Just as the trade finance market thought the worst was over, the global economy was hit by the double shock of the Arab uprisings and the Japan earthquake. But it is unlikely these events will throw the industry off-course, writes Rebecca Spong.
As 2011 dawned, market optimists believed that the year would see increased deal pipelines and more buoyant market conditions for trade finance.
The more wary spoke of their concerns about new banking regulations, problems in the eurozone and volatile commodity prices.
Even swift regime changes do not necessarily imply a return to growth.
But few could predict that within the first quarter of the year, Japan would be hit by an earthquake and tsunami of unprecedented proportions, and that protests in Tunisia would escalate into the so-called Arab Spring, and see autocratic Arab regimes across the Middle East and North Africa tumble one after the other. The collapse of Libya into civil war was a development few foresaw.
Expectations of growth in both the Mena region and Japan are now clearly far more muted than they were at the start of the year.
The global trade finance market seemingly got off to a slow start during the first quarter of the year, with volume falling 12% year-on-year to US$27bn. This is the lowest quarterly volume since the third quarter of 2009. Activity fell to 176 deals, down 21% on the first quarter of 2010.
But market sentiment suggests that this apparent slow start is less a reflection of the recent double shocks of the Japan earthquake and the Arab uprisings, but rather the result of, as one market participant put it, “a cocktail of issues”, which makes signing deals increasingly difficult.
Regional impact in Mena
The ousting of Tunisia’s ruler Zine al-Abidine Ben Ali and the overturning of Egypt’s President Hosni Mubarak’s 30-year rule in the first two months of this year will, it is hoped, help build strong democracies and improve the financial stability of the countries’ populations.
In the short term the conflict will inevitably slow regional growth for 2011.
“Egypt for instance is expected now to record growth in the region of 1% in 2011, following 5% growth in 2010,” notes Gaurav Ganguly, economist for insurer Equinox Global. “Growth in Tunisia is expected to halve from 4% to 2%,” he adds.
The bigger question is where is Egypt going now and how committed the government is to democracy?”
A new report released in May from the Institute of International Finance (IIF) confirmed that both Egypt and Tunisia will fall into recession this year due to the political upheaval.
The turmoil has also negatively affected regional financial markets. The IIF report states that the turmoil has raised risk premia, leading to some widening of spreads for credit default swaps (CDS).
The institute notes that spreads are still not as high as those in certain parts of the eurozone. “These, however, have remained far below comparable measures for, say, peripheral Euro-area countries. Nonetheless, funding costs have risen for those countries having to refinance maturing debt this year,” it reports.
Based on Bloomberg data, the IIF reports that CDS spreads for Egypt as of April 29 widened to 351 basis points, but this remains below spreads in Ireland, Portugal and Greece. Greek CDS hit 1300bp at the end of April while Portugal and Ireland hit 649bp and 661bp respectively.
Equity markets in the Arab world were hit hard in early March by the unrest but have also since been on the rebound.
Pricing and deal volume
If CDS pricing and the stock market is anything to go by, the international financial markets have only temporarily been affected by the political turmoil in the Mena region.
Trade finance markets have proved equally, if not more, resilient. During the unrest in Egypt and Tunisia, banks were closed for a number of days leaving them unable to process letters of credit and other trade documents, but this was just a temporary measure.
Middle East trade deals were infrequent, even before the uprisings in Tunisia, Egypt and then Bahrain and Syria.
Simon Lay, managing director at London Forfaiting Company tells GTR he has seen “relatively few” Middle East deals over the past six months., which was partly due to the fall-out from the Dubai World debt crisis.
Lay says he saw far more North African transactions in the market, “although those with any Libyan or Sudan connection command a pricing premium and close scrutiny of the underlying transaction or goods”.
But, when the uprisings began, costs inevitably rose. “North African pricing increased dramatically after the demonstrations, particularly for the more turbulent countries.”
He adds that although Libya and Syria remain challenging markets for any new business, elsewhere he is starting to see a return to normality.
“There was a knee-jerk negative reaction to these events which impacted even upon countries like Tunisia and Morocco, but these have largely subsided,” he comments. Sema Zeyneloglu, global head, global financial institutions, emerging markets, from Rabobank shares Lay’s views. “Volumes on Mena business have declined and tenors have shortened. Pricing has increased, but not dramatically.
“Many banks have a diminished appetite for secondary deals, with some banks having a primary deals only policy,” she says.
Lay further comments that although pricing on risks for long credit periods still offer a good premium compared to previous levels, but deals under one year have returned to very competitive rates.
Claims and capacity
The political risk (PRI) and trade credit insurance market seems to have so far survived the turmoil in the Middle East, with few signs of major defaults by Egyptian or Tunisian borrowers.
[We might] see examples of contractual counterparties seeking to use events in Japan as an excuse to renegotiate terms or avoid contractual obligations.”
Adrian Lewers, head of political risks and contingency at the insurer Beazley comments: “[The turmoil in Tunisia and Egypt] hasn’t produced any material or significant claims activity to the market. This means that whilst there are a few claims, we don’t believe that events in these two countries will change the market or shake people’s confidence.”
In March, GTR reported that there were growing concerns surrounding borrowers such as the Egyptian oil company EGPC, which has US$3bn-worth of pre-export finance loans on its books.
Market sentiment is far calmer now. “In terms of EGPC, it has continued to perform reasonably well, and we’ve seen a short-term opportunity to write some EGPC payment risk at more favourable pricing that we’ve seen before,” Lewers adds.
Similarly, Michel Léonard, chief economist and senior vice-president at Alliant Insurance, reports that he is not seeing an increase in trade credit default rates in the Mena region.
“There is very little increase in actual losses. The main reason for this is the difference between headline risk and direct company or transaction risk. One has to look at the headlines, and then see how this trickles down to specific companies, receivables and debt obligations.”
Beazley’s Lewers observes that there are presently few underwriting opportunities in the Mena region. Before the crisis, use of insurance was not consistent across the Middle East, although it was more common in North Africa. Lewers remarks that the heightened risks in the region have not yet led to an influx of business.
“Until the region returns to stability or the outlook is clearer, I don’t think you’ll see the insurance market doing very much – or indeed being asked to do much. We didn’t see a rush of inquiries to insure risk in the region during the height of the Spring uprising, although business is starting to pick up again slowly as we move into May.”
He adds that the heightened risk environment does not always seem to translate into higher insurance premiums being charged.
“Recently we have seen at least two fairly substantial political risk policies come in to be renewed in countries such as Egypt and Saudi Arabia, and the expectation from the client and broker is that the market will renew these as before.”
The deals he refers to are policies priced two or even three years ago, and now some parts of the PRI market are unwilling to charge increased pricing.
“We find this staggering. For if you can’t charge an increase in Egypt today – what situation does the market think they can get an increase in,” Lewers asks.
Equinox Global’s Ganguly comments that the insurance market will eventually see an effect on capacity and costs from the Mena unrest. “These events mean that insurers are reluctant in the short term to increase capacity on these regions.
“Bear in mind that the region has not been loss-free for insurers over the last few years. The credit crisis resulted in several prominent defaults and claims out of the region, and more recently, a number of claims relating to disputed contracts have emerged from Algeria.”
Although risk pricing on North African risk has stabilised in the short term, the market will be watching to see how quickly these fledgling democracies push through reforms and ensure the economic benefits of the revolution filter through to the poorer sections of society.
Beazley’s Lewers notes: “The bigger question is where is Egypt going now and how committed the government is to democracy?”
One of the key drivers is how to price sovereign risk.”
As the IIF report outlines: “Among the populations of countries such as Egypt, Tunisia, Jordan and Morocco, expectations are that change will bring about a revival of growth that will be more widely shared, improved job opportunities and in general a better life”.
If such expectations are not fulfilled, the stability of these new democratic regimes cannot be guaranteed.
But as Ganguly at Equinox Global notes: “Even swift regime changes do not necessarily imply a return to growth. Much depends on the transition time, the nature of the regimes, their ability to administer, the state of public finances they inherit and so on. All these factors add to the uncertainty around growth in the region.”
In Egypt for instance there is a wave of investigations into corrupt practices under the Mubarak regime.
“Businessmen in the region with ties to certain governments that have been pushed out or remain under pressure, are seeing popular campaigns being led against them,” observes Henry Smith, Middle East Analyst at Control Risks.
But he notes, “If we have a transition into more democratic, accountable government – with a knock-on beneficial impact on the economy through better governance and more transparent privatisation processes for instance – this would have positive ramifications for the business environment despite opening up a range of new issues for companies to consider. However, in the short term a resumption in operations is heavily contingent on the return of political stability.”
Léonard at Alliant adds that depending on how events unfold over the next 12 to 24 months, the change in power within Egypt and Tunisia could be seen in the long term as a reduction of risk. “Our view in Egypt and elsewhere is that any autocratic regime offers the appearance of stability, but in practice such appearance does not negate the actual instability arising from a population unable to express its discontent through gradual democratic means.”
With the concept of a stable autocratic regime being undermined by current events, Léonard adds that he is seeing more demand for credit insurance or political risk insurance for countries such as Saudi Arabia.
The ongoing armed conflict in Libya means that for the majority of the trade finance market the country is off-limits.
Arab Banking Corporation (ABC), which has the Central Bank of Libya as one of its major shareholders, has publicly stated it is focusing on new regions in order to make up for the lost Libyan business. ABC published its Q1 results in April, revealing a consolidated group net profit of US$48mn, 17% higher than the first quarter of 2010.
Hassan Juma, president and chief executive of ABC commented in a public statement: “ABC is not subject to sanctions relating to the ownership of the Central Bank of Libya but scrupulously complies with all sanctions regimes, and thus has lost a certain amount of its Libyan business. We are taking steps to replace this business with other customers and geographies.”
Smith from Control Risks believes it could be a while before banks and corporates do return to Libya.
“Libya could be in a protracted military stalemate for a substantial period of time, with no signals that a negotiated solution is on the horizon.”
He adds that unless a real military effort is stepped up against Muammar Gaddaffi, he appears unlikely to go.
Smith comments: “It is possible that if the conflict became further drawn out, the international community would need to lend greater assistance to the economy in the opposition-held areas. This may be through adjusted sanctions, where business could be allowed to operate in the north-east of Libya, which would possibly allow a tentative resumption in oil production in the eastern region. However, while this would grant revenue for the opposition to govern, on top of international donations, it encourages the continued de facto partition of the country.”
The political risk insurance market is anticipating some significant fallout from the Libyan crisis.
“The market has reasonably significant exposure to Libya. If you look at some of its main trading partners with Libya over recent years, France, Germany and Italy in particular, their exporters will have significant exposure remaining under export contracts with Libya. We are in a wait-and-see situation, watching to see how the Libyan situation plays out and whether or not contracts can be performed,” comments Beazley’s Lewers.
However, other areas of trade finance, such as the structured commodity finance market will see limited impact. For instance, Nick Grandage, partner at Norton Rose, remarks that Libyan oil flows are not significantly financed by structured trade and commodity finance.
Simon Cook, partner at SNR Denton tells GTR that the law firm has been asked by several banks to look at sanctions issues on Libyan connected deals. “We have also been asked to advise where confirming banks have refused to pay out under letters of credit where the applicant had a Libyan connection.”
In terms of Libya’s impact at a macroeconomic level, it did momentarily push up oil prices. The Libya effect on the oil prices is now perceived to be over, with the global energy market having already priced in a shutdown of oil and gas production in Libya.
It is widely accepted that rising oil prices are not solely fuelled by Libya’s halted production capability, but by general uncertainty about the Middle East region during the first quarter, as well as speculation and increasing demand.
From the day Tunisia’s ruler was removed from office at the end of January to May 2 when Al Qaeda figurehead Osama Bin Laden was killed, oil prices rose approximately from US$90 to US$112 a barrel.
Other Arab exporters of oil have in fact benefited from Libya’s shutdown, with oil producers such as Iraq and Qatar projected to record double-digit growth fuelled partly but increased LNG and crude oil production according to the IIF report.
The Gulf Cooperation Council countries will see their average growth projected to rise from 5.1% in 2010 to 6.5% in 2011.
Economic growth in Japan however is set, predictably, to slow following the devastating earthquake and tsunami in March.
The natural disaster had an immediate impact on export and import flows, and the Bank of Japan lowered its growth forecast for 2011 from 1.6% to 0.6%.
Immediately after the disaster, the Japanese economic minister suggested that the economic impact would be limited. Yet, in late April, statistics were released showing that the country’s industrial output fell by record levels in March. Factory output dropped by 15.3%, marking the biggest ever fall in production.
The ratings agency Standard & Poor’s cut its Japan sovereign rating outlook to negative in late April.
Fears surrounding radiation leaks have only exacerbated the situation, and slowed down potential economic recovery.
Grandage at Norton Rose tells GTR that the radiation risk might even affect export contracts. “It might be the case that we see examples of contractual counterparties seeking to use events in Japan as an excuse to renegotiate terms or avoid contractual obligations”.
Supply chains have also been hit, with the impact being most severe in Japan’s electronics and automotive industries. Importers in Europe and America for instance have been unable to import car parts and electronic goods from their usual Japanese suppliers.
But Alliant’s Léonard tells GTR that the disaster has not yet led to a string of non-payments and defaults under trade credit insurance policies. “The main impact has been on corporate earnings, not on the accounts receivables/payables accounts of corporates.
“The last thing that would suffer would be accounts receivables. However, a contraction in GDP may weaken corporate earnings and the credit rating of companies.”
Although the economic impact on Japan is more entrenched than initially thought, a report from Moody’s Analytics suggests the disaster has had a mixed effect on the wider Asian region.
The outlook for China and India has not been altered, but South Korea, Taiwan and Thailand will see their forecasts for 2011 downwardly revised by 0.2%. Most Asian countries will see their exports to Japan fall in the short term but many, particularly commodity producers, will in the long term see an increase in demand for their exports to support Japan’s reconstruction efforts.
Moody’s Analytics predicts that exports from Australia of thermal coal and liquefied natural gas will grow later this year.
Malaysia will see exports of crude materials, mineral fuels, LNG, machinery and transport equipment rise in the second half of 2011.
Ganguly at Equinox Global comments that globally speaking the impact of Japan’s disaster will be short term. “There is good reason to believe that the effect of this will be temporary, though it is complicated by the high level of integration of the Japanese supply chain.”
He adds: “From a global perspective, while Japan has a large role in the world economy, it is not in the driving seat.
“The world looks much more to countries such as China and India these days than it does to Japan for global growth. Thus, while Japan’s growth falls this year, the impact on the rest of the world is much more limited. Additionally, it is reasonable to expect strong growth in 2012 off the back of recovery efforts, which will be positive for global demand.”
Financial markets, including trade finance, seem to be successfully absorbing the shocks of the Mena crisis and Japan disaster. Looking at CDS rates alone, the ongoing eurozone crisis is causing banks more concern.
But the events in Mena form part of a series of problems the financial markets have faced in recent years that are helping to reshape the way banks and insurers might assess risk in the future.
Michel Léonard tells GTR that he is seeing “a tremendous increase in demand on the consulting side” to explain how to accurately price sovereign risk.
Léonard compares the situation in the Mena region to the divergent problems in the eurozone.
“Previously we were asked to explain the difference between an OECD and an emerging market, say UK and Ghana. Now the analysis is much more granular: on the one hand, what’s the difference in risk premium between Greece and Germany, and on the other hand, Indonesia and India?”
He adds: “The primary impact in the Middle East and North Africa has been a change in risk perception.
“One of the key drivers is how to price sovereign risk and how to translate, integrate and structure this risk premium into transactions. How do we improve our analysis? It is easy to compare UK risk to Zambia risk for instance, but far harder to compare Indonesia risk to Tunisian risk.”
However Norton Rose’s Grandage comments that understanding regional risks is a speciality of trade finance bankers, and that is why the market is unlikely to be as affected by political upheaval as other financial markets.
“Generally speaking, most regions of the world that the trade finance market lends to, those lenders understand those regions well. Trade banks operating in the Middle East are not going to be scared off by headline risk like the more skittish general syndications market might be.” GTR