This blog, over the last couple of months, has intermittently pointed to the difficulties of obtaining trade finance (particularly letters of credit) as playing a role in the fall in international trade. Because L/Cs are a profitable backwater at most banks, serving smaller/midsized customers (big ones are more likely to deal with existing supply chains and use an open order system), the problem has gotten amazing little attention despite its potential importance. Then again, this verges on being a back office business, and thus is a part of the financial system plumbing that gets little notice even when it starts to leak.
The Atlanta Fed’s Macroblog has a nice piece on the issue today, “Credit Storm Hitting High Seas?” (hat tip reader Andrew), written by Galina Alexeenko and Sandra Kollen. Worth reading in in its entirety, and here are some key sections:
International trade amounts to about $14 trillion and, according to the World Trade Organization (WTO), 90 percent of these transactions involve trade financing. Trade-related credit is issued primarily by banks via “letters of credit,” the purpose of which is to secure payment for the exporter. Letters of credit prove that a business is able to pay and allow exporters to load cargo for shipments with the assurance of being paid. Though routine in normal times, the letter of credit of process is yet another example of how transactions between multiple financial intermediaries introduce counterparty risk and the potential for trouble when confidence flags….
n general, exporters and importers in emerging economies may be particularly vulnerable since they rely more heavily on trade finance, and in recent weeks, the price of credit has risen significantly, especially for emerging economies. According to Bloomberg, the cost of a letter of credit has tripled for importers in China, Brazil, and Turkey and doubled for Pakistan, Argentina, and Bangladesh. Banks are now charging 1.5 percent of the value of the transaction for credit guarantees for some Chinese transactions. There have been reports of banks refusing to honor letters of credit from other banks and cargo ships being stranded at ports,….
These financial market woes are clearly spilling over to “global Main Street.” The Baltic Dry Index, an indirect gauge of international trade flows, has dropped by more than 90 percent since its peak in June as a result not only of decreased global demand but also availability of financing that demand.
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I agree that this is a big issue, but I’m also hearing that some big foreign customers are using LOC problems as an excuse to get out of contracts entered into during better times.
Read Global trade is shrinking, fast!
Maybe it’s not that bad…Think global but buy local. Forget comparative advantage theory.
Yet another dislocation from our refusal to clean up bank balance sheets…
Until an FDR Bank Holiday or Swedish Plan is implemented every market will be effected.
And still, to this date, I can name only a handful of financial writers or well known economists that have called for either of these measures.
The damage is mounting daily and here we sit with the Fed and the Treasury playing favorites. The coming Obama administration is loaded with the same financial advisor ilk that cheerlead the propositions that caused this mess.
This won’t end well and it will be worse than it ever had to be …
Yet another dislocation from our refusal to clean up bank balance sheets… this won’t end well and it will be worse than it ever had to be …
Pretty much sums it up. I can’t imagine a clean purge, where we could’ve at least retained faith in our government, would have been worse than this staggering zombie.
Maybe Mellon was right, even if Smoot and Hawley weren’t.
I work in the global logistics industry… and we haven’t seen any negative effects of Letters of Credit for any of our clients. Not even anecdotley…
Remember, a letter of credit is essentially an escrow account for trade (to make sure when you order an XBox, you pay only when you get a working XBox), so there would be no logical reason for another bank not to accept it… there is no counterparty risk.
Also, I can’t imagine a scenario where a Letter of Credit could “strand a ship at port”. Shipping lines do not get paid through letters of credit. They get paid through normal invoicing type operations because they usually only contract with large global companies like Walmart or a NVOCC forwarder that does a large book of business with them and has to be licensed.
What we have seen is companies (and even industries) citing the economic crisis as a reason for all kind of bad business practices they had been doing long before the crisis hit.
Anonymous ~ we haven’t seen any negative effects of Letters of Credit for any of our clients. Not even anecdotley…
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You are a liar my friend … You couldn’t possibly have not noticed …
from macroblog
“International trade amounts to about $14 trillion and, according to the World Trade Organization (WTO), 90 percent of these transactions involve trade financing. Trade-related credit is issued primarily by banks via “letters of credit,” the purpose of which is to secure payment for the exporter. Letters of credit prove that a business is able to pay and allow exporters to load cargo for shipments with the assurance of being paid. Though routine in normal times, the letter of credit of process is yet another example of how transactions between multiple financial intermediaries introduce counterparty risk and the potential for trouble when confidence flags.”
http://macroblog.typepad.com/macroblog/2008/12/credit-storm-hi.html
This IS another credit market effected by our refusal to clean up the banks … We need an FDR Bank Holiday – Swedish Plan immediately!
I’m familiar with an oil trading business that uses Letters of Credit. You don’t dock and deliver the boatload full of oil until you have assurance that it will be paid for.
I don’t know about rejecting LOCs on major banks, but I know that LOC is a typical method of guaranteeing payment.
The European client I saw indirectly suggested there was an effect (they have operations in emerging markets, buy commodities for production, super strong balance sheet). They made it sound as if the process had become more difficult and they had to post additional security for the L/C (they didn’t go into details, just the impression). But how many mid sized buyers are the equivalent of AAA with a long established history? This would presumably have a bigger impact on newer/weaker credits.
Anon 6:52-
You are correct… they do use L/Cs for payment, but the fact that they have the Letter of Credit means that boats are never sitting in a port waiting for payment. The financing is worked out long before a ship sails.
The L/C gaurentees the money is available for payment (protecting the vendor) and the goods have been delivered as contracted (protecting the buyer)… just like an escrow account, with no counterpaty risk that would cause a bank to reject it.
Mmckinl-
I’m glad you are an expert on a topic that is dealt with in passing on a blog. I’m sure you also thought there was a rice shortage in the US when the news sensationalized a Costco running out of rice 6 months ago.
“the cost of a letter of credit has tripled for importers… Banks are now charging 1.5 percent…”
What this is, most likely, is local banks in “developing” parts of the world taking advantage of their customers and using the financial crisis as an excuse. But this is not caused by the crisis and is limited in scope to a few localities/banks… it is the exception, not the rule.
I’ll state it again… we haven’t seen this effect trade for any of our customers. If it did effect our customers, a lot of companies (including my own) would get into this business because you get to collect fees with no risk with almost no additional overhead.
Trade volumes are dropping because orders are getting smaller or canceled due to too much inventory with slackening demand.
Letters of Credit are just a nice Red Herring. You can’t blame everything one the bankers.
I have been told of specific cases (credit history of importer, type of cargo) of different established importers with rock solid balance sheets where the seller’s bank would not accept the L/C from the buyer’s bank. And these were big international banks, not funky regional ones.
With banks still putting money on deposit at the Fed rather than lending to each other in the interbank market, why should they take the even greater risk of an L/C transaction? GE even withdrew from DIP financing, which is one of the lowest risk businesses out there.
Yves,
What you are talking about has to do with the relationship between the buyer and their bank. Often times, the bank only requires the buyer’s company to post a portion of the amount actually being gaurenteed in the L/C because they know your company is good for the rest due to the relationship, history, etc… and it allows the buyers company to free up capital.
It wouldn’t surprise me at all that banks are requiring a little more “collateral” or are raising the margin requirements or however you want to look at it.
Newer/weaker credits don’t usually get these terms and typically have to have most if not all of the money upfront before the letter of credit is issued for obvious reasons.
In a healthy company, this will tie up more capital and make them re-evaluate the length of their supply chain, but they will still be able to trade… they just need to manage their cash differently.
Again …
Anonymous ~ “we haven’t seen any negative effects of Letters of Credit for any of our clients. Not even anecdotley… “
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These are your words … I say BS.
In the following posts you have weaseled to the point were companies are reevaluating their supply chains …
Get your lies straight …
I’ve had a theory for a while now that goes like this.
There obviously needs to be an intergenerational wealth transfer. The boomers are essentially selfish so they’ll try to keep as much as possible for as long as possible.
Unfortunately their market is much smaller then their supply. We saw equity heights reached as boomers flooded through the system bebinning in 1980’s. We will see equity lows as boomers roll out the other end.
Why the lows? Because the market is younger productive people who are earning but can’t afford the Boomer asetts. The prices must drop. Especially because the boomer boom was massively credit fueled.
Of course massive wage price increases would achieve the same thing.
First, re-evaluating a supply chain is never a negative thing.
"reevaluating a supply chain" is a long term (3-5 year) strategic intiative in companies where they analyze to optimize their global operations. Examples of factors considerd in this evaluation are: lead times, availability of labor, infrastructure & utilities, economic incentives, inventory turn, saftey stock, cash flow and financing to name just a few.
All of these contribute to the final cost of the product, the profitability of the company, expected cash flow and capital structure… and when important things such as capital get tied up in ways that it hasn't in the past, it can alter the way a company does business and deals with financing.
The shift doesn't happen overnight, but when the market changes fast, most companies have a cushion of capital where current business is still happening… but this capital usually comes at a cost… so when you reevaulate the supply chain, you have to factor this cost in.
Quick example: On $100 Letter of Credit, you put up $50 and your bank puts up $50. Your Supply Chain group says with this set up (among other factors), Australia is the optimum place to produce. Now let us say the bank now requires another $25 for the order making it a 75/25 split. If you source from Australia, that extra $25 (which has a real cost to your company)is unavailable for at least 8 weeks because you have an order lead time and then 6-7 weeks travel time on the water. If you got the product from Mexico, that $25 would only be unavailable for 1 week…
Network alignment happens constantly in every economy, not just bad ones. It doesn't shut trade down.
Some quick data points on trade:
1) YTD Ocean TEUs (Container trade, not bulk/commidity) is up 7-8% YoY.
2) YTD Air volumes are down only 4% YoY (Air is relatively small volume wise and usually is only high value goods).
Both of these are pretty good considering what is going on. Large freight providers' numbers are along these lines as well. Goods are still moving.
1) YTD Ocean TEUs (Container trade, not bulk/commidity) is up 7-8% YoY.
2) YTD Air volumes are down only 4% YoY (Air is relatively small volume wise and usually is only high value goods).
I don’t know if YTD YoY measures are very useful in quickly changing environment like ours. There’s much higher frequency data out that makes it apparent that global trade is shrinking, fast.
It’s really nice to hear anecdotals that are positive, for once, though. :D
I have to respond to the commenter above that is blamming all this on the boomer generation. Do you have your head up your ass? I am 60, have been paying into SSI since I was 14 and don’t have a lot to show for it.
The problems we face have been with us for a long time. We have a class society where there are the rich, their toadies that keep things going for reasonable money and then the rest of us. It has nothing to do with a generation of folks and I dare say that selfisness can be ascribed to many Americans, regardless of age.
@ndk re mellon. Now basically everybody is crying for bailout and fiscal stimulus. Very few voice the idea of debt liqidation. It has come up as an idea at this blog and at Hellasious sudden debt.
As I have only my common sense working for me lacking training in the field of economy I do have difficulties to think of a roadmap to stability of the financial system without addressing the debt/insolvency issues first.
Mellon could not have been a complete moron, see quote below. I whish there would have been powerful voices with regard to the injustice of taxing income earned through paid work higher than income on capital gains.
“The fairness of taxing more lightly income from wages, salaries or from investments is beyond question. In the first case, the income is uncertain and limited in duration; sickness or death destroys it and old age diminishes it; in the other, the source of income continues; the income may be disposed of during a man’s life and it descends to his heirs. Surely we can afford to make a distinction between the people whose only capital is their mettle and physical energy and the people whose income is derived
from investments. Such a distinction would mean much to millions of American workers and would be an added inspiration to the man who must provide a competence during his few productive years to care for himself and his family when his earnings capacity is at an end.”
Someone from within an industry, who clearly knowledgeable about the subject tell you what they are seeing, and you call them a liar?
And base it on a blog posting?
A lot of what goes on in the real world does not equate very well with what the financial press reports.
As an example, I have seen numerous postings and press reports of meltdowns within the hotel industry, and that hotel construction is in a huge glut.
I am sure that is true in areas, but where I am, your four story box hotel is one of the continuing areas of activity. In this particular case the complicating factor is that the continuing population shift to Southern US states gives a background level of demand (and oversupply in other areas) that doesn’t factor in very well in to simple national level statics.
If an industry insider tells you that it is not affecting him/her, it probably isn’t. And the fact that the letter of credit issue increases costs would hopefully be mitigated by lower fuel costs.
The global just-in-time supply chain has been sited as a potential problem area within the world economy. But it’s not like supply disruptions have never occurred before, and no thought has been put into the problem.
I remember spending a sunny week on a ship near the Canary Islands as we waited for ‘Letter of Credit’ problems to be sorted out. Not alone can you wait in port of origin or port of destination but you can wait anywhere in between. The Baltic Dry Index off 94% is a once in five lifetimes catastrophic event that will affect investment in ships for decades to come.
Well, the Baltic Dry seems to have a little bounce in the past 3 days but overall, it is has being off by over 90+%
It does seem like the perfect storm with finance, oversupply of vessels, slowing demand, over speculation by shipowners and a host of other issues.
http://shipchartering.blogspot.com
Citing the Baltic Dry Index is beating a dead horse. It is true that the BDI recently plunged but it plunged back to it's historic mean of the last 15 years.
The BDI went ballastic during the commodities bubble that recently crashed. The BDI crashed along with commodities…back to it's normal range.
See this link for chart illustrating what I have stated. This is the third time that I have attempted to correct the misconception about BDI. When will someone get it?
Once at the site click to change chart to 'last 15 yrs' and click display.
http://www.findata.co.nz/markets/Quote.aspx?e=INDEX&s=BDI
yves
“established importers with rock solid balance sheets where the seller’s bank would not accept the L/C from the buyer’s bank”
incoterms basics – when does an exporter look at the importer’s balance sheet?
not with an l/c,where the buyer-cum-importer credit standing is irrelevant
“and these were big international banks, not funky regional ones”
vikram bandit’s shoddybank? – ROFL
Back to LOCs –
There was an interesting piece in Bloomberg about UPS offering letters of credit to smaller companies that could no longer get them from traditional sources.
Additionally, DHL has decided to exit NA citing deteriorating economic conditions. FedEx is refusing to give guidance.
I believe the industry insider is still seeing volume because larger the supply chain has much larger lead times. Consumer goods moved by air have a lead time of 3-4 weeks. Industrial goods by surface have lead times of 10 – 15 weeks. Commodities, particularly if bought in future markets can have lead times of 6 months.
In conclusion, I would look towards the air freight as a canary.
River, the BDI went to its normal range and then went below in. 700 is below anything in the past 20 years – AND it’s not adjusted for inflation. Additionally, even at the lower end of the past 15 years, ships got pulled from service. What’s going to happen now when the real BDI is far below previous contractionary levels?
The reason that I pointed out the current BDI is that all over the internet I have been reading ‘Horrors! BDI drops 94% in very short time!’
No one bothers to mention that the BDI climbed to record highs before plunging.
I am trying to add perspective to the BDI movement, not debate how many shipping companies are going under. When commodity prices skyrocketed the BDI rose, when commodity prices fell the BDI fell. I see no phenomena or threat to world trade here. Shipping has always been subject to economic cycles. Check the current hardships of US Trucking Cos. You will find that they are suffering along with air freight and ocean freight.
Let us examine the situation and place it in historical perspective. Mountain over a mole hill. When freight is available to be hauled, ships will haul it…as always.
Nothing to see here, please move along. Pay no attention to the man behind the curtain.
LOCs and the BDI are two different subjects. Those attempting to make a case that the BDI has crashed due to problems with LOCs are waaay off base.
The global economy is melting down, and shipping is way off because trade of finished goods and commodities are way down. Where can one find a conspiracy in this? If every damn ship that sailed had 96 letters of credit from worthy banks it would not cause world trade to suddenly increase. I enjoy connecting dots as much as the next person. There are no dots to connect here.
The Federal Reserve, in its insane quest to revive the dead via monetary injections, has outrun its bailout capacity and is now considering issuing its own debt. That would be illegal–not that it seems to matter much these days–but the Fed is taking steps to at least put a "rule of law" fig leaf over its un-Constitutional activities. According to today's Wall Street Journal, the Fed has approached Congress for permission to issue debt in some form, on its own.
The strain on the Fed has grown as it proliferated "lending facilities" to inject cash into first, commercial banks and thrifts, and then into investment banks, and finally into corporations, money-market mutual funds, commercial paper markets, asset-backed securities markets and mortgage-backed securities markets. After running in the $800-$900 billion range all year, the Fed's balance sheet began to soar in September, the month where we saw a dramatic downturn in the crisis, where Treasury moved to back Fannie Mae and Freddie Mac; Lehman Brothers failed; AIG collapsed under the weight of its credit derivatives obligations; Merrill Lynch sought the dubious safety of a merger into Bank of America; Goldman Sachs and Morgan Stanley became bank holding companies; and Washington Mutual failed, the largest depository institution failure yet. By the end of September, the Fed's balance sheet passed the $1 trillion mark for the first time ever, and in early November passed the $2 trillion mark. Loans outstanding by the Fed have increased from $71 billion when the spigots were first turned on in December 2007, to $1.3 trillion as of last week, and overall, the Fed, the Treasury and the FDIC have committed over $8 trillion in guarantees, equity injections and loans, into the financial system.
It has not been enough, as the pace of the collapse is accelerating and the year-end accounting looms. Banks are facing, even in the extraordinarily lax regulatory framework of today, huge losses for the fourth quarter, but it remains to be seen whether, even with the huge cash injections from Treasury and the Fed, they will be able to admit those losses. Big losses will be scary, but the inability to admit those losses should scare people even more.
This process is clearly not sustainable, as more and more people are beginning to realize. The Fed's attempt to issue debt is a de facto admission of failure–failure of its ability to bail out the system, and the failure of the policy of bailout in general. It is time to admit that & say the system is Dead.
To Anonymous @ 12:50 pm : where is the Fed proposing to issue debt by itself? I cannot find the story.
Thanks.