2008 was a doubly difficult year for commodity trade financiers in Asia, contending with both the huge volatility in commodity prices and then the crushing blow of the credit crisis. Although the two are not directly related, for commodity financiers, they were a very nasty combination. “I know a lot of people whose lines have been pulled,” says K Ravikumar, CFO of Olam, the Singapore-based agricultural and food supply chain manager. “Our bank lines have not changed at all … but we did have situations last year where our counterparties defaulted on us. We acted quickly to minimise the losses.”

Ravikumar’s experience from the crisis is shared around the region: when Asian buyers of soft commodities were faced firstly with a rapid decrease in the amount of credit available and then with an equally rapid decline in the price of those commodities, many decided to just walk away from their commitments. Nearly every bank in the region – even if not on the record – will admit to having had some defaults by buyers of commodities in the second half of last year. As a result this year, chastened and flint-eyed, banks and businesses are much more cautious in their dealings in the soft commodity market.

Part of the problem with the soft commodity market is that there are just so many companies involved in the market – by some estimates up to 100,000 importers in Asia alone. This presents huge logistical problems for banks. In Asian commodities, about 25% of the trade is done using letters of credit (LCs) whereas only about 10% of the business in other non-commodity trade finance is done with LCs. While the LC business is profitable for banks, it is nevertheless a time-consuming and expensive process confirming LCs for 25% of the 100,000 importers of commodities in Asia.

In 2008, with rapidly rising prices, the problem was exacerbated by a huge spike in the number of players in the commodity markets, many of them first-time participants who were attracted by the apparently easy money on the table. The more participants in the market, the higher they pushed the prices. “A lot of the price rises in commodities were due to speculators,” says Kenny Wei, head of Asia Pacific trade finance at Rabobank in Hong Kong. “We are now seeing similar volumes of commodities being traded but at much more reasonable prices.” The implication is that both the speculators at the corporate level, and the non-specialists at the banking level have now left the market, leaving it less frothy and financing driven.

“We actively provide conventional trade services and finance to large commodity players in the market” says Sanjay Tandon, the Asia Pacific head of trade services at Citi in Hong Kong. “The wild swings in commodity prices last year have required extra vigilance not only in processing but also in closer evaluation of the counterparties involved and the underlying trade”.

Prices on the up again
With soft commodity prices edging back up again, the lessons of 2008 are having a large effect on the activities of those still in the market in 2009. One of the main lessons is that it is imperative to minimise risks as far as possible. And having experienced so much volatility in the commodity prices, it is this risk that banks and companies are looking to mitigate first and foremost. Many banks and soft commodity traders are reporting that they are much more reluctant to enter into commodity trade financing without a concurrent hedge to take out price risks on the other side.

Ravikumar at Olam reports that 85-90% of all products are sold forward or hedged, locking in prices at the time of sale. International banks report working much more closely with the commodity sales and trading desks to hedge out any price risks they may be exposed to. Others report taking a holistic view on the entire soft commodity supply chain, to get good intelligence on potential price movements.

“We are very careful when we deal with certain commodities markets, especially those where we have seen non-payment due to documentary related issues involving other banks,” says Yanti Agustin, Asia Pacific head of global trade finance at JP Morgan in Singapore. “Knowing players in the entire chain is essential and having a global presence with a strong network in Asia is allowing us to have a competitive advantage and to serve our clients well.”

Having hedged out price risks, soft commodity players are anxiously trying to repair the damage caused by the other blow they received last year by trying to hedge out their counterparty risks. This is a common refrain across the whole gamut of banking, and in commodity trade finance it has an added piquancy due to the sheer number of counterparties involved in the business. “During the price swings of the last two quarters, we took extra caution by increasing internal screening of our document checking as well as disbursement under LCs upon acceptance by issuing banks to minimise documentary risks,” says Agustin.

With 75,000 Asian companies trading open account in commodities, it is very difficult for banks to get a full picture of all their counterparts’ credit. As a result, many are taking out credit insurance, not only from domestic ECAs but also from the private credit insurers, who are all reporting record business.

“Commodities were the fastest growing sector for us until about nine months ago,” says David Anderson, regional manager, Asia Pacific credit and political risk at Zurich Financial services in Hong Kong. “It is now down a bit but even now a lot of the business going forward will depend on prices.” Anderson reports that business is going very well, mainly from banks looking to hedge out the credit exposure of counterparties.

The overall message is that with volumes down and volatility still a worry, banks are returning to a much more risk-averse stance. Rabobank for one is perhaps the most advanced and specialised of the soft commodity trade finance banks in Asia. Food and agriculture is its core business but even Rabo is taking a more hard-nosed approach to the business. “We were very active in the first half of 2008 but in the second half volumes dropped and we took a wait-and-see attitude due to the uncertainty,” says Kenny Wei, head of Asia Pacific trade finance at Rabobank in Hong Kong. “Now prices have come down a lot and buyers have been trying to find a way out.”

Alongside this tightening and specialisation, some banks are looking at the erosion of participation as a way to secure more market share, not just in the traditional commodity finance arena, but also up and down the supply chain. Standard Chartered is active throughout the supply chain of agricultural trade finance in Asia, working with medium and large agricultural producers on everything from pre-planting loans, to helping them with export and storage finance. It is a business rooted in their belief that demand for soft commodities is much less elastic than for hard commodities.

“A lot of commodity houses provide financing but we take it further,” says Sriram Muthukrishnan, global head of supply chain finance at Standard Chartered in Singapore. “We take an end-to-end view of agricultural trade finance from crop finance to hedging and off-taking. It’s a fast growing business for us.”

This approach is also being mirrored by some of the largest commodity companies in Asia. Olam is based in Singapore but sources soft commodities from 60 countries. It is active in cocoa, coffee, cashews, peanuts, sesame, rice cotton and wood. It is one of the 40 largest companies in Singapore and in May this year, sold US$300mn of new equity to Singapore sovereign wealth fund, Temasek.

In response to the crisis and to mitigate the risks of counterparty defaults, the firm has instigated a number of new policies. Firstly, it is demanding a 10-20% advance from its buyers to minimise non-payment risks. It has also decided to start delivering its commodities onshore from the warehouse itself. This mitigates its delivery risks. “We have to be responsible,” says Ravikumar. “The old way of doing things has gone, along with confidence in the banking industry.” Ravikumar says that in trade finance this means that it is hard for its buyers to open LCs now. “A lot of the LC discounting has disappeared,” he says. “Our counterparties cannot open LCs as freely as they could in the past.”
Along with such a bearish attitude to credit, some of the biggest players in the market are bearish towards soft commodity prices and are unconvinced that the recent price rallies are sustainable.

“Prices have started to stabilise but the market is still weak in terms of demand,” says Tan Kah Chye, global head of trade finance at Standard Chartered in Singapore. “All commodities are inputs to end consumer products and I don’t see many people rushing out to buy … right now.” Even so, demand for soft commodities which support food and agricultural production tend to hold up better in downturns than hard commodities, which go into the production of consumer goods. Food is not a discretionary spend, whereas a new washing machine or car can wait a year.

The pricing of soft commodities is actually based on its trading and logistics costs. Tan at Standard Chartered believes that as well as the effect of speculators, the price rises of soft commodities were directly correlated with the price of oil as their freight charges went up due to the rise in oil prices. These prices have since collapsed and now recovered again. If oil does carry on rising, then it will support higher soft commodity prices.

Whether such a return to high prices will encourage the bit players back to the market seems unlikely. Especially in the bank market, such was the carnage at the end of last year, that there are just a lot fewer entities around. “There has been consolidation in the market among commodity banks,” says Wei at Rabobank. Those banks that are present have to work up and down the supply chain and have some mechanisms for hedging out the price risks. This favours the specialists and proves the rather paradoxical point that soft commodity trade finance is not a commodity business.