With the Chinese government implementing stringent anti-inflationary policies, Cybil Hui-ch en Chou assesses how this will affect trade finance business in the region.

Chinese trade banks celebrated a bumper year in 2010 with the biggest players collectively chalking up double-digit year-on-year growth.

For ICBC, its domestic branches granted nearly US$30bn of international trade financing in the first quarter of 2011, up 160.27% year-on-year, while its overseas branches conducted more than US$16bn of international trade financing in the same period, up over 100%.

This was thanks to the gradual recovery of China’s trade partners in the developed world and robust demand from emerging markets.

Yet, the Chinese trade picture in 2011 might be slightly bleaker as lenders bear the brunt of a raft of tightened monetary policies to curb inflation.

“While financiers haven’t observed a conspicuous increase in funding costs for Chinese transactions over the past year, the government-induced tightened monetary policies have nevertheless spurred Chinese banks to demand higher interest margins and therefore have driven foreign lenders in China to follow suit,” says Michelle Ling, managing director and regional head of export finance at Société Générale Asia in Hong Kong.

“At of the end of 2010, interest margins in China leapt by 40-50 basis points against a backdrop of the improved Chinese long-term foreign and local currency sovereign credit ratings from A+ to AA- awarded by Standard & Poor’s in December, meaning China is a good risk,” Ling adds.

“These factors have made Chinese loans more expensive than those doled out by Western and Asian peers like Japan and Korea. Such interest margin hikes can prompt Chinese exporters to mull cheaper credits through syndicated loans or bond issuances, while also spur foreign buyers to factor in potentially higher buying costs when they ponder whether to import from China.”

Bruce Alter, head of trade and supply China, at HSBC China in Shanghai, reflects: “Liquidity, especially in Rmb-denominated bank products and loans, is an issue because of tightened monetary policies. As a result, Rmb-denominated trade loans have been somewhat impacted. Our loan book (trade exposure) across imports and exports, whether in Rmb or foreign currency, has continued to grow in the first five months of 2011, but was well in line with recent tightening policy guidelines.”

Few can deny that the long-term momentum of Chinese trade remains on a strong upward trajectory, particularly in commodity trade with the emerging Latin America, Africa, Middle East and the rest of Asia.

“While Chinese exports such as machinery, equipment and consumer goods to long-term trade partners like the US and Europe remain massive in terms of volume, the pace of growth has slowed due to the global financial crisis. Things have now improved, but during and even after the crisis, hard-hit Western buyers were concerned about over-stocking and subdued or erratic consumer demand,” Alter says.

“In contrast, in the last two to three years we’ve seen exponential growth in commodity trade flowing to China from core suppliers in Latin America, such as Brazil, as well as Africa, the Middle East and Australia. A part of this is related to domestic Chinese infrastructure development, spanning into second and third-tier cities, as well as simply keeping up with strong domestic market demands.

“Commodities trade finance is central to our Chinese trade finance operations, taking up a substantial portion of our books. After all, China is a commodities-driven import/export environment,” he notes.

A safe umbrella

Yet, there are emerging regions or countries where high risks cannot be fully covered by Chinese commercial banks. In this instance, banks either avoid the region entirely, or look to a multilateral agency to provide extra risk capacity.

Chinese lenders, including the state-run Export-Import Bank of China (China Exim) and joint-stock commercial lenders like Minsheng Bank and Bank of Beijing, have participated as confirming banks in trade facilitation programmes under the International Finance Corporation (IFC), Asian Development Bank (ADB), European Bank for Reconstruction & Development (EBRD) and Inter-American Development Bank (IADB).

“We have facilitated exports from China to the Commonwealth of Independent States (CIS) and Southeastern Europe,” says Rudolf Putz, head of the EBRD Trade Facilitation Programme (TFP).

“Typical transactions are exports of machinery and equipment, consumer electronics, computers, shoes and clothing from China to Russia, Ukraine, Belarus and Central Asia.”

“In most cases, EBRD TFP guarantees were issued to confirming banks outside of China. Only a very few transactions have been done with confirming banks in China because Chinese banks often do not confirm letters of credit issued by EBRD client banks, even if the risk would be fully covered by the EBRD.”

Since 1999, the TFP has been instrumental in 244 transactions with the overall value of about €58mn, with beneficiaries domiciled in China.

“The risks involving member countries vary from one country to another, including political, legal, economic, financial, banking sector-related, institution-specific, as well as systemic risks in principle,” Putz says. “In particular, failures to honour payment obligations have frequently been a consequence of (soft) currency crises. Also, disruptions caused by public unrest are known to negatively affect banking operations including trade finance.”

In Asia, ADB’s Trade Finance Programme (TFP) facilitates Chinese goods to be sold intra-regionally by providing credit guarantees to Chinese banks.
“Since its inception, the programme has supported 107 transactions involving Chinese exports to Vietnam and Indonesia, with Bangladesh receiving the greatest volume of Chinese exports under the programme. Chinese exports supported by the ADB’s TFP range from capital equipment in the textile sector to telecoms and computers and generators,” says Steven Beck, head of trade finance at ADB.

TFP assumes risk on banks in the more challenging Asian markets, with its highest user countries being Bangladesh, Pakistan, Vietnam, Sri Lanka and Nepal, where private sector gaps for trade finance are the greatest.

“While Chinese exports to Vietnam, Indonesia and Bangladesh will continue to flourish, we shall also see more potential in supporting Chinese exports into fast-growth markets like Mongolia, Sri Lanka and Central Asia,” Beck adds.

“So far, demands for exports from China via the ADB TFP have been for a variety of capital goods. We would broadly expect this demand to continue as they are the products that frontier markets in Asia need most urgently,” he adds.

“As Chinese manufacturing moves up the value chain, it is possible that over time, the types of products that China exports and that are in demand might also change.”

Moving up the quality ladder

The nature of China’s manufacturing capabilities and exports are beginning to evolve.

The construction of China’s first high-speed rail project in Asia linking itself to Southeast Asia is planned in 2011, starting its first leg in Laos with plans to eventually extend the line through Vietnam, Cambodia, Myanmar, Thailand and Malaysia to Singapore. To pull off the task of allowing rail travellers to traverse from China to Singapore in one day, negotiations with a host of governments will need to be ironed out.

China is also building high-speed rail links in Turkey, Venezuela and Saudi Arabia, and has expressed interest in bidding for projects in the US.

With regards to energy, China exports mainly generators and other coal and gas-fuelled energy products and imports most of its hydro, solar and wind equipment.

“China sells coal-fired power plants all over the world, snapping up 20% of global share. Vietnam, for example, awards 90% of its total EPC contracts to China alone,” says Ling at Société Générale.

“Meanwhile, an interesting trend is seen in China’s transformation from a small and lower value-added shipmaker catering to its domestic market to the world’s largest ship manufacturer, overtaking Japan and South Korea and exporting large and high tech ships, including LNG vessels with attractive prices to countries like Norway and Germany.

“The timing is perfect, as European ship buyers have aimed to diversify sources of supply following the global financial crisis that resulted in a shortage of export credit agency (ECA) funding for some European shipbuilders. Today, China accounts for around 40% of the global ship manufacturing market by value.”

Financial product diversification

As the level of complexity in Chinese deal structures deepens, the size of transaction volumes soars and the types of transactions become more diversified, there are higher demands by Chinese traders for more sophisticated solutions to effectively mitigate risks and to speed up the process of easing cashflows strains.

Driven by these factors, structured trade, commodity finance, supply chain, factoring and forfaiting have all experienced exponential growth in China over the years. CCB, for example, registered more than 100% year-on-year growth in most of these products in 2010.

“There has been a growth in forfaiting business to previous years in China due mainly to the fact that Chinese banks need dollar liquidity thanks to the high reserve requirements, and as the dollar is depreciating, it makes sense to sell them right away,” says a trade professional in Hong Kong.

“The China forfaiting business is greater than the US and at least the same or greater than in Europe. This is because letters of credit (LCs) are used more in China and Asia in general than elsewhere.

“In Europe and the US, factoring and supply chain finance is used more than in China. This is where China lags.”

While LCs remain a significant international trade settlement method in China, open account and/or supply chain solutions are beginning to gain traction.
Kao Fang Ming, head of trade for China at JP Morgan treasury services notes: “For international trade settlements, LCs remain significant. However, as China evolves and matures, we are increasingly seeing a greater prevalence for open account and/or supply chain solutions. As a company grows, its network of suppliers, vendors and partners correspondingly expands. Hence there will be a need to achieve a more integrated and more efficient platform for its payables and receivables, which could typically be achieved through open account and/or supply chain. Despite that, LCs as one of the world’s oldest and most reliable trade instruments, will not likely disappear anytime soon.

“For domestic trade, advance payment, cash, drafts and open account are traditional settlement methods. We also see an increasing trend in companies seeking to integrate domestic and international trade into a single platform,” she adds.

Commodity finance opportunities

By product type, structured trade finance (STF) yields fatter margins for lenders in China.

“Competition in the Chinese trade finance market is fierce and pricing on basic traditional trade is very tight given that foreign lenders compete against large domestic players, such as the big four state-run commercial banks,” Alter of HSBC notes.

“As opposed to basic core trade products like negotiations and confirmations, STF, which ranges from warehousing finance to pre-shipping financing and features large, complicated transactions and involvement with foreign entities, yields higher margins given the greater risks involved.”

As for commodity finance, there are risk factors that need to be addressed.

“There are many dominant commodity trade players within Asia. During the financial crisis, few lenders came out unscathed. The crisis took its toll on some foreign banks that may have focused a bit too much on revenue generation without having the right balance of credit risk and operational risk management culture,” Alter says.

“Third-party involvement, multiple back-to-back flows involving offshore trading companies or middlemen and a weak credit structure all could lead to problems.”

He explains that in the case of commodity trade, when prices plummeted to almost half the original price tag during the crisis, some buyers couldn’t take possession of their goods, while sellers needed to deal with dwindling orders and find alternative markets.

“To avert such financial headaches, lenders should have a strong knowledge of credit structures and their customers and implement a credit risk management culture first and foremost. They should also opt for risk-hedging instruments such as insurance and collateral to shun 100% exposure to such risks,” Alter adds.

ECA issues

For risk mitigation purposes, Chinese and foreign lenders such as JP Morgan and BOC have forged cooperation with China Exports & Credit Insurance Corporation (Sinosure) to develop factoring or forfaiting businesses. There are, however, efficiency issues banks hope will be tackled for Chinese
ECA-backed transactions.

“Current Chinese rules stipulate that Sinosure-backed export credits exceeding a certain amount are subject to approval by the ministry of finance or even the state council as well, which can prolong the approval process for months. Contrary to Sinosure, well-developed ECA programmes adopt more streamlined approval procedures, with Korea Trade Insurance Corporation (K-Sure) being a good example as it simply gives a green light to a trade credit facility once its board members give the nod,” says Société Générale’s Ling.

“We are seeing an increase in project finance activities in Asia and beyond. Most project finance deals would require ECA support as a risk mitigant. So far other ECAs, including K-Sure, Japan Bank for International Cooperation (JBIC) and Nippon Export and Investment Insurance (Nexi) are now active in the project finance field, but Sinosure is catching up very fast,” she adds.

Inflation risks

Going forward, China would still struggle to meet its 4% inflation target this year, as the Chinese premier Wen Jiabao signalled in June. Given the inflationary environment, economists expect that interest rates in China will rise further in the second half of 2011 even as economic growth slows down.
While rate hikes may caution trade banks in China for their full year business projections, for some, their impact on trade finance operations might not be too problematic.

“There could be more interest rate hikes in the second half of 2011 so we need to take a conservative view. That said, we still anticipate volume turnover in imports and exports to exceed the previous year,” HSBC’s Alter estimates.

Escalating inflation has spurred People’s Bank of China (PBOC) to issue a slew of monetary tightening policies to rein in inflation.

In January 2011, it ordered the nation’s four biggest banks to cap their combined new loans in the first quarter at Rmb726bn (US$110bn), well down from the Rmb2.6tn level in the first quarter of 2010. The big four − Industrial & Commercial Bank of China (ICBC), China Construction Bank (CCB), Bank of China (BOC) and Agricultural Bank of China − typically account for about half of new loans in China.

Curbing the lending binge aside, Chinese authorities have raised the deposit required reserve ratio (RRR) of banks for six times since the dawn of the year, meaning banks have to set aside a record 21.5% of their capital in reserve from June 20 for tackling inflation and checking liquidity. Analysts estimate the latest increase will freeze capital worth about Rmb370bn (US$56.92bn).

Meanwhile, the China Banking Regulatory Commission (CBRC) said in June it is drafting new regulations concerning capital adequacy ratio
(CAR) to keep China’s banking industry in compliance with the Basel III framework.

The new standards set the minimum capital adequacy ratio for banks of systematic significance at 11.5%, while that for banks with non-systematic significance at 10.5% from next year.

According to the CBRC, the average CAR of commercial banks was 11.8% at the
end of March 2011, down 0.4% from the end of 2010.