Commodity trade finance hasn’t flourished in India, but this could be changing, argues Willem Klaassens.

It has not escaped anyone that the Indian economy is on the rise. Over the past decades, India has effectively played a catch-up game, which was accelerated by far-reaching reforms in the early 1990s. Trade barriers have consistently been broken down during this period and infrastructure has been improved.

India’s GDP growth of more than 9% has been among the highest in the world, something even the recent credit crisis and the resulting global downturn have not been able to alter dramatically.

The production, processing and trade of commodities account for a considerable part of India’s economy.

Agriculture is the largest single sector contributor to India’s GDP. According to the Food and Agriculture Organisation (FAO) of the United Nations, agriculture in 2010 still contributed more than 18% to India’s GDP, more than Brazil, Indonesia, Thailand or China.

Developing the financial sector

Even though the commodity sector is such a large contributor to India’s GDP, commodity trade finance is not well-developed in India. The large state-owned banks, which continue to dominate the financing landscape, are not well-versed in classic or European-style commodity trade finance (CTF) − the transactional financing of trade and processing of commodities, where relying on underlying commodity assets as security for repayment of loans is one of the critical factors.

Today, balance sheet lending in India has the upper hand, although it used to be very different.

In the old days, balance sheets did not really exist. Or, if they did exist, they were utterly unreliable. Whether they were intentionally made unreliable to assist in lowering tax bills or whether it was due to lack of standards, such balance sheets would certainly not support lending. This was, at the time, by no means different from the situation in several other countries: Brazil, the Soviet Union, Pakistan or Indonesia, to name a few.

In the past, the only reliable way to secure a bank loan granted to a commodity company was by taking control of the underlying physical stock, something that all local banks in India would regularly do. The physical stock was later, when needed, returned against cash payments.

When balance sheets became more reliable, Indian banks slowly lost their appetite for commodity trade finance; understandably because commodity trade finance requires a lot of involvement from the bank and therefore appears to be expensive. The infrastructure of the bank also has to be able to support the daily monitoring of stock levels, quality and product movements, the handling of the documentation and trade documents.

Today it appears that what little CTF business is done in the Indian market, European commodity banks do it, either in India itself or from their Singapore offices.

There are a handful of other reasons for this apparent lack of CTF-inspired business. Firstly, banks compete on pricing in an environment where liquidity is abundant.

Companies in the Indian commodity sector now reap benefits because there is enough liquidity in the market. And similarly to other parts of the world, more liquidity results in financing structures being loosened to the point of having little or no structure at all.

Another reason for not having a buoyant CTF business is the perceived lack of pressure to make above average returns on risk-weighted assets. This may cause the state-owned banks to lack interest in CTF.

Shareholder pressure, which generally pushes privately-owned banks to consistently improve the ways they employ their capital, is hardly present.

The opportunities

The potential entry of new privately-owned banks in India may change all this; their entry depending on the conclusion of discussions between the European Union (EU) and India on a free trade agreement (FTA).

One of the key demands of the EU for any form of FTA is the liberalisation of the Indian financial services sector. This would enable European banks to take stakes in a range of smaller state-owned banks, giving Europeans immediate access to the vast Indian market. In return, it would provide India with a broadening of its financial capabilities.

It would also increase competition in the commodity arena. A more open financing sector with more private investor involvement could provide a basis for redeveloping a classic commodity trade finance business.

Unlike state-owned banks, privately-owned banks will need to seek the best ways to employ their capital. And taking into account all of the opportunities that the Basel II accords provide within the different asset classes, privately-owned banks will start using physical commodities owned by their clients to secure the loans they are entering into. Several commodities, especially ones that are traded in liquid markets, are very beneficial to doing business in the classic CTF way; when properly taken as security they lower the capital a bank needs to finance transactions almost as much as cash does.

Basel III is not expected to change any of this, and will add no extra requirements to single deals that are secured by commodities. Basel III presents requirements that concern only the complete portfolio of a bank; it introduces two new ratios that banks in the future need to adhere to, the leverage ratio and the liquidity coverage ratio. Both ratios will not constrain short-term, trade-related financing deals that are secured by liquid commodities. They are expected to penalise some other trade-related businesses that many banks offer, most notably long-term export credit agency (ECA)-covered transactions, hence the scramble by many of the big banks to strengthen their capital base.

For smart companies and banks, however, the capital play that will ensue upon liberalisation of the financing sector in India will be vital for their global competitiveness.

Adjusting, increasing or mixing the level of security will drastically lower the amount of bank capital needed to finance a commodity transaction. This in turn should lead to a downward adjustment of the pricing that the bank charges its client without giving in on the shareholder required returns.

Negotiable warehouse receipts

One of the classic commodity trade finance opportunities clearly visible in the Indian commodity markets is financing on the basis of warehouse receipts. This technique opens up a wide range of possibilities and increases access to financing for a host of commodity companies, for traders as well as producers or processors. Negotiable warehouse receipts allow the transfer of ownership of stored commodities without the need to actually deliver the physical commodity. When these receipts are indeed issued in negotiable form, they are suitable as underlying collateral for loans.

Until very recently, financing against warehouse receipts was not readily available in India. The warehouse receipts issued by the various warehouses were not negotiable, making it hard to use as security. Also, the warehouses lacked the quality needed to assure appropriate handling, storage and transportation of commodities, which regularly led to missing goods and almost always resulted in losses for the financing banks. Furthermore, the warehouses didn’t have the capabilities to perform additional services like segregation, blending or grading.

However, the Indian government, recognising that warehouse receipt finance could rapidly increase the liquidity in the rural areas and facilitate finance to farmers, introduced a negotiable warehouse receipt (NWR) system at the end of April this year. This ensures that warehouses registered by the newly-created warehousing development and regulatory authority can issue negotiable warehouse receipts. For the first time, these instruments have become fully negotiable on the back of legislation by the central government.

With the launch of the NWR system, the government also recognised the need to improve standards of warehouses across the country. Modernisation of warehouse facilities and introduction of world-class standards have now become a priority. Once done, it will attract additional financing, not only for farmers in rural areas, but also for all other companies that have a need to store commodities.

Willem Klaassens was global head of the commodity traders and agribusiness division at Standard Chartered Bank in Singapore for four years.