Foundations of Structured Trade Finance by Dr. Benedict Okey Oramah by Dr. Benedict Okey Oramah - Read Online

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Foundations of Structured Trade Finance - Dr. Benedict Okey Oramah

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2015

Chapter 1: Introduction

Trade and development

Trade has over the centuries been known as a major source of economic growth, with trade performance considered a valid explanation of why some nations are more economically successful than others. Adam Smith (1725–1790) and David Ricardo (1772–1823) are some of the early economists to expound theories of international trade and the gains from trade. Their respective theories of Absolute Advantage and Comparative Advantage¹ provided the foundation for the field of international economics and trade finance.

Experiences with globalisation have broadened and enhanced the insight gained from those early studies. The role trade plays in promoting economic growth and development is therefore well documented in the wide literature of development economics and includes:

i.Enabling nations to specialise in the production of goods and services they have comparative advantages in producing, thereby facilitating global efficiency in production;

ii.Improvements in national and global welfare as it leads to increased production of goods and services due to specialisation and also enables nations to access what they do not produce;

iii.Facilitating access to innovation and technology; and

iv.Providing better quality of goods and services at lower prices to peoples all over the world.

It is no wonder then that major ancient civilizations were propelled by trade: the ancient Egyptians, Phoenicians, the Chinese, the Romans. More recently, the Dutch ascendancy during the 17th century,² the emergence of Britain as a global power, the rise of Japan and the so-called ‘Asian tigers’, and the accelerating Chinese economy were/are all basically trade-driven.³

Due to the importance many economies attach to trade as a result of the benefits that can be derived from it, trade has also been a source of tensions and wars among nations. In order to minimise the scope for such tensions and expand the benefits of trade to all participants, many nations of the world began, in 1947, the negotiation of rules to govern the conduct of international trade. These negotiations, conducted largely under the auspices of the United Nations Conference on Trade and Development (UNCTAD), led to the signature of two key multilateral treaties: the General Agreement on Tariffs and Trade (GATT), signed in 1947; and the Treaty of Fez, signed in 1994, which led to the creation of the World Trade Organization (WTO).⁴ The WTO is charged with the responsibility of managing the implementation of the agreed multilateral trading rules and adjudicating disputes that may arise.

These two treaties accelerated the process of globalisation and the rate of growth of world trade. In this regard, world trade volumes expanded at an average annual rate of 6 per cent between 1948 and 1993, and by an average annual rate of 8.3 per cent between 1994 and 2000 (Figures 1 and 2). By contrast, between 1913 and 1939, world trade as a whole was stagnant.⁵

Figure 1: Trends in world merchandise trade, 1960–2010 (current US$ billion)

Figure 2: Growth rate of world trade, 1960–2010 (%)

A measure of the pervading role of trade in global economic activity is the rising share of trade in global output. Figure 3 shows that, whereas the ratio of global trade to global gross domestic product (GDP) was at 18 per cent in 1960, it had risen to 36 per cent in 1980, 40 per cent in 2000, and 50 per cent in 2010. Despite the rapid increase in the rate of expansion of global trade and its share of global GDP, differences exist at regional level. A distinguishing feature of Latin American and African economies in the 1990s and 2000s is their relatively low degrees of openness – that is, lower ratios of their total trade to GDP, compared to other developing regions (Figure 4).

Figure 5 also shows that regions with a high degree of openness (East Asia and Pacific) appear far more competitive globally, with their share of global trade far higher than others. In the period 1990–2000, Africa fell into the category of regions with poor trade and economic performance.

Figure 3: Global merchandise trade share of global GDP, 1960–2013 (%)

Africa’s share of world trade, for instance, declined from a peak of 6.3 per cent in 1960 to approximately 2.1 per cent in 2000. Following the implementation of an export-led structural adjustment programme (SAP) under the auspices of the Bretton-Woods institutions in the 1980s and 1990s, trade began to recover in Africa and other developing regions in 2000. For instance, Africa’s share of world trade increased between 1990 and 2010 to reach 3.3 per cent. The value of Africa’s total trade roughly quintupled, rising from US$203 billion in 1990 to over US$1.27 trillion in 2012.

A number of reasons have been adduced for the poor trade performance of some developing regions during the 1980s and 1990s,¹⁰ but lack of appropriate trade finance is generally believed to have been a major constraint as far as Africa was concerned.¹¹ UNCTAD suggested that the performance of Africa’s merchandise trade was a reflection of its inability to tap into competitively priced trade and project financing, which are critical for improved trade performance. Moors di Giorgio also observed that ‘Without proper financing, a commodity producer may not expand its facilities; a trading company may think twice before buying from a high-risk country; and an importer may simply go out of business.’¹² It follows therefore that trade finance is crucial in converting a poor trade performing nation into a leading trading economy capable of making the great leap from a poor country to a middle- and ultimately a high-income country. This fundamental fact is the point of departure for this book.

Figure 4: Share of merchandise trade in GDP among developing regions, 1960–2012 (%)

Figure 5: Share of global trade among developing regions, 1960–2012 (%)¹³

Purpose and outline of this book

The purpose of this book is to introduce readers to the fundamentals of structured trade finance (SFT) – an instrument that is generally believed to be appropriate in financing trade in difficult environments. STF has proven itself as an effective instrument for attracting trade finance to those regions that receive limited trade finance and which lag behind in trade and economic performance. In Chapter 2, we will review the genesis of trade finance difficulties faced by some developing regions, using Africa as a case study. Chapter 2 also prepares the reader for an understanding of the basics of trade finance structures by providing a quick overview of payment methods and instruments normally used in international trade. This sets the stage for introducing structured trade finance in terms of definition and conceptual foundations as presented in Chapter 3. Chapter 4 details the essential steps in deal structuring as well as their building blocks. Chapters 5 and 6 respectively discuss application of STF in structuring commodity-type deals and deviations therefrom with practical examples. In Chapter 7, the book discusses the application of structured trade finance in financing non-physical commodities, with emphasis on ‘commoditised’ revenue flows, and Chapter 8 reviews pricing issues as they relate to structured trade finance. Chapter 9 examines operational risk issues in structured trade finance, while Chapter 10 reviews some real life examples of successful and failed deals and the factors that contributed to the outcomes. Chapter 11 concludes the book, pointing out various advantages of structured trade finance over traditional trade finance.

This book has been written to provide practical insights into the subject of structured trade finance. It recognises that it is perhaps one of a few books that attempt to address the complex issue of structured trade finance in one volume and is therefore organised such that it will be useful to beginners, experienced practitioners, and senior executives of financial institutions involved in structured trade finance and its emerging variant dubbed ‘supply chain finance’. It is also useful to officials of firms engaged in international trade, as well as students of finance and international trade. While it addresses basic trade finance structuring issues, it also provides numerous practical (real life) examples that give useful insight into the complexity of financing trade under a difficult environment. It also touches on critical issues that impact the use of bank capital in implementing deals, delving into pricing and operational risk issues critical under the current regulatory environment that places a lot of emphasis on bank capitalisation. It is hoped that the book will be a useful tool to all bankers and practitioners in the interesting and challenging field of structured trade finance.

References and notes

1.Maneschi, A., Comparative Advantage in International Trade: A Historical Perspective. Elgar, Cheltenham, 1998.

Marrewijk, C. van, Absolute advantage, in Reinert, K., and Rajan, R. (eds.), Princeton encyclopedia of the world economy, Princeton University Press, 2008.

2.Dollinger, P., The German Hansa, Routledge, London,1999.

3.For an understanding of the role of trade in the economic emergence of modern China, see, for example, Rougu Li, Institutional Suitability and Economic Development: Economics Based on Practices in China, China Economic Publishing House, 2008.

4.The signing of the GATT treaty provided a basis for fruitful discussions and negotiations, for a substantial reduction of tariffs and other trade barriers, and the elimination of preferences, on a reciprocal and mutually advantageous basis. Between 1947 and 1994, when the GATT was in force, there were a total of eight rounds of negotiations: Geneva I (1947), Annecy Round (1949), Torquay (1951), Geneva II (1955–59), Dillon (1960–62), Kennedy (1962–67), Tokyo (1973–79), and Uruguay (1986–94).

5.Chatterji, B., Trade, Tariffs, and Empire, Oxford University Press, 1992.

6.World Bank World Development Indicators, 2014.

7.Ibid.

8.Ibid.

9.Ibid.

10.Yagci, F., and Aldaz-Carroll, E., ‘Salient Features of Trade Performance in Eastern and Southern Africa’, Africa Region Working Paper Series 76. Washington DC, World Bank, 2004. UNCTAD, ‘Leveraging Offshore Financing to Expand African Non-Traditional Exports: The Case of the Horticultural Sector’, UNCTAD/DITC/COM/2003/4, 2003.

11.Afreximbank Annual Report, 2004; UNCTAD, ‘Leveraging Offshore Financing to Expand African Non-Traditional Exports: The Case of the Horticultural Sector’, UNCTAD/DITC/COM/2003/4, 2003.

12.Giorgio, E. M. de ‘The rural finance revolution’, African Business; December, 1998.

13.World Bank World Development Indicators, 2014.

Chapter 2: Trade finance flows to developing countries

The need for trade finance

Due to the fact that in most trading activities certain critical expenses are required to be incurred before revenues arise, financing gaps occur in the value chain. These gaps can be funded by participants in the chain using their equity resources or through borrowing. Due to the high volume nature of trading, participants in the chain are usually unable to meet the funding needs using their own resources, creating a need for financing.

Trade, especially commodity trade (the main trading activity of developing countries), is by its nature a volume-driven business. This is because commodity markets (cocoa, coffee, tea, copper, oil, oil seeds, grains, petroleum, etc.) are some of the few markets in the real world that are close to being perfectly competitive. In perfectly competitive markets, sellers are individual price takers, as they face perfectly elastic demand curves (Figure 6);¹ they cannot individually influence market prices (P) and therefore take them as given. They can maximise profit by varying their output (Q) and costs only. As a result, commodities are traded on thin margins. Traders therefore require large volumes to achieve aggregate trading profit or net revenues necessary for them to remain in business.

Figure 6: Perfectly elastic demand curve

To illustrate this point, consider a soybean oil that traded at US$1,056.67 per metric tonne. (Table 1 presents average prices of selected commodities in 2013). At what can sometimes be a generous margin of 5 per cent, a trader in that business can only make just about US$52.83 per tonne. To realise a trading profit of US$100,000, the trader needs to export 1,892.86 tonnes of the soybean oil. This will require an amount of about US$1.9 million to fund the commodity purchase.

Table 1: Selected commodity prices 2013.²

This financing need is not limited to commodity purchases. The trader may also have to fund the cost of logistics; namely, local transportation, warehousing, quality inspection charges, insurance, government levies and taxes, shipment, and certain bank charges. These costs are mostly required to be paid before exports occur, creating additional financing needs for the trader. The financing requirements extend up the value chain to the farmers, most of whom require money to pay for inputs, such as fertilizers, equipment, chemicals, and labour, to support their activities. In view of the highly competitive nature of commodity markets, especially exports, and lack of access to credit by most farmers, traders/exporters of agricultural commodities attempt to gain competitive advantage by advancing credit to the farmers to be repaid from the farm produce.

With regard to metals and minerals, the financing need is in the area of funding operating expenses for extracting and primary processing of the minerals as well as export logistics. Mining houses may also require funding for capital equipment acquisition.

Export of manufactures also calls for various expenditures that need to be undertaken before exports occur. At the production level, the firm has to purchase raw materials, pay for labour, electricity, and other operational expenses. Once production occurs, export logistic expenses arise, such as warehousing, local transportation, shipping, insurance, bank charges, etc. In cases where the manufacturer is not the exporter, the exporting entity will have to assume the export logistics and related expenses in addition to the cost of purchasing the manufactured product from the producer.

Imports also create a funding gap. An importer, in most cases, has to pay for goods before they are shipped or delivered, or they will have to provide an acceptable payment assurance to their suppliers. They also need to meet other operational expenses, including shipping, customs duties, warehousing fees, and other charges. As with exporting, most traders are unable to maintain reasonable volumes by funding the imports with their own resources. Accordingly, import financing is an important product provided by financial institutions to bridge the funding gap many importers face.

Tables 2 and 3 illustrate in some detail the funding gaps in international trade that generate the need for trade finance.

It can be seen from Tables 2 and 3 that exporting and importing present operators with significant funding gaps arising from various sales, marketing, and logistic activities that must be done prior to receipt of sales proceeds. An exporter might not have any need for funding if buyers paid for their produce upon ordering. Likewise, an importer might not need funding if it were possible for the exporter to deliver the importer’s orders at the exporter’s expense and the importer was thus only required to pay for the goods upon completion of sale. It is because the above scenarios are not usually the case in everyday life that the funding gaps in trading arise. And as was argued earlier, it is the role of trade financiers to bridge those gaps and ensure efficiency in trading.

Table 2: The funding gap in exporting

Table 3: The funding gap in importing

Trade finance flows to developing countries – A brief historical review of the African case

Some definitions

The funding gaps in international trade described in the opening section of this chapter, and shown in Tables 2 and 3, are the main drivers of trade finance demand. It follows that the ability of a country to improve its trade is to a large extent dependent on the ability of participants in the trading chains to raise the financing required to bridge the funding gaps in the trade cycle. Trade finance has historically played an important role in bridging this gap. Such financings have, however, taken various forms over the years in response to changing market circumstances. In what follows, we attempt to track the evolution of trade finance flows to Africa. By focusing on Africa’s historical experience, we bring to light useful insights in understanding the origins of structured trade finance – a new trade finance technique pioneered in Africa and which has become a technique of choice in financing trade in difficult environments.

It is important at this juncture to define what is meant by trade finance, as such a definition will facilitate a better understanding of the subject matter of this book. Trade finance is a generic term for all the financial instruments that are used independently or jointly in bridging the financing gap in trading activities as well as in providing performance and payment assurances to trade counterparties. Trade finance ensures an efficient completion of marketing cycles. It is usually provided by banks but may also be provided by non-bank institutions, such as finance houses and trading companies. The trade payment and finance instruments commonly used in trade finance are described briefly below and include:

a.Open account payment method – Goods traded under this instrument are not covered by advance payment or any form of payment assurances. The goods are shipped and delivered before payment is due. Invoices covering such shipments are usually paid within 30–90 days. Obviously, this is the most advantageous option to the importer in cash flow and cost terms, but it is consequently the highest risk option for an exporter. Due to the intense competition for export markets, foreign buyers often press exporters for open account terms since the extension of credit by the seller to the buyer is becoming more common. Exporters who are reluctant to extend credit may face the possibility of the loss of the sale to their competitors. However, with the use of one or more of the appropriate trade finance techniques, such as pre-export financing, export working capital financing, buyer credit programmes, government-backed export guarantee schemes, export credit insurance, and export factoring, the exporter can offer competitive open account terms in the global markets while substantially mitigating the risk of non-payment by the foreign buyer. Open account payment methods are common in trade in manufactured consumer products, handicraft, certain agriculture exports (e.g. fruits and vegetables), and similar items. Some of these goods are sold on a consignment basis with payments made by the buyer upon onward sale of the items.

b.Documentary collections – This is a trade payment method whereby the exporter entrusts the collection of a payment to the remitting bank (exporter’s bank), which sends documents to a collecting bank, usually in the importer’s country, along with instructions for payment. Funds are received from the importer and remitted to the exporter through the banks involved in the collection in exchange for those documents. Documentary collections may involve the use of a draft that requires the importer to pay the face amount either on sight (document against ­payment – ­D/P) or on a specified date in the future (document against ­acceptance – ­D/A). Although banks do act as facilitators for their clients under collections, documentary collections offer no verification process and limited recourse to the remitting and/or the collecting banks in the event of non-payment.

c.Documentary letters of credit – Also known as a ‘letter of credit’³ or ‘L/C’, a documentary letter of credit is a written undertaking by a bank, at the request of the importer/buyer, to pay an exporter/seller for product(s) supplied, provided that the exporter/seller complies with the terms and conditions laid down in the documentary credit. In other words, a letter of credit is a document that a financial institution issues to a seller of goods or services which provides that the issuer will pay the seller for goods or services the seller delivers to a third-party buyer. The issuer will normally obtain reimbursement from the buyer or from the buyer’s bank. Documentary letters of credit are internationally recognised instruments that help enhance the creditworthiness of, and the probability of payment by, overseas trading partners. The document serves essentially as a guarantee to the seller that it will be paid by the issuer of the letter of credit regardless of the buyer’s credit conditions. In this way, the risk that the buyer will fail to pay for goods and/or services delivered is transferred to the letter of credit’s issuer.

    Letters of credit are used primarily in international trade for large transactions between a supplier in one country and a buyer in another. In this way, they help a seller to mitigate country risk usually inherent in international transactions. They are also used in the land development process in the USA to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. Letters of credit can also be used in domestic trade (domestic letters of credit) to cover the risk of non-payment. The parties to a letter of credit are the supplier, usually called the beneficiary, the issuing bank (of whom the buyer is a client), and sometimes an advising bank (of whom the beneficiary is a client). The letters of credit can take many forms: irrevocable or revocable, confirmed, unconfirmed, or special (transferable, revolving, green clause, red clause, or standby). Letters of credit are usually governed by the Uniform Customs and Practice (UCP) Rules of the International Chamber of Commerce. The latest rule (UCP 600) was introduced in 2007. Drafts are generally less expensive than letters of credit.

d.Drafts, bills of exchange – A bill of exchange is an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time a sum certain in money to, or to the order of, a specified person, or to the bearer.⁴ In other words, it is a non-interest-bearing written order used primarily in international trade that binds one party to pay a fixed sum of money to another party at a pre-determined future date. The ability to negotiate or discount bills of exchange can be an important source of finance in international trade. The bill of exchange can provide easier access to financing because it enables the financing bank to retain a claim on all parties to the bill. In addition, parties that finance bills of exchange can, in certain circumstances, obtain stronger rights than the party transferring the bill to them. Bill discounting usually provides access to interest rates lower than the rates obtainable for overdraft or loan a seller can normally access.

    A draft is a cheque drawn by a bank on itself or on its agent.⁵ In practice, an entity that owes money to another buys the draft from a bank for cash and hands it to the creditor to make them more at ease with the credit.

e.Line of credit – An arrangement between a financial institution, usually a bank, and a customer that establishes a maximum loan balance that the bank will permit the borrower to maintain. The borrower can draw down on the line of credit at any time, so long as they do not exceed the maximum set in the agreement. The advantage of a line of credit over a regular loan is that interest is not usually charged on the part of the line of credit that is unused, and the borrower can draw on the line of credit at any time that they need to. Depending on the agreement with the lender, a