Slide Deck 8

Still Thinking About Trade Finance

International Corporate Finance – Slide Deck 8

Spring 2010
X51.9405

Mark Foley
 Trade Finance
•Obviously, Bankers Acceptances and other forms of documentary credit can
provide short term trade finance

In most cases trade finance is short term by its nature – you should not need
long term finance for inputs to production, or for consumer goods, or
anything which is consumed within a short period

But there are needs for medium term and longer term cross border finance

i.e. some forms of equipment amortize over a few years

Aircraft can last twenty years and often need longer term finance to make
the sale

Often the kinds of export credit agencies step in with loan to provide longer
term finance – think U.S. Exim Bank loans
 Trade Finance

• In these cases the government credit agency takes the majority of the
country risk and tries to avoid taking the credit risk
• Typically government agency loans require a minimum down payment (to
remove moral hazard) and often a local bank guarantee

•How might a down payment by the buyer reduce moral hazard?

• The EXIM banks usually don’t fund the deals but let their domestic
commercial banks fund the deals against an Exim bank guarantee

• The various countries compete to offer attractive credit facilities to foreign

buyers
 Forfaiting

• Forfaiting is a private sector mechanism particularly adapted to financing

capital equipment

• It began in the communist era to enable the communist countries to buy

more capital equipment from the west

•(as an aside, the Eurodollar market derives its name from the
Russian government placing US$ with a French bank which had the
cable address “Euro Bank” this was born the Euro dollar

• Prior to Forfaiting, they paid cash for everything, which obviously kept
their purchase volumes down
 Forfaiting

• The eastern bloc countries were a great credit risk for decades

• Forfaiting works by having the importer of the equipment sign a series of

promissory notes (usually for every six month period for 3 to 7 year)

• Most of the time the importer gets its bank to ad a guarantee or aval

• These notes are given to the exporter, who can then discount them with
its bank

• Naturally this can be expensive, as the banks have to worry about the
country risk and the credit risk
 Forfaiting

• The sot of Forfaiting is usually built into the cost of sale one way or
another, though in competitive situations, exporters may choose to accept
these costs in their profit margin

• For this reason the exporter may often only discount the notes for enough
money to cover immediate needs and hold onto the remaining notes to
keep as much profit as possible – exporters can also think that country risk
premiums may decline with time – as we have seen for many emerging
markets countries

• Exporters can also use the notes for collateral against bank loans if the
cost of borrowing is lower than the cost of the discount
 Barter, Countertrade Etc.

• These forms of trade finance are relics of early political systems and were
much more used when there was a communist bloc of countries
• Barter arrangements approximate the Ricardian model of comparative
advantage i.e. Cuba traded sugar for oil from Russia in barter
arrangements
• Countertrade also used less specific arrangements called counter purchase
– one country bought some goods a from another and the seller agreed to
buy a certain amount of goods from the buyer, usually in the future
• Sometimes sellers would not find what they wanted from the original
buyer and sell their rights to still other countries which did – this is called
switch trade
• These sort of arrangements took up almost 20% of world trade back in
those days but are significantly less important now
 Project Finance

• Large Cross border projects are often done with project finance
• In project finance the sponsor of the project, (i.e. a power plant, a beach
resort etc.) tries to secure financing based on the cash-flows coming from
the completion of the project
• Often the sponsor does not want to tie up its available bank lines or give
guarantees
• The search is for banks and other lenders which will take the construction
risk and the risk that the cash flows will repay (amortize the loans)
• In most cases a thinly capitalized company is established to “own” the
project
• In the construction phase the builders (who are usually different from the
operators) supply performance bonds and bank guarantees to get the
structure built.
 Project Finance

• Some banks specialize in this aspect of the deal

• Once constructed the operations are often contracted to an operating
company, and revenues (i.e. the national power company contracts to buy
the electricity from the power plant0 are assigned to the lending banks
and used to pay down the debt.
• These deals by their nature are large and complex and done of a
mix&match basis, depending on negotiations
• I.e. the sponsor may give a full guarantee or partial guarantee
 Oil, Not China, Is The Real Destroyer Of America’s Trade Balance

• Courtesy of Vincent Fernando at Clusterstock

• UBS’s head of Asia-Pacific economics argues that the real global trade
imbalance isn’t U.S.-China, it is U.S.-oil. As shown below, current account
surpluses from fuel exporting-nations have been a far larger driver of total
global trade imbalances coming from emerging markets.
• China’s current account surplus (in blue) has been large in recent years, as
a percentage of the global economy, but it has been dwarfed by fuel
exporters (in green):
 Oil, Not China, Is The Real Destroyer Of America’s
Trade Balance
http://www.themarketguardian.com/2010/04/oil-not-china-is-the-real-destroyer-of-america%E2%80%99s-
trade-balance
• Jonathan Anderson of UBS, via Caixin:
• Looking at the movements from the late 1990s through 2006, when the
overall U.S. deficit worsened from 2 percent of GDP to nearly 7 percent of
GDP at the trough, a full three percentage points of that adjustment came
from other advanced economies and from fuel imports;
• only two percentage points came from China and other non-fuel emerging
markets.
• And the recent drop in the U.S. deficit had almost nothing to do with
China; again, it was oil prices and developed trade that explains the entire
swing over the past 18 months.
Gonzalo Lira: “Systemic Contradictions”: The Euro zone De Facto Currency Peg, and
the Death Spiral We Are Currently Witnessing
By Gonzalo Lira, a novelist and filmmaker (and economist) currently living in Chile

• I would argue that, with the way things are going, it’s Europeans and their
Euro zone which will soon be relegated to the dustbin of the past.
Precisely because of its “systemic contradictions”.
• The end of the Euro zone will be a tragedy—and I would argue, we are
currently witnessing it.
• Let’s review:
• The Euro zone was born out of the Common Market, formed back in 1958,
to the west of the Iron Curtain. In 1990, the Berlin Wall collapsed, so by
1992, a reunified Germany was effectively married to France and Club
Med. The rationale was, economic union would beget political union, or at
least political peace. In 1999, the Euro was born—a common currency for
the members of the Union. Another step in European integration.
• So far, so good.
• However, though a series of complicated methods were used to control
the debt, deficit and inflation levels of the various Euro-economies, one
fact remained: Every country of the Euro had the same currency, while
every country kept the right to float its own debt.
• And of course—as we now all know—each country’s debt was assumed to
be backed by the rest of the Union, when in point of fact, it was not.
• From this way of looking at the Euro zone, the natural inference is to think
of Greece as a small part of a larger, healthier whole. A part that is going
down the drains, true, but it won’t bring the larger whole down with it.
• But this is a false inference. It’s an easy logic trap to fall into, because the
Euro as a currency papers-over the differences within the Euro zone. The
Euro makes the Euro zone look like one big happy family, but with a black
sheep named “Greece” that has to be sorted out.
• However, this is not the case. The Euro zone and the European monetary
union is actually several different economies at vastly different levels of
development, which so happen to have a common currency—but they
have nothing else in common.
• Because—unlike in the US—in the Euro zone, each member state can
issue its own debt. Therefore, each member state can borrow its way to
equality of wealth, instead of earning it.
• Looked at this way, it becomes obvious that the Euro isn’t a common
currency—rather, it is a very complex fixed rate exchange system.
• In other words, a currency peg.
• So instead of thinking of the Euro as €, common to all Euro zone countries,
it would be smarter to think of the Euro as GER-€, or FR-€, or IT-€, or SP-€,
and so on—a different Euro for each member economy, all of which
happen to be fixed at a one-to-one parity.
• Now it becomes obvious what we’re looking at—when we look at Europe
today, what we’re really seeing is Latin America circa 1980.
• Thinkit: A bunch of countries in Latin America fixed their exchange rates to
the US dollar; at different times and for vastly different reasons, but for
the present discussion those issues don’t matter.
• At first, this dollar-peg worked like a charm. The Latin American countries
found themselves with a false sense of prosperity, bought and paid for
with cheap dollar-denominated debt—until the inevitable crash of ’82. (In
Argentina, it happened again in 2001—those gauchos never learn.)
• The dollar didn’t suffer because of the fixed exchange rates—it was all the
poor saps south of the border who suffered, and greatly at that.
• Latin American debt suddenly had no buyers, and all the previous debt
had to be paid off.
• With no incoming dollars, that dollar-denominated debt broke the Latin
American economies.
• If we look at Europe with Latin American lenses, we realize that the Euro
zone is in exactly the same position—it’s a bunch of over-indebted
countries with their currency pegged to, of all the economies of the world,
Germany.
• Because the role of the US dollar in this fixed-exchange rate system is
today being played by the German Euro—the GER-€. And it’s the deflation
of the GER-€ which is absolutely killing the Euro zone.
• Going back to the Latin American example, at least those countries had
the option of ending their dollar-peg and floating their currencies, once
their debt levels broke them.
• But the Euro zone members can’t do that! Or rather, they can break
away—but they won’t break away, until it’s too late and the damage has
been done.
• Various European-wide subsidies and programs and wealth-redistribution
schemes—otherwise known as bribes—will keep the countries all tied up
for a while. For quite a while, in fact, human nature being what it is, and
hope always being the last thing to die.
• Each day the fixed exchange rate continues, though, is one day closer to
complete Euro zone collapse—which will be a tragedy. Because European
prosperity insures European peace, from the Urals to the Irish Sea.
• But by the time they all realize that the GR-€ is destroying their
economies—much like the dollar-peg in ’82 trashed the Latin American
economies—it will be too late.
• The European Union will be wrecked, much as Latin America was wrecked
in ’82. And that crisis ushered in all sorts of foolish craziness in many many
places.
• We are currently watching this wreckage—we just don’t realize it. Greece
is not an aberration—it’s not even the canary in the coal mine: It’s the
beginning. The GR-€ is wreaking havoc on all the other countries of the
Euro zone, starting of course with the weakest, Greece.
• But it won’t end there—far from it. The GR-€ will take out, in no particular
order, Portugal, Italy, Spain, until it eventually hits France.
• Then it’s over for the Euro zone. Because once France decides to break
away, there’s no more Euro zone—and possibly, no more political stability.
• The single most important reason for the collapse of the Euro zone is that
each member state was allowed to issue its own debt.
• This ability, coupled with the fixed-exchange rate otherwise known as the
Euro, is the core “systemic contradictions” of the Euro zone.
• Right now, we are watching the Euro zone in its death spiral. And I’m afraid
that all the talk of IMF bailouts of Greece and whatnot aren’t addressing
the key problem: Sovereign European debt.
• If somehow, all European debt could be centralized, then maybe the Euro
zone would survive.
• But if the Europeans lack the political will to sort out Greece now, then
such collectivization of European-wide sovereign debt is impossible.
• So that mean, the Euro zone death spiral is inevitable. And we are now
watching it unfold.
 Blogs I like

• http://ftalphaville.ft.com
• http://www.calculatedriskblog.com/
• http://www.nakedcapitalism.com
• http://brontecapital.blogspot.com/
• http://jessescrossroadscafe.blogspot.com/
• http://www.businessinsider.com/clusterstock
• http://www.zerohedge.com/
• http://globaleconomicanalysis.blogspot.com/
• http://baselinescenario.com
• http://boombustblog.com/
• http://www.ritholtz.com/blog/