fed's research department.