George Wilson, Head of Institutional Trade at Absa Corporate and Investment Bank, takes a look at why and how trade finance holds the key to African development.
For decades, financial institutions, governments and organisations have provided strategic aid to Africa to encourage prosperity and reduce poverty, but the best way to allocate support remains unclear. This lack of direction is also highlighted in African trade development. While big infrastructure investments, government grants and loans serve their purpose, they are fraught with corruption interfering with real world improvement and this overlooks an essential ingredient – trade finance.
At the same time, swathes of well-intentioned global banking regulation from Basel, seeking to protect the global economy from the misconduct of global investment banks, has unintendedly penalised and impeded emerging market (EM) trade finance in Africa.
Various DFIs have begun to offer trade programmes through African commercial banks as part of their developmental mandate which are a great start, but they are too clunky, as they are condition and evidence dependent, without recognising the true nature of real African SME trade and ultimately won’t be effective in alleviating the problem.
Either supranational and influential government bodies and regulators need to recognise how EM transactional banking can be fostered without being a casualty of banking regulation, or DFIs need to walk back their funding limitations, conditionality and ESG demands. Otherwise, a new solution is required.
All the evidence suggests that there will be no shift towards more favourable EM trade regulation and the DFIs won’t accommodate the realities of African trade, so the alternative proposed here is digital portfolio securitisation of African trade finance. This would neutralise the baleful effects of Basel, satisfy the DFI’s evidential demands and practically progress developmental trade.
Research like the ICC’s Global Survey on Trade Finance in 2016 identified a longstanding problem in African trade finance. It found that there was around US$120bn of trade held up across the continent because businesses were unable to obtain the necessary financing, which in turn stifled economic progress. This trade gap also disproportionately affects smaller countries and vulnerable SMEs. Small African businesses cannot afford to have their capital tied up in a transaction that could take months, so they need an institution to bridge the gap, which is currently very difficult to obtain.
This hurdle is largely regulatory. Although empirically, trade finance assets rarely default and are priced more finely compared to other debt, they are still beholden to the capital reserve requirements of Basel II. The primary intention of this regime is to prevent investment banks from causing another global economic crisis such as 2008, but it also prevents African banks from using their scarce capital to facilitate trade in Africa.
Trade finance must be added to balance sheets, meaning a commercial bank will not lend money if it is not profitable enough. In effect, Basel compliance pushes them out of trade finance and towards other assets that yield better returns, such as derivatives, corporate debt and project finance.
Trade in Africa is typically financed by African banks: the international supplier wants to be paid immediately they export the goods and the African buyer needs at least six months to pay through their cash conversion cycle, and African banks supply this funding. Another unintended consequence of Basel III has been to substantially increase the cost of exactly this type of short-term dollar liquidity to make it unviable for African banks to supply this African trade funding.
Additionally, whilst these challenges pre-date Covid-19, the pandemic has drastically exacerbated them, with two core impacts. The first is physical. Not only has the closing of borders and ports made moving goods slower or impossible (for example shipping can take 180 days instead of 90 days), but trade finance is analogue and paper-heavy and pandemic restrictions played havoc with the documentary flow trade finance depends upon.
The second core impact is the knock-on financial effects. African trade is usually denominated in US dollars and African banks are reliant on international banks or their countries’ limited US dollar-denominated exports for dollar liquidity. With the impact of Covid-19, these international banks have restricted their dollar liquidity supply, resulting in rationing by African banks including central banks, which has caused significant liquidity issues throughout the continent and the resultant reduction in trade finance. On top of this, the consequent risk of greater defaults has diminished the quality of credit in Africa and has resulted in downgraded credit ratings. This in turn makes it even more unprofitable for African banks to provide the trade credit that merchants are reliant on for survival and growth.
DFIs do offer well priced liquidity in support of trade and working capital. The problem is that, universally, they only offer these loans for a minimum of two or three years: the majority of real African SMME trade finance is modally 90 days in tenor and overwhelmingly less than one year. This tenor mismatch of the trade asset and the funding liability’s duration makes two-year DFI trade loans unusable to fund vast portfolios of 60-day trade assets.
A partnership for progress
With the situation degrading, something must be done to facilitate trade finance in Africa and a solution may lie in a partnership between African banks, DFIs, international banks and fintech or IT companies. Unlike commercial banks, DFIs are not held to Basel III, so they engage in strategies to bridge the trade finance gap. By taking a more active role in trade finance, they could deliver the developmental results that big capital injections simply cannot achieve. Undeniably, these organisations are highly successful with traditional aid for infrastructure projects like hospitals or ports that take years to build. But trade finance cuts right to the core of development by facilitating transactions among businesses of all sizes contributing as much as 30% GDP growth in developing economies.
However, DFIs cannot deliver this trade finance directly to those African countries that need it. From a practical standpoint, they do not have the necessary resources or contacts in order to do so. Furthermore, trade finance is very granular and involves a constant stream of thousands of assets, all maturing at different times, and all for different, and relatively small, sums that have been originated from across the continent. Unfortunately, DFIs do not have the scope or reach to process and track each of these assets and sums because they lack boots on the ground, and are based in cities such as Washington DC, London or Paris.
Fundamentally, only African banks can originate and process these assets. Basel III, however, makes holding these assets on their balance sheet not financially viable, so partnering with DFIs in order to distribute these assets enables African banks to manage this risk on their books, neutralising the Basel capital cost problems.
Once the regulatory capital affliction has been resolved, perfectly tenor matched funding can be obtained for the whole blended portfolio of African trade risks from international banks rich in dollar liquidity who can price appropriately against the best credit quality of DFIs. This also relieves the DFIs of their trade tenor lending handicap.
However, these DFI/bank partnerships are not that easy to manage. The remoteness of DFIs and the internal reporting requirements that they are required to adhere to mean they ask a lot from these African banks, which can stifle the distribution of capital. The conflict hinges on the level of detail that DFI trade programmes require from African banks regarding the underlying transactions that the capital given is supposed to finance. But, practically speaking, this is very difficult considering trade is usually short term and high volume paper-based and the volume of activity is so large. As it stands, it is virtually impossible to provide the required reporting of so many revolving transactions.
Adding to this, DFIs are increasingly ESG conscious. Although positive, this can also have detrimental knock-on effects for trade finance. DFIs are now asking for specific details to showcase their green or social credentials which are difficult to obtain, and funding can be withheld if the criteria is not met. For example, a DFI could require that trade finance funding directly supports female-owned businesses only or SMMEs with annual turnovers less than a set amount. Whilst commendable, the availability of this data is difficult to obtain and makes the DFI support requirements almost impossible to comply with.
How to proceed
There are two ways forward. The simplest solution is for DFIs to relax reporting demands and work only with banks they trust to do their due diligence, but this will probably be highly unlikely. Failing that, the required reporting information needs to be improved through digitalisation.
There has been lots of talk about the digitalisation of trade transactions, but the current reality is far from that goal. To make the system work, we need a data-based portfolio management approach, whereby African banks can plug into a portfolio securitisation system via an API to immediately capture all the reporting information that the DFIs require and present the international banks or investors with a defined asset they can understand and finance. This would require a technological overhaul of African trade processes, and currently, it appears the burden to do so falls on smaller African banks, who are the least qualified and resourced parties in the global problem.
It must be a digital solution deployed on the ground at the transactional level, as this is the only feasible way to marshal and manage such vast, unsynchronised, ephemeral securitised portfolios. This would seem ideally suited to trade fintech innovators or the prominent global IT companies, perhaps organised and financed by DFIs or developed governments as a practical expression of their developmental responsibility.
This underlying barrier to African economic progress has not been fully recognised by the market. Yet, once the financial industry understands it and acknowledges it, this digitalisation problem is solvable. The bigger goal at stake is to provide what is necessary to give the necessary boost to economies in Africa, especially in the face of Covid-19. Trade finance is the cornerstone of commerce and has the potential to be the engine of growth that will make African economies more self-sufficient.