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Trade finance usually performs very well when liquidity is scarce. However this particular credit cycle may prove to be nasty enough to trump those dynamics, writes Erika Morphy.

Around the beginning of September, a trade finance boutique had planned to start soliciting capital for a new fund it was going to announce. It would have been a significant milestone for the firm – indeed a milestone for the entire small universe of trade finance hedge funds, many of which are still deploying capital from their first fund.

Then the crash on Wall Street occurred, followed by the collapse of the US stock market, a severe crisis of confidence in the global banking system and the rollout of an extraordinary coordinated effort among global central banks and financial authorities to combat the crisis with interest rate cuts and huge injections of liquidity into the global financial system.
In the grand scheme of things, a trade fund pulling back from the market – either by intent or because of lack of investors – seems hardly worth mentioning.

But it is, in fact, a telling indicator of how this credit cycle is affecting structured trade finance.
Normally, structured trade finance’s performance is directly inverse to the level of liquidity in the market. For the last year, structures and pricing have been tight, while margins for banks loosen. One would think, therefore, that as the credit crunch enters a new phase – a crisis phase – it would be easy times for bankers.
However, this particular cycle is proving to be unprecedented in its scope and reach and severity. Libor at one point had risen to all-time highs; it only gradually began to decline in the last two weeks of October. Rates for trade credit have madly risen – spreads in some cases have reached 300 basis points above Libor.

In short, the financial system is threatening to become so misaligned that even trade finance might be at risk, worries one banker in continental Europe.
Structured trade finance may be one of the most secure banking activities – but if the liquidity drought is severe enough that security may become irrelevant, this banker says.
“There is very little new short-term money available. And while established funding commitments are being met, banks are being stingy with new commitments.”
“Some of the banks are not able to fund themselves at Libor; the cost to them now in their existing facilities is completely disproportionate to what they are charging borrowers, so they are being very wary of extending new commitments.”
In the longer run, the realignment in the banking sector may introduce additional competition in the trade finance space particularly supply chain finance.

With the investment banks of Wall Street now de facto commercial banks, it is possible they will move into these disciplines, another banker theorises. “Bank of America, which now owns Merrill Lynch, has done well with its supply chain finance business – the Goldman Sachs etc that are looking for new cash streams might look in this direction.”
Before the industry reaches for those possibilities, though, banks must work through this heightened crisis phase.  The measures introduced by the world’s central banks are bound to eventually thaw credit markets; too much liquidity has been introduced for any other scenario to unfold.

Meanwhile, rescue measures for the world’s trade finance system are being introduced in various quarters.
The World Trade Organisation (WTO), for example, is creating a taskforce within the WTO Secretariat to monitor the effects of the financial crisis on trade finance. Also, the WTO is convening a meeting of major providers of trade finance on November 12 to find ways to loosen trade finance credit logjams, should it become necessary.
Most banks are reporting high volumes of trade finance business, but some are concerned they might lack the capacity to meet the demand, particularly due to the rising cost of funding. With the price of trade finance heading ever upwards, WTO director-general Pascal Lamy has aired concerns that a lack of funding could severely damage trade in developing economies, and could be the precursor to rising protectionist tendencies.

“Raising barriers at the frontier, starting with barriers to trade in goods or services, is often a tempting political option, under such circumstances. The role of the WTO as a firewall against protectionist responses is thus vital. It is not so much about any direct effect on markets as for sustaining confidence in global co-operation and institutions,” Lamy explained to the WTO trade negotiations committee.
How much weight the WTO carries in the global trade finance system remains to be seen. However it is clear from comments made by Lamy that the global body will do what it can.  “One third of the world economy, mainly in emerging countries, still has a big growth potential and we must try and make sure that this engine can work through trade,” he remarked to the WTO’s general council.
The World Bank’s International Finance Corporation (IFC), as another example, has said that it will consider offering direct loans to finance trade in developing countries, which are being shunned by an increasing number of international banks. It has already requested and received a US$500mn increase in its global trade finance programme, which facilitates trade finance for trade with emerging markets.

And in Brazil, the government recently injected US$20bn into domestic private-sector banks. It has promised to finance trade directly through the state banks if that measure proves to be insufficient.
Will it work? “In ordinary times such measures would have an impact,” a European banker says. “But these are clearly very interesting times.” For those not familiar with it, that paraphrase of the Chinese proverb – ‘May you live in interesting times’ — was a curse, not an expression of well wishes.