Trade finance—the world economy’s grease—used to be easy to find. It’s now so expensive that it threatens to halt global commerce. The Baltic Dry Index—a barometer of world trade—fell to the lowest in nine years at 815 points on 4 November, a drop of 93% from its peak in May. Shippers were the first to get hit, but importers, who now have to borrow at prohibitive rates, are also feeling the pain.
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A year ago, importers might have paid only 100 basis points above the London interbank offered rate (Libor) to finance trade. Today it’s likely to be around 300 basis points over Libor. One basis point is one-hundredth of a percentage point. World demand is slowing, so why is the cost of trade rising?
Demand for letters of credit—the simplest form of trade finance—has skyrocketed. Under these agreements, an importer’s bank extends to an exporter’s bank a credit line that is released once the conditions of the trade are met. This assures the seller—who may not know his counterparty—that he will be paid.
When the economy was buoyant, the seller would collect payment directly from the buyer’s open account when goods were delivered. But recently, even buyers and sellers with long-standing relationships have begun to question their counterparties’ health. Traders now want their banks to guarantee each transaction.
But banks are struggling to fulfil their age-old function of financing trade because they no longer trust each other. Some are refusing to take on counterparty risk from other banks altogether. Add to this their constrained balance sheets, currency volatility and more rigorous risk assessment, and it’s not surprising that the cost of trade finance has shot through the roof.
Those who can afford it are paying a steep price to trade. Those who can’t are running down their inventories or trading less. But the longer trade finance remains sclerotic, the larger the threat to the world economy becomes. Corporate defaults could rise, pushing up the cost of insurance even further and dragging trade and the economy down in a vicious circle.
When the World Trade Organization, the World Bank, the International Monetary Fund and the largest trade financiers convene on 15 November to discuss the impact of the credit crunch on trade finance, they should act quickly to loosen the noose.