Trade & Supply Chain

Mitigating trade finance risk

Published: May 2013
Portrait of Anande Pande
Anande Pande, Global Head of Trade, Royal Bank of Scotland (RBS):

Global trade is slowing as a result of the renewed uncertainty we are seeing in both Europe and the US. The latest study from the World Trade Organisation (WTO), published in April 2013, put world trade growth at 2% in 2012 and forecasts 3% growth for this year.

This downtrend will amplify trade finance risk for corporates in Asia in two respects. Firstly, the probability of customers declining shipment in certain industries may increase – something we saw a lot of during the last financial crisis. Secondly, trade flows are shifting, with more trade now taking place within Asia and more in the new corridors opening in the Middle East, Africa and the CIS nations. But while these corridors provide the corporate in Asia with a counterbalance for sluggish demand in Europe and the US, they also bring new problems.

What can a corporate do to mitigate the new risks it will inevitably face when moving into new markets? The first port of call is the credit control department. Start with the basics and evaluate the financial robustness and delivery capabilities of your buyers and suppliers. You may also want to diversify, as far as possible, the locations in which you trade. As we saw in recent years when natural calamities caused the collapse of whole supply chains in Japan and Thailand, buying from one country in order to minimise costs is a strategy which could come back to bite you.

The strength of your legal documentation is another important consideration. If you are selling to an overseas market, you must be aware of the laws of that particular country and whether a potential claim will be enforceable. So the risk function is not only mitigating the risk on the balance sheet. A company needs a very strong risk management focus that takes into account the various non-financial risks that also come with trading.

Letters of credit (LCs), like all paper documentation, are liable to occasional errors that could give the importer the right to refuse payment. To avoid this scenario, find out what your banks are offering in terms of outsourcing solutions in which they prepare the export documents on your behalf to ensure they are not discrepant. Explore electronic trade solutions whenever possible as this reduces documentation error and increases administration efficiency.

With open account as the dominant force in Asian markets, corporates may also want to consider insurance companies that provide risk mitigation for a pool of buyers. The Bank Payment Obligation (BPO) could also help. As a risk mitigant for open account transactions – although still a work in progress – it will help corporates, not only to manage risk on open account transactions, but also increase their trade volumes across the world.

Portrait of Steven Beck
Steven Beck, Head of Trade Finance Programme, Asian Development Bank (ADB):

Corporates must not be deterred from exporting to challenging markets because of payment risks. That may sound like an imprudent thing to say, but the fact is there are ways of shifting these risks off corporates’ books.

LCs and other trade finance instruments have been in existence for hundreds of years. They work well to mitigate risk. Financial institutions can ‘confirm’ (guarantee) trade finance instruments such as LCs, thereby removing the emerging market payment risk. To enhance commercial banks’ ability to assume emerging market payment risk on behalf of corporates, the ADB established the Trade Finance Programme (TFP), which works with commercial banks to support trade in the most challenging markets.

TFP diminishes commercial bank trade finance risk. In 2012 TFP supported $4 billion in trade in the most challenging markets. Of TFP’s 18 markets, its five most active markets were Vietnam, Pakistan, Bangladesh, Sri Lanka and Uzbekistan. TFP is in the process of expanding to Myanmar, where there is huge interest from corporates, and in turn their banks, to cover payment risk associated with sales to this frontier market.

In addition to working with commercial banks to reduce payment risk, corporates can also look to insurance, covering payment risk either on buyers – in some cases this is not possible – or from a buyer’s bank under trade finance instruments such as LCs.

There are ways for corporates to mitigate payment risks in frontier markets. ADB, among other multilateral development banks, is playing its part to bolster financial institutions’ capacity to support corporate sales in tough markets. Corporates should be encouraged to expand into frontier markets knowing that associated risks can be managed, regardless of how challenging the market may seem.

Portrait of Simon Constantinides
Simon Constantinides, Regional Head of Global Trade and Receivables Finance, Asia Pacific, HSBC:

A tectonic shift in global trade patterns is underway, forcing many exporters to seek new opportunities, but alongside those opportunities come new – or at least unfamiliar – risks. As businesses switch their focus from the moribund markets of Europe and North America to the vibrant – but more volatile – environment of the emerging economies, they are being squeezed between falling incomes and the rising cost of covering their exposure. It has never been more important to keep the costs of risk mitigation under control. There are two main areas of increased risk: new and untested customers and unpredictable currencies.

Trade finance insurance can be a key element of a broader risk mitigation strategy, but the most effective and cost-efficient way of cutting the danger of default from a customer is to work with a trusted partner which has extensive network and experience on the ground to bridge the gap between markets. Intimate knowledge of the local corporate landscape can give an inside track on potential problems before they become critical and frequently leads to lower costs for credit guarantees.

Currency risks can be less easy – and therefore more expensive – to hedge, but certain effective strategies are emerging, particularly in Asia. Loose monetary policies in the West have led to excess cash flowing in and out of emerging markets, in response to fluctuations in the capital risk/return equation. For a trader operating in such a volatile environment, an unlucky currency call can make the difference between success and failure.

Full hedging can be expensive, but certain trends are becoming apparent in emerging Asia. Professor Takatoshi Ito of the University of Tokyo calculated that after controlling for the G3 currencies (US dollar, Japanese yen and the euro), RMB accounts for between 40% and 49% of the fluctuation in the Singapore dollar, the Indonesian rupiah and the Malaysian ringgit, and between 30% and 39% for the Indian rupee, Thai baht, and Taiwan new dollar. After more than half a century as a closed book, the RMB is now establishing itself as a global currency, and the creation of a broad range of hedging instruments is part of that process. It is clear that as exporters explore new markets, they are being exposed to new risks, but with the right partner and the right strategy they can be cost-effectively minimised.

Portrait of Sridhar Kanthadai
Sridhar Kanthadai, Regional Head of Transaction Banking, North Asia, Standard Chartered:

As growth in trade continues to shift from West to East, an increasing number of Asian corporates are expanding beyond their borders. This means they have to operate in new markets with new suppliers under different local regulations. Financial and economic challenges of the past five years have refocused companies’ concerns around counterparty, cross-border liquidity and bank risks. Impact of evolving regulatory requirements such as Basel III is also prompting companies to take a much closer look at how they manage their risk exposures.

Therefore it is critical that Asian corporates find efficient ways of managing risk and cost associated with trade transactions. Here are a few options for Asian corporates’ consideration.

Firstly, it is important to choose the right option for your needs. Starting from the LC to pre-payment, the gamut of options available for companies is staggering. Domestic trade typically uses variants that are established in the particular market. While historically cross-border trade has relied on the documentary origins such as LC, there is an increasing acceptance of open account trade. For those who still prefer the payment certainty of an LC but want the efficiency of open account trade, the Bank Payment Obligation (BPO) is a new solution that is the best of both worlds.

Secondly, complex supply chains using procurement hubs and re-invoicing centres have resulted in significant value flows for many industries, a big portion of which is inter-company. The regulatory and capital overheads that banks now face and, the potential reduction in financing for less creditworthy names, have also driven needs of companies to manage and support supply chains while managing the risks. Corporates need to look for an experienced financial partner that is able to support these needs, whether it be through receivables financing to reduce credit exposure and improve their days sales outstanding (DSO) and working capital measures; buyer financing to accelerate their receivables and release buyer credit; or vendor financing to extend payment terms and in turn improve working capital.

Thirdly, trade credit insurance is a good risk management tool for Asian corporates to consider in order to mitigate the risks of open account trade. The insurance would help de-risk their business growth while supporting an increasing volume of financing transactions.

The next question

“Where is the best place in Asia to set up a regional treasury centre and why?”

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