Does Trade Finance Drive Trade? | 27th April 2015
Explaining the slowdown in global trade growth
- Trade Finance has not maintained the growth required to ensure that trade deals between businesses are adequately financed.
- Much of this is due to uncertainties in commodity prices and a greater perception of risk, especially in emerging and frontier markets, that is increasing compliance requirements within trade financing organisations.
- Trade Finance and global equities were highly correlated until the onset of QE in Japan.
If Quantitative Easing (QE) in Japan and Europe was meant to do anything, it was meant to weaken the yen and the euro in order to stimulate export-led recovery. It is too early to tell if this has happened in Europe, but it certainly has not happened in Japan and the signs in Europe are not encouraging. Alongside QE, weaker emerging market currencies against the US dollar should also be promoting trade, yet the CPB Netherlands Bureau reported in April that global trade in January and February 2015 had contracted. The World Trade Organisation reduced its trade growth forecast for 2015 to 3.1% and the Delta Economics forecast remains lower at just 1.4%.
The trade verdict on QE has to be a resolute “thumbs down”. Not only has the effect in Europe and Japan been minimal, the UK still struggles to understand why, despite a weak currency post-crisis for all except the last 12 months, there has been no export-led growth.
It is possible, of course, that analysts and economists have been looking at the wrong thing. After all, why would bond purchases on unprecedented scales do anything except stabilise bank balance sheets, de-risk sovereign debt to some extent, and prompt cross-border capital flows into equities and tangible assets such as property? What we should be looking at are the more fundamental reasons for slower trade growth: the risks around its financing.
Figure 1 | Trade finance and trade growth compared (2002 – 2020, forecast)
Source | DeltaMetrics 2015
First, trade finance accounts for some 80% of world trade including all insurances and guarantees. Around half of this is in the form of either letters of credit or on open account and covers commodity and infrastructure, supply chains and project finance. Figure 1 shows the way in which total trade finance has trended since 2002 and forecasts up to 2020.
Three things are remarkable from the chart:
- Trade finance actually started to decline between 2006 and 2007 as the seeds of the financial crisis were beginning to germinate. This was accompanied by a flattening out of global trade growth followed by the well-documented drop in world trade in 2009.
- Trade finance grew exponentially in 2010 as trade recovered but growth in emerging markets, especially Asia, was nearly twice the level of that in Europe (nearly 60% compared to just under 30%) and nearly 20% higher than in the US.
- Trade finance has slowed dramatically since 2010 and although we are expecting some growth towards 2020, this will not be on the same scale that would be able to promote the same sort of rapid trade growth that characterised the immediate post-crisis growth in trade.
Second, the slowdown in trade finance is affecting core commodity and supply chain markets (Figure 2). Alternative energy, represented by vegetable oils, is a sector where growth in trade finance is evident over the next two years. However, the picture for this year is bleak for other commodity sectors, such as iron and steel and oil and gas, continuing into 2016 for iron & steel. Arguably, this represents lower oil and iron ore prices, which are inhibiting investment in 2015. But the effects will be to slow rates of infrastructure growth. Similarly, contraction in trade finance to core supply chains, such as pharmaceuticals and automotives, suggests a weaker outlook for global demand for these products.
Figure 2 | Changes in trade finance for core commodity and supply chain markets, 2015 & 2016
Source | DeltaMetrics 2015
Third, the explanation for why core trade finance markets are slowing is, to a large extent, due to risks and uncertainties around finance into emerging and frontier markets, considered at the recent ICC Annual Banking Summit in Singapore. These discussions come in the wake of ethical and compliance issues around trade finance in some of the world’s largest financial institutions. This is being met with greater calls for compliance and regulation but, of course, this will take a few years to embed. In the meantime, it will restrict the availability of letters of credit and push more trade finance into open account, where a company itself takes the trade finance risk. In essence, the costs of due diligence for projects in emerging economies are too high relative to the returns, while commodity prices remain weak.
Against this backdrop, it is hardly surprising that the flow of investment capital into equities rather than into trade finance has been particularly marked since the middle of 2013 when the stories first broke (Figure 3). The correlation between trade finance and the S&P 500 up to that point was 71% but has since broken down as equities have continued to rise and trade finance has declined.
Figure 3 | Monthly value of world total trade finance (including insurances), USDbn versus S&P 500, Last Price Monthly, June 2001 – December 2015 (forecast)
Source | DeltaMetrics 2015, Bloomberg
Trade can be seen as risky: some of the countries that are richest in commodities and trade growth potential have under-developed financial structures and are unstable geo-politically and politically; emerging market growth is fragile while China readjusts its economy; lower oil and commodity prices favour developed nations but while demand remains weak, returns cannot be assured. At Delta Economics, our modelling suggests that any pick-up in trade finance is not likely for at least another three years, with a resultant impact on trade growth globally.