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International Finance - EM Strasbourg Business School - Final Research Paper by Daniel Patino

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The role of trade finance.

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International Finance - EM Strasbourg Business School - Final Research Paper by Daniel Patino

  1. 1.                                         RESEARCH    PAPER   The  Role  of  Trade  Finance:     Evidence  from  the  2008-­‐2009  Great   Trade  Collapse                                              University  of  Strasbourg  -­‐  EM  Strasbourg  Business  School     Masters’  in  International  and  European  Business   International  Finance  (EM375M53)   Academic  Year  2013-­‐2014   Professor  Dr.  Erasmus  S.  Kaijage     Daniel  PATINO   Student  Number  21210030   19th  of  December  2013    
  2. 2.   1   TABLE OF CONTENTS I. ABSTRACT………………………………..………………………………………….2 II. INTRODUCTION AND BACKGROUND……………………………….................3 III. RESEARCH PROBLEM, OBJECTIVES AND QUESTIONS…………………..…4 IV. EMPIRICAL LITERATURE REVIEW…………………………………...………..5 1. - The role of trade finance…………………………………………………………………….5 2. - Brief reference to the main trade finance instruments in use……………………….....6 2.1. - Documentary credits and trade credits………………………………………..…….….6 2.2. - Insurance instruments……………………………………………………………….….…6 2.3. - Instruments issued by governments and government-related institutions……….…7 3. - Reasons for the recent trade finance shortages………………………………………….7 3.1 - Failure in the trade finance market………………………………………………………7 3.2. - Cost of implementation of the Basel II and Basel III frameworks…………………..8 4. - Causes for trade collapses: the compositional effect, trade finance and vertical fragmentation…………………………………………………………………….…………..……8 4.1. - Presumptive absence of impact from national protectionist…….…………………...8 4.2. - Circumstances identified as drivers of trade collapses……………………………….9 4.2.1. - The Compositional effect…………………………………………………………….…9 4.2.2. - Trade finance shortages……………………………………………………………..….9 4.2.3. - Worldwide vertical fragmentation of production ………………………………….10 5. - The hypothesis of the impact of trade finance shortages on trade collapses…...…..10 5.1. - The hypothesis of the impact of trade finance shortages on trade collapses……..12 5.1.1 - Research focused on developed economies…………………………………….……12 5.1.2. - Research focused on emerging and developing economies……………………....13 5.3. - Criticisms to the hypothesis of the impact of trade finance on trade………..…….14 6. - The impact attributable to credit shortages in the availability of trade finance: Evidence from the IMF and the BAFT…………………………………………………….….14 7. - Policy reactions and remaining challenges……………………………………...……..16 V. SUMMARY OF THE LITERATURE REVIEW, CONCLUSIONS AND RESEARCH GAPS………………………………………………………………...…..18 VI. RECOMMENDATIONS FOR FUTURE RESEARCH……………………...……19 REFERENCES…………………………………………………………………………20
  3. 3.   2   I. ABSTRACT According to the World Trade Organization, trade finance provides sustain to nearly 90% of the world’s trade. Threatening this crucial function, the ongoing financial crisis has raised a number of obstacles to the supply of international trade finance, marked by a significant contraction in trade credit. This shortage in the offer of trade finance instruments, together with a prominent decrease in the consumption of imported goods stemmed from the economic recession, has eventually led to the so- called “Great Trade Collapse” affecting transnational trade flows since mid-2008 until early in 2009. As many authors and international organizations have noticed, international trade flows have collapsed at a faster rate than that of the world’s GDP during the period at hand, yielding the most conspicuous trade contraction the humanity has suffered since the irruption of the Great Depression in 1930. This research paper aims to discuss to what extent international trade finance plays a crucial role in the preservation of the current financial and trade systems, highly globalized and interdependent. Bearing this purpose in mind and using the last trade collapse as illustration, we will study the different reasons undermining the mechanism upon which trade rely, the relative weight attributable to international trade finance and the reasons underlying shortages in the supply of trade finance instruments during periods of financial instability. To conclude, the most relevant policy proposals destined to the mitigation of trade finance shortages will be exposed as an illustration of means to avoid similar phenomena in the future.
  4. 4.   3   II. INTRODUCTION AND BACKGROUND According to the World Trade Organization1 , around 90% of the world trade flows are sustained through trade finance, frequently under the form of credit or guarantee, and related services, such as counterparty default risk assessment, payment guarantee to the exporter or insurance against exchange rate risk, which have become crucial for the smooth and predictable functioning of the trade system. The current financial crisis has raised a number of obstacles for the supply of trade finance instruments, marking a significant contraction on the offer of trade credit that definitely undermined the foundations of the whole international trade system. Many economists (e.g. Davin Chor and Kalina Manova2 ), defend that two circumstances stemming from the 2008 global financial crisis underlie the collapse of trade flows: on the exporter side, the scarcity of trade credit during the peak of the crisis limited the financial soundness of export-import operations; on the consumer side, the adverse economic forecast, high unemployment rates and deficiency of credit available for the finance of consumption and investment dropped the demand of imported durable and non-durable goods. Hence, the shortage of trade credit combined with the shrink in the demand for imported goods has eventually led to the so-called “Great Trade Collapse” (2008-2009), affecting world trade flows since mid-2008 in a magnitude that is estimated around 30% relative to the world’s GDP3 and dropping at a faster rate than this latter magnitude or in any other period in history since the 1930’s Great Depression (obviously excluding the World War II). This decline in international trade flows has spread worldwide its pernicious effects in combination with the phenomena of vertical fragmentation of global value chains, given that the process of globalization has been stimulating during the last two decades the interconnection among countries through the trade of intermediate goods that nourish trans-national production lines and supply chains. This combination of circumstances has provoked a chain reaction that eventually has contributed to the spread of recessionary trends worldwide, even to countries with a low degree of exposure to the U.S.’ subprime market. Numerous governments, public-baked institutions and international organizations, including the World Trade Organization (WTO) and the International Monetary Fund (IMF) assisted by the G-20, have reacted with limited success to this shortage through trade policies aimed to cover the demand of trade finance that private institutions have failed to supply. According to the WTO, this gap in supply in the trade finance market                                                                                                                 1 WORLD TRADE ORGANIZATION, “Trade Finance: The Challenges of Trade Financing”. 2 CHOR D., and MANOVA K., “Off The Cliff and Back? Credit Conditions and International Trade During The Global Financial Crisis”. Journal of International Economics, Issue 87, 2012, pp. 117. 3 EATON J., KORTUM S., NEIMAN B., and ROMALIS J., “Trade and The Global Recession”. National Bureau of Economic Research, NBER Working Paper Series, Working Paper 16666, Cambridge, December 2009, pp. 1.
  5. 5.   4   can be estimated between $200 and $300 billion, encouraging the raise of issuing prices of financial instruments4 . III. RESEARCH PROBLEM, OBJECTIVES AND QUESTIONS This research paper reviews the existing academic and official literature on the impact of trade finance instruments shortages on the volume of trade flows and more specifically focusing in the experience learned from the “Great Trade Collapse” (2008- 2009). The following main questions will be developed during this work: - First, the role of trade finance as a mean to reduce uncertainty and extra costs related to cross-border transactions will be analyzed. The main instruments currently in use for this objective will be briefly exposed. To conclude this section the reasons identified by the World Trade Organization as triggers of the trade finance shortage will be explained. - Secondly, the reasons underlying the recent trade collapse will be identified. As we will see later, not only international trade finance, but also the composition of the demand for imported goods, the globalization of value chains and, potentially, protectionist measures have contributed to the irruption and spread of the trade collapse. - Third, arguments in favor and against the hypothesis of the impact of trade finance instruments shortage on the volume of international trade will be provided, based in the findings of research papers carried out by the academia and devoted to the analysis of such correlation. - Fourth, with the aim of obtaining a more accurate picture, we will analyze evidence provided by the International Monetary Fund regarding the perception the impact of trade finance. - Last, the trade policies implemented at the international level will be explained, as well as the main lessons we can draw from the management of the trade collapse.                                                                                                                 4 AUBOIN M. and ENGEMANN M., “Trade Finance in Periods of Crisis: What Have We Learned in Recent Years?”. World Trade Organization, Economic Research and Statistics Division, January 2013, pp. 1-29
  6. 6.   5   IV. EMPIRICAL LITERATURE REVIEW 1. - The role of trade finance Companies involved in international trade frequently rely on external capital to support expenditures related to export operations. Fixed costs related to export are, for instance, researching the profitability of untapped markets, adapting the product to the needs and regulations of the export market, or to maintain international distribution channels, whereas variable costs comprise freight, insurance, duties and clearances for each unit or bundle of goods exported. International trade often requires, by nature, longer delivery times than intra- domestic transactions and hence increases working capital needs. As a matter of fact, carriage of goods by sea, which accounts for the transportation of roughly 90% of world trade by weight5 , may imply transit periods of several weeks and hence accounts receivable will be issued in favor of foreign purchasers whenever COD (i.e. cash on delivery) is the chosen term of payment. These cross-border transactions entail, inter alia, two major risks: default risk, or the probability of the foreign purchaser refusing the reception of the goods sold under the pretext of a breach in the sales contract, and exchange rate risk, or the exposure to adverse fluctuation in the exchange rate of the currency of payment. Private financial operators, governments and certain international organizations are committed to meet the needs derived from export activities through the supply of trade finance instruments. As we have alluded above, the World Trade Organization estimates that these instruments provide coverture to around 90% of the world trade flows. The economists Silvio Contessi and Francesca de Nicola noticed6 that the supply of trade finance instruments responds to two main purposes: on the one hand, they provide an injection of working capital (i.e. current assets minus current non-financial liabilities under the IFRS) to companies requiring liquid assets; on the other hand, they provide credit insurance against default risk, exchange rate risk, and political risk (i.e. not only the probability of political instability but also of imposition of trade restrictions such as embargoes, quotas and additional tariffs during the transit of the goods). In conclusion, international trade is more vulnerable than domestic trade due to risks derived from counterparty and exchange rate risks and thus trade credit and other insurance instruments are crucial. Problems arise, though, when is the financial institution providing credit finance itself lacks of the required solvency to be considered as trustworthy, which undermines a system aimed to the mitigation of risk. Under such circumstances, national export-import banks must cover the deficiency of trade credit,                                                                                                                 5 DAVID P., and STEWART R., “International Logistics: The Management of International Trade Operations”. Cengage Learning, Third Edition, 2010, pp. 262. 6 CONTESSI S., and DE NICOLA F., “The Role of Financing International Trade During Good Times and Bad”. The Regional Economist, January 2012, pp. 6.
  7. 7.   6   yet the recent trade collapse demonstrate that, despite their intensive commitment, this movement reached the market late7 . 2. - Brief reference to the main trade finance instruments in use Trade finance comprises a number of instruments aimed to well different ends. We will distinguish between instruments providing credit to trade, those aimed at the coverage against certain trade-related risks and those offered by governments and public agencies to facilitate trade flows. 2.1. - Documentary credits and trade credits The primary distinction can be drawn between documentary credit and generic trade credit, as proposed by Contessi and de Nicola8 : On the one side, documentary credit in the form of letters of credit issued by commercial banks is the paramount instrument for financing international trade. Under this instrument the issuing institution assumes the undertaking as to pay the exporter a certain pecuniary sum on behalf of the importer provided that the terms and conditions of the sale contract have been duly observed. The use of letters of credit allows the importer to allocate generated cash flows to other productive activities and ensures the payment to the exporter in due time. Thus, documentary credits are employed to mitigate risk when the creditworthiness of one of the parties cannot be reliably assessed, as contract enforcement between banks is easier than between trading partners. On the other side, generic trade credit is the traditional instrument in use (i.e. short-term credit covers around 80% of the trade credit according to market surveys9 ), consisting in the exporter agreement to sell the goods on account and thus allow the foreign purchaser to pay at a certain date, commonly 30, 60 or 90 days after the delivery. When this occurs, the credit is recorded as an account receivable in the exporter’s statement of financial position (i.e. balance sheet), and hence the company itself is financing the acquisition by its foreign customer. 2.2. - Insurance instruments Different end pursue the so-called insurance instruments, aimed to the mitigation of the specific risks that international trade entails: Firstly, some instruments bear the function of covering the exporter or the importer against gains or loses derived from fluctuations on the exchange rate of the currency of payment. Options, forwards, futures, swaps and spot contracts fall into this category. Secondly, as a widely used alternative to the letter of credit we find the bill avalization, by which commercial banks guarantee the payment to the exporter against the realization of default risk, that is to say the breach by the foreign purchaser of its undertaking as to pay the goods ordered.                                                                                                                 7 MCKINNON R.I., et al., “Collapse in World Trade: a Symposium of views”. The Magazine of International Economic Policy, Washington D.C. Spring 2009, pp. 30. 8 CONTESSI S., and DE NICOLA F., “The Role of Financing International Trade During Good Times and Bad”. The Regional Economist, January 2012, pp. 7. 9 WORLD TRADE ORGANISATION, “Trade Finance and the WTO”. WTO E-Learning, March 2013, pp. 2.
  8. 8.   7   Lastly, as another mean to avoid the risk of default linked to the concession of trade credit we find the contract of forfeiting. When this contract is signed, the exporter transmits the debt from a sale on account to a third party, often a financial institution, who will advance the exporter a sum of money equal to the value of the debt minus a discount. Through this contract the exporter transmits to the third party the risk of default related to the transaction in exchange of a discount fee. 2.3. - Instruments issued by governments and government-related institutions Firstly, export credit insurance agencies can be found amongst the institutions involved in the financing of international trade. These institutions intermediate between national government and companies involved in international trade, with the aim of providing financial services, whether in the short (i.e. up to 180 days) or long (i.e. up to 3 years) term, meeting the need of credit to cover production and transportation costs, as well as insurance services protecting against a range of risks, from exchange rate fluctuations to political instability10 . Secondly, many central banks offer what is known as refinancing schemes, similar to the forfeiting mechanism above explained, whereby commercial bills from international trade transactions are discounted at preferential rates. Lastly, specialized financial agencies, commonly under the denomination of “Export-Import Banks” or abbreviated “Exim Banks” (e.g. the Export-Import Bank of the United States, Export-Import Bank of China, Exim Bank of South Africa, and so forth), are devoted to the emission of instruments that cover the financing needs of companies involved in international trade. 3. - Reasons for the recent trade finance shortages According to Marc Auboin and Nadia Rocha, both economists at the Economic Research and Statistic Division of the World Trade Organization, two would be the major reasons for shortages in the supply of trade finance instruments, namely potential market failures and cost of implementation of the Basel II rules.11 3.1 - Failure in the trade finance market Misinterpretations of commercial risks, always accompanying financial crises, are likely to trigger a phenomenon of “herd behavior” amongst private financial operators. This perception of commercial risk is correlated to the uncertainty provoked by changes in the creditworthiness of banks, country risk, prolonged exchange rates fluctuations, lack of transparency and adverse signals sent by credit rating agencies. In such cases, trade finance suppliers are reluctant to provide credit to banks showing signs of an unsound financial situation or to suffer excessive risk exposure by operating directly and under their own account in secondary markets, which has led, together with an                                                                                                                 10 CONTESSI S., and DE NICOLA F., “The Role of Financing International Trade During Good Times and Bad”. The Regional Economist, January 2012, pp. 8. 11 AUBOIN M. and ROCHA N., “Trade Finance: The Grease in The Wheels of Trade”. World Trade Organization, Economic Research and Statistic Division, March 2009, pp. 1-7.  
  9. 9.   8   aggravated insufficiency of liquidity in monetary markets and the reassessment of customer and country risks, to an escalate in prices and limited supply of trade finance instruments. The fact that the current financial crisis has led to more restrictive credit conditions along with a declining availability and increasing prices seems to be generally accepted amongst economists. Nevertheless, the impact of these worsened conditions in the access to trade finance instruments on the volume of trade flows remains difficult to assess given the scarcity of data, with no comprehensive statistics available, and the subjective component underlying lending decisions. 3.2. - Cost of implementation of the Basel II and Basel III frameworks The strict capital requirements enforced by the Basel II and III frameworks have difficult the access to trade credit during the ongoing financial crisis. This negative impact is especially intense in the case of developing countries, since these regulations require larger amounts of capital for activities bearing higher risk of default, typical operations taking place in these countries. The implementation of risk weights and the confusion between counterparty and country risks enforced in the Basel II rules have raised frictions for institutions willing to finance transactions involving parties in developing countries. Additionally, the Basel III rules impose the requirement of a 100% leverage ratio for letters of credit not reflected in balance sheet (extensively used in commercial operations in developing countries)12 . This has encouraged risk adverse trade credit suppliers to revise their exposure to such regulatory requirements and deviate finance flows to other safer projects for the sake of profitability. 4. - Causes for trade collapses: the compositional effect, trade finance and vertical fragmentation Hoda El-Ghazaly and Silvio Contessi propose an interesting identification of the causes underlying the “Great Trade Collapse”13 , trying to respond to the fact that despite trade finance has been proven a trigger of the trade collapse, its relative impact compared to other culprits still causes dissention. As we will see, not only deficits of trade finance, but also the interdependency of countries in terms of production and demand provoked a chain reaction with fatal consequences for international trade. 4.1. - Presumptive absence of impact from national protectionist Contrarily to the general assumption of trade protectionist measures raised by governments during recessionary periods, El-Ghazaly and Contessi defend that such                                                                                                                 12 AUBOIN M. and ENGEMANN M., “Trade Finance in Periods of Crisis: What Have We Learned in Recent Years?”. World Trade Organization, Economic Research and Statistics Division, January 2013, pp. 1-29 13 EL-GHAZALY H. and CONTESSI S., “The Trade Collapse: Lining Up the Suspects”. The Federal Reserve Bank of St. Louis, The Regional Economist, Vol. 18, No. 2, April 2010, pp. 10-11.
  10. 10.   9   measures virtually have not been implemented during the last trade collapse. The reason for this argument is that the World Trade Organization prohibits, controls and sanctions the application of any form of quantitative measures14 and restricts the application of tariffs in a discriminatory manner15 . Others, for instance Richard Baldwin and Simon Evenett16 , have identified an increase in protectionist measures in certain countries in an attempt to react to the crisis, yet have not found a remarkable impact of these measures on the collapse of trade. 4.2. - Circumstances identified as drivers of trade collapses Reductions on trade flows have been traditionally attributed to shrinking internal demand of imported final goods. Nonetheless, other additional reasons such as trade finance and vertical fragmentation of trade deserve equal attention. 4.2.1. - The Compositional effect The impact of decreases in demand of goods on international trade can be amplified when the degree of involvement in international trade is unequally distributed amongst industries. When consumers readjust their spending, the composition of the decrease in demand may affect in a more intense magnitude the decline in trade than the decline in GDP for the mere reason that the most affected industries may account for the biggest share of trade. This explains why during the last US recession the industries suffering the largest downturn in output accounted for the largest proportion of trade decline (e.g. industrial supplies, computers, automotive vehicles, engines and so forth). 4.2.2. - Trade finance shortages Trade finance ensures the soundness of the bulk of international trade flows and hence the deficit of trade credit has been one of the main contributions to the decrease in the number of transactions. Exporting companies count with lesser incentives to get involved in cross-border operations when the access to finance becomes limited or unaffordable, as has been proved by Tim Schmidt-Eisenlohr17 , who proved through data on bilateral trade volumes that trading partners undertake a more reduced number of transactions when trade finance costs are higher and also in negative correlation to the distance between the import and export countries as this increases the lapse between delivery and payment. It can also been observed that industries with a stronger dependence on external financing have suffered more intensely the scarcity of credit.                                                                                                                 14 Article XI.1 of the GATT 1947: “No prohibitions or restrictions other than duties, taxes or other charges, whether made effective through quotas, import or export licenses or other measures, shall be instituted or maintained by any contracting party on the importation of any product […]”. 15 Article III.1 of the GATT 1947: “[…] internal taxes and other internal charges […] should not be applied to imported or domestic products so as to afford protection to domestic production”; and Article 16 BALDWIN R. and EVENETT S., “The Collapse of Global Trade, Murky Protectionism, and the Crisis: Recommendations for the G-20”. The Graduate Institute of Geneva, Centre for Trade and Economic Integration, 2009. 17 SCHMIDT-EISENLOHR T., “Towards a Theory of Trade Finance”. University of Oxford, January 2012.
  11. 11.   10   4.2.3. - Worldwide vertical fragmentation of production Vertical fragmentation has been propagating during the last two decades alongside with the process of globalization. International shippers have developed economies of scale, based on the increasing volume of international trade flows that eventually have resulted in lower transport costs. Under this new cost structure, vertical fragmentation has spread value chains worldwide, and hence each step in the production process, from the source of raw material to the retail of finished goods to final customers, entail the performance of cross-border trade operations. Nowadays the largest share of international trade from and into industrialized countries is conformed of flows of productive assets and intermediate goods rather than final goods. As the authors note, in the case of the United States the relevance of vertical fragmentation is such that intermediate goods account for about three fourths of the total inbound and outbound, which can be understood if we consider, for instance, that the country is the biggest consumer of technological devices in the world (i.e. goods which are manufactured along supply chains with production stages deployed over different countries). In definitive, under this globalized production scheme a drop in the demand of final goods is likely to spark off a chain reaction with fatal consequences for the demand of intermediate goods downstream the value chain, and thus spread the effects of an economic slowdown to other countries in a more than proportional pattern. There is evidence pointing that the effects of the “Great Trade Collapse” have been more severe on industries making intensive use of intermediate goods. Even though not commented by the authors, it worth’s pointing out at the crucial role that trade finance plays throughout these globalized value chains, making feasible and sound the transmission of goods as they move downstream this globalized system upon which depends the bulk of the world’s economic activity. 5. - The hypothesis of the impact of trade finance shortages on trade collapses International trade shrunk by approximately 30% in relation to the world GDP between mid-2008 and early 2009. According to a research paper published by Jonathan Eaton, Samuel Kortum, Brent Neiman and John Romalis18 , the bulk of this decrease is associated with a loss in weight of tradables over the total cross-border demand in favor of durable manufactures, accounting the latter for some 65% of the decrease in manufactures trade. The combined effect of durable and non-durable goods is estimated to account for 80% of the decrease in international trade during the “Great Trade Collapse”.                                                                                                                 18 EATON J., KORTUM S., NEIMAN B., and ROMALIS J., “Trade and The Global Recession”. National Bureau of Economic Research, NBER Working Paper Series, Working Paper 16666, Cambridge, December 2009, pp. 3.
  12. 12.   11   The remaining 20% decrease in trade (or nearly 27% according to a survey carried out jointly by the IMF and the BAFT –see below in this paper–) would be explained, as many economists agree19 , by trade credit constraints as banking systems around the world emit signs of unsound financial situation and dispel global suppliers of trade finance from providing the demand of trade financing instruments. This eventually limited the accessibility of export companies to external finance, aggravating more intensely companies operating in sectors highly dependent on external capital. Source: ASMUNDSON et al., “Trade Finance in the 2008-09 Financial Crisis”. International Monetary Fund, Working Papers, January 2011. As we can observe in the graphic above, the contraction of trade flows during the peak of the “Great Trade Collapse” can be partially explained by the contraction of trade finance markets. This section is devoted to contrast evidence gathered by researchers in the U.S and Europe, both in favor and against the relevance of trade finance on the number of firms involved in international trade and the volume of trade flows. For the sake of intelligibility I will not reproduce the econometric models built and employed by the below-mentioned authors but rather distill the essence of their findings.                                                                                                                 19 e.g. BRICONGNE J.C., FONTAGNE L., GAULIER G., TAGLIONI D., and VICARD V., “Firms and The Global Crisis: The French Exports in The Turmoil”. European Central Bank, Working Paper Series, No.1245, September 2010.
  13. 13.   12   5.1. - The hypothesis of the impact of trade finance shortages on trade collapses The availability of trade finance instruments defines the likelihood of the involvement of companies in international trade operations. These may need external finance to cover, on the one side, fixed costs related to the start-up of export activities, while on the other side, marginal costs related to the export of each additional unit. Hence, from a logical standpoint it seems evident that the degree of accessibility to international trade finance exerts an influence over the number of exporters (i.e. extensive margin) and the magnitude of goods exported (i.e. intensive margin)20 . 5.1.1 - Research focused on developed economies Kalina Manova provides evidence in favor of the impact of accessibility to trade finance on the volume of trade flows on the grounds of two facts: dependence on external finance varies across industries and the cost and availability of external finance vary across countries21 . By analyzing the impact of equity markets liberalization cases occurred during the last decades in certain nations, the author proves that such processes boosted the volume of trade flows in a remarkable higher degree when it came to industries more dependent on external finance and to economies formerly counting with less active financial markets and higher costs due to restrictive trade policies. Another research, carried out by Kalina Manova jointly with Davin Chor, is devoted to demonstrate that worsening credit conditions were the mean whereby the financial crisis of 2008 affected trade flows and subsequently led to the Great Trade Collapse22 . Countries maintaining higher interbank interest rates, hence counting with limited access to credit, generated lower amounts of inbound trade flows to the U.S. during the peak of the crisis. Consequently, industries highly dependent on external finance showed more marked decreases on exports, as these were more responsive to the cost of external capital than those from sectors less dependent on credit. In definitive, interventionism through policies aimed to reduce the cost of external capital (e.g. altering interbank interest rates), potentially increase the accessibility of exporters to credit and therefore generate gains on the volume of trade flows. Crossing the Atlantic, it is possible to broaden our point of view through numerous research papers not limited to U.S.-focused data. For instance, Jean-Charles Bricongne, Lionel Fontagné et al., carried out a research focused on the effect of credit constraints on French exporting companies23 . According to their findings the overall impact of                                                                                                                 20 CONTESSI S., and DE NICOLA F., “The Role of Financing International Trade During Good Times and Bad”. The Regional Economist, January 2012, pp. 8. 21 MANOVA K., “Credit Constrains, Equity Market Liberalizations and International Trade. Journal of International Economics, Issue 76, 2008, pp. 33-47. 22 CHOR D., and MANOVA K., “Off The Cliff and Back? Credit Conditions and International Trade During The Global Financial Crisis”. Journal of International Economics, Issue 87, 2012, pp. 117-133. 23 BRICONGNE J.C., FONTAGNE L., GAULIER G., TAGLIONI D., and VICARD V., “Firms and The Global Crisis: The French Exports in The Turmoil”. European Central Bank, Working Paper Series, No.1245, September 2010.
  14. 14.   13   trade credit constraints remained limited in the case of France, given that the weight of exporting companies highly dependent on external finance instruments was modest compared to the whole spectrum of French companies involved in international trade. The authors remark that in the case of France, which is similar to the majority of developed countries, international trade is virtually limited to a small number of big multinational companies, while a large number of small competitors can afford to undertake cross-border trade operations on an irregular basis. As a matter of fact, in France the top 1% of companies involved in international trade account for 63% of the total national exports, whereas the 80% of low tier companies amount merely 3% of the total outbound trade. Nevertheless, the authors proved that the above-mentioned reduction by 20% on trade flows would have been driven by credit constraints affecting industries highly dependent on trade finance instruments. Amiti and Weinstein24 provide an example from the Pacific. These authors proved that in the case of financial crises affecting the Japanese economy during the 1990s the contraction of external trade was partially instigated by scarcity on the supply of trade finance, caused by the unsound health of the Japanese banking system, which accounted for nearly one third of the exports drop. These authors, hence, demonstrated causality between the health of the banking system and the volume of exports, which became more intense for those companies contracting with financially unsound banks. Industries highly dependent on international trade finance would be, according to various studies mentioned by Contessi and de Nicola25 , the pharmaceutical, plastics manufacturing and computer electronics industries. Contrarily, other industries show a limited dependency, as is the case of tobacco and pottery industries. 5.1.2. - Research focused on emerging and developing economies Focusing on data published by the World Bank comprising more than 5,000 exporting companies in 9 developing and emerging economies, Nicolas Berman and Jérôme Héricourt analyzed the effects of financial conditions on the intensity of export activities in such countries26 . Their findings point that the coverture of initial fixed and sunk costs required to access foreign markets are the key determinant for the likelihood of a company to perform export operations, and thus the degree of accessibility to trade finance focuses its influence on the initial decision of whether or not to serve markets abroad. Little impact bears, nevertheless, the financial situation of an exporting company on the decision of continuing operations once the entry decision has been made, given that any subsequent fixed cost required is considerably lower than the                                                                                                                 24 AMITI M., and WEINSTEIN D., “Exports and Financial Shocks”. National Bureau of Economic Research, NBER Working Paper Series, Cambridge, December 2009, pp. 2. 25  CONTESSI S., and DE NICOLA F., “The Role of Financing International Trade During Good Times and Bad”. The Regional Economist, January 2012, pp. 9.   26 BERMAN N., and HERICOURT J., “Financial Factors and the Margins of Trade: Evidence from Cross-Country Firm-Level Data”. Centre National de la Recherche Scientifique, Documents de Travail du Centre d’Economie de la Sorbonne, Paris, 2008.
  15. 15.   14   initial costs. The authors also proved that financial development impacts positively the likelihood of undertaking exporting activities, since the more financially developed is an economy the more productive will its local companies be and therefore the more these will export. 5.3. - Criticisms to the hypothesis of the impact of trade finance on trade collapses Against the hypothesis of the role of trade finance, we can mention Andrei A. Levchenko, Logan T. Lewis and Linda L. Tesar27 . These authors analyzed the econometrical correlation between the availability of financing instruments and variations on international trade through the contrast of data relative to imports and exports in U.S.’ industries characterized by an intensive use of trade credit. Whereas there is evidence that trade flows dropped more severely in the case of sectors depending more intensively on trade finance, the authors did not find clear evidence of more pronounced impacts on trade flows from countries suffering stronger credit contractions and state that even though cross-sector differences can be admitted the average impact would be nullified. Therefore, the authors conclude that the 2008 trade collapse would be explained by the compositional effect and vertical specialization, both analyzed above, assuming that the impact on trade derived exclusively from a decrease on economic activity. 6. - The impact attributable to credit shortages in the availability of trade finance: Evidence from the IMF and the BAFT A survey carried out by the International Monetary Fund (IMF) and the Bankers’ Association for Trade Finance (BAFT) in March 2009 and targeting 44 relevant banks from 23 countries, sheds light on the impact of worsening credit conditions on the availability of trade finance28 . This survey reveals that, in line with the situation in credit markets, the value of issued trade finance instruments decreased between October 2008 and January 2009 compared to the previous year-to-date, leaded by a pronounced decline of letters of credit. As we can see in the graphics below, the utmost decline has been caused by a dramatic drop in the value of letters of credit, by an average of 11% during the analyzed period, as 71% of the surveyed banks pointed to a decline in the value of this instrument. In contrast, instruments under the form of export credit insurance and short- term export working capital caused little impact, with average declines of 4% and 3% respectively.                                                                                                                 27 LEVCHENKO A., LEWIS L., and TESAR L., “ The Collapse of International Trade During the 2008- 2009 Crisis: In Search of The Smoking Gun”. National Bureau of Economic Research, NBER Working Paper Series, Working Paper 16006, Cambridge, May 2010, pp. 17-19. 28 INTERNATIONAL MONETARY FUND and BANKER’S ASSOCIATION FOR TRADE FINANCE, “IMF-BAFT Trade Finance Survey: A survey Among Banks Assessing the Current Trade Finance Environment”. FI metrix, March 2009.
  16. 16.   15   Source: “IMF-BAFT Trade Finance Survey: A survey Among Banks Assessing the Current Trade Finance Environment”, pp.3. Virtually all the world’s regions have experienced declines in the value of the issued trade finance instrument, yet differences in terms of intensity can be drawn: Eastern Europe experienced the highest average decline during the period, 13%, whereas Middle East and Magreb suffered a much limited 5% decrease. When it comes to industrialized countries as a whole, 9% is the decline suffered in average between October 2008 and January 2009. According to the surveyed institutions, the shrink in demand for imported goods would explain around 73% of the decrease in aggregated value of the offer of finance instruments, while the remaining 27% would be attributable to the scarce credit availability. When asked about the reasons for the decline in value of trade transactions, around 57% of these banks pointed at limited credit availability, both at their own institutions and at counterparty banks, 73% to the shrinking demand, and 11% to the economic slowdown or increased global risk. Last but not least, the survey exposes an increasing trend on the price of trade finance instruments, which would support the WTO economists Auboin and Rocha’s first thesis of failures in trade finance markets. The graphic below reflects that the ongoing financial crisis has, indeed, negatively affected the evolution of pricing conditions between 2008 and 2009: export credit insurance has doubled in price, followed by documentary credit as the second most affected group, while short and medium-term lending were issued at slightly lowered prices. Despite the price increase, only letters of credit experienced a remarkable reduction in issued value, as we have formerly discussed, while export credit insurance remains virtually unaffected during
  17. 17.   16   the analyzed period. The latter may probably stem from the increased perception of risk that has characterized the 2008 financial crisis. Source: “IMF-BAFT Trade Finance Survey: A survey Among Banks Assessing the Current Trade Finance Environment”, pp.8. Confirming Auboin and Rocha’s second thesis on the cost of implementation of the Basel II and Basel III rules, increased capital requirements have, as 58% of the respondents admit, impacted the price evolution between October 2008 and January 2009. Whether the implementation of the rules has undermined or improved the banking system’s ability to provide trade finance remains discussed: 33% of the institutions believe these rules exert a negative impact due to greater restrictions and cost of capital, while 27% state that these encourage a more selective offer of trade finance through the obligation of undertaking a more diligent and individualized risk analysis. As it has been also noticed by Auboin and Rocha, the survey demonstrates that the Basel II Rules have hardened the access to trade finance in developing countries as 83% of the banks claim the establishment of more cautious guidelines in the offer of instruments to certain countries and 60% perceived an increase in the probability of defaults, which point to country-related and default risks avoidance. 7. - Policy reactions and remaining challenges29 In response to the “Great Trade Collapse”, public and private institutions have undertaken different measures with the aim of mitigating the impact of the current financial crisis on the ability to offer trade finance instruments and of covering the gap between its supply and demand (which, as we know, is estimated between $200 and                                                                                                                 29 Based on AUBOIN M. and ENGEMANN M., “Trade Finance in Periods of Crisis: What Have We Learned in Recent Years?”. World Trade Organization, Economic Research and Statistics Division, January 2013, pp. 1-29
  18. 18.   17   $300 billion and related to the liquidity deficiency in monetary markets). Most of the improvements in this field have been encouraged by the partnership between the International Monetary Fund (IMF) and the World Trade Organization (WTO) as their work is complementary given that a sound financial system is needed to ensure the consistent flow international trade while this latter contributes to reduce the risk of payment imbalances and financial crisis. A major issue during the trade collapse was the absence of comprehensive international trade finance statistics, pointing to difficulties of the statistical system to record short-term capital flows which, as we have previously noticed, account for 80% of trade credit. As a consequence balance of payments and trans-national banking statistics have been seriously undermined. The WTO has reacted to this drawback by promoting the construction of survey-based data sourced from professionals in the field of trade finance, yet this measure, even being practical in a period requiring quick responsiveness, cannot provide the level of detail required for sound decision-making and that comprehensive statistics can provide. Consequently, the WTO, the IMF, the BAFT, the ICC and the SWIFT are working together to consolidate the gathered data in a single publication which is intended to yield a sound statistic database in the future. The main advancement, nonetheless, concerns the gathering of all the stakeholders when designing and implementing measures to avoid trade finance gaps affecting global and regional trade flows: on the one side, a contact group is formed of export credit agencies, banks, multilateral and development agencies; on the other hand the WTO and the World Bank have worked together to ensure the support of the G-20. This has resulted in a trade finance initiative, designed at the G-20 summit in London (2009), aimed at flexibly identify any stakeholder affected along the trade credit supply chain and respond to its needs with the ultimate goal of mitigating risk that can be eventually misinterpreted and lead to market failures. To provide those needs, the G-20 approved a trade finance package ensuring the availability of a $250 billion pool to support trade finance in a 2-year period and providing guarantee instruments that can be supplied by export credit and multilateral agencies to cover political and commercial risks, which has proved to be effective and responsive in recovering balance in trade finance markets. Additionally, a working group has been established with the aim of monitoring the implementation of the London trade finance initiative through data on commitment and utilization rates (i.e. through this data we can observe that the average utilization reduced to 40% in the second half of 2009 compared to 68% in the first half of 2009, pointing at the progressive recovery of trade finance markets). Despite the relative success of the measures implemented at the G-20 level, the structural financial drawbacks affecting developing countries, namely amongst others the gap between perceived and actual risk and the stringent requirements enforced under the Basel II and III frameworks, remain unaddressed in line with the absence of long- term public commitment and scarce support to multilateral development institutions.
  19. 19.   18   V. SUMMARY OF THE LITERATURE REVIEW, CONCLUSIONS AND RESEARCH GAPS The recent financial crisis has severely impacted the volume of international trade flows through, inter alia, the channel of trade finance markets. Other mechanisms contributing to the spread and intensification of the “Great Trade Collapse” are identified by the academia as the compositional effect of demand of imported goods, the vertical fragmentation of value chains fueled by the process of economic globalization, and protectionist measures that arise overlooking the WTO agreements, yet the latter remaining discussed. Empirical evidence collected and analyzed with occasion of the “Great Trade Collapse” supports the hypothesis of the impact of accessibility to international trade instruments on the number of exporters (extensive margin) and the magnitude of international trade flows (intensive margin), which intensifies in the case of industries highly dependent on external financial sources. From the side of the offer of trade finance instruments, financial institutions have faced a more difficult scenario driven by a deficit of liquidity, the misinterpretation of risk, whereas from the side of the demand of such instruments, exporters are discouraged by higher prices and a more selective criteria applied for the concession of credit. Moreover, the conditions imposed by the Basel II and Basel III frameworks raise further barriers to the access to trade finance, especially when partners from developing countries are involved as higher capital requirements are requested along with increasing risk. More discussed is the relative weight of trade finance on the decline in trade flows occurred during the 2008-2009 period. Generally speaking, most of the economists agree that, despite the biggest bulk (between 70 and 80%) should be accounted to the shrinking demand of imported goods, a considerable share of such decrease can be allocated to frictions in the offer of trade finance (between 20 and 30%). The conclusions reached by the different authors mentioned can be summarized as follows: - Improvements in the availability of trade finance instruments are likely to increase the volume of trade flows, especially when it comes to industries highly dependent on external finance (Manova, 2008). - Higher interbank interest rates and in general worse conditions to obtain access to trade finance are likely to negatively impact the volume of trade flows, especially within sectors more responsive to the cost of trade finance. Policies aimed at relaxing such stringent conditions potentially stimulate trade flows (Manova and Chor, 2012). - Concentration of trading capacity in the hands of a few top tier competitors (i.e. multinationals), as it is common in most developed countries, reduces the dependency on trade finance and thus the impact of worsening conditions (Bricongne et al., 2010). - In the case of developing countries, the accessibility to trade finance is crucial for the initial decision of setting up export operations, as higher fixed and sunk costs must be undertaken to access a new market, whereas once a company has already started cross-border operations its financial situation bears little impact as additional fixed costs
  20. 20.   19   are considerably lower. Furthermore, financial development impacts positively the volume of trade flows through increased productivity (Berman and Héricourt, 2008). - Against the hypothesis of this impact, some authors have argued that no evidence of correlation between stronger credit contractions and variations of international trade can be drawn, as the average impact would be nullified and the causality would be more clearly explained by the compositional effect (Levchenko et al. 2009). Some authors, therefore, have challenged the hypothesis of the impact of trade finance shortages on the decline international trade. With this aim econometric models have been used to prove the absence of correlation between both phenomena. Leaving aside potential drawbacks of such analysis (i.e. absence of a reliable statistical database on trade finance), the most comprehensive information up to date, that is to say the data released by the IMF, the WTO and the BAFT, shows that up to 27% of the trade collapse has been potentially caused by the shortage of trade finance. Regardless the higher weight of the impact stemmed from demand composition, the share attributable to trade finance is not negligible, and especially considering that 90% of world’s trade relies in such instruments. Therefore, policies aimed at the alleviation of financial conditions potentially contribute to ensure the smooth, reliable and predictable flow of trade during financial crisis. VI. RECOMMENDATIONS FOR FUTURE RESEARCH Research on the role of trade finance should be resumed as more comprehensive and reliable statistics becomes available. This would help to definitely shed light on the diverging findings the academics have reached through the analysis of macroeconomic data that, due to its incompleteness, can lead to biased conclusions that underestimate the role of trade finance. Additionally, a vast majority of the research papers published on the topic are flawed by an exclusively US-centric focus and thorough analysis of the ASEAN, MERCOSUR and EU economies remain scarce. Hence more accurate research scoping the whole picture of global trade and other regions would be beneficial to policy-makers elsewhere in the world. To conclude, my last recommendation would concern the research on the current ability of developing countries to access the international trade system, complementing the findings and proposals reached at the WTO, IMF and World Bank level, especially when it comes to the reformulation of the Basel II and III frameworks. Remaining liquidity issues in monetary markets of several developing countries show how the liberalization of financial markets, when not accompanied by further development of the financial system, does not by itself guarantee the access to trade credit and mitigate the perception of counterparty risk. The impact of the phenomena of “South to South cooperation” on economic development and trade in developing countries is also a relevant issue pending investigation.
  21. 21.   20   REFERENCES - AMITI M., and WEINSTEIN D., “Exports and Financial Shocks”. National Bureau of Economic Research, NBER Working Paper Series, Cambridge, December 2009. - AUBOIN M. and ENGEMANN M., “Trade Finance in Periods of Crisis: What Have We Learned in Recent Years?”. World Trade Organization, Economic Research and Statistics Division, January 2013. - AUBOIN M. and ROCHA N., “Trade Finance: The Grease in The Wheels of Trade”. World Trade Organization, Economic Research and Statistic Division, March 2009. - BALDWIN R. and EVENETT S., “The Collapse of Global Trade, Murky Protectionism, and the Crisis: Recommendations for the G-20”. The Graduate Institute of Geneva, Centre for Trade and Economic Integration, 2009. - BERMAN N., and HERICOURT J., “Financial Factors and the Margins of Trade: Evidence from Cross-Country Firm-Level Data”. Centre National de la Recherche Scientifique, Documents de Travail du Centre d’Economie de la Sorbonne, Paris, 2008. - BRICONGNE J.C., FONTAGNE L., GAULIER G., TAGLIONI D., and VICARD V., “Firms and The Global Crisis: The French Exports in The Turmoil”. European Central Bank, Working Paper Series, No.1245, September 2010. - CHOR D., and MANOVA K., “Off The Cliff and Back? Credit Conditions and International Trade During The Global Financial Crisis”. Journal of International Economics, Issue 87, 2012. - CONTESSI S., and DE NICOLA F., “The Role of Financing International Trade During Good Times and Bad”. The Regional Economist, January 2012. - DAVID P., and STEWART R., “International Logistics: The Management of International Trade Operations”. Cengage Learning, Third Edition, 2010. - EATON J., KORTUM S., NEIMAN B., and ROMALIS J., “Trade and The Global Recession”. National Bureau of Economic Research, NBER Working Paper Series, Working Paper 16666, Cambridge, December 2009. - EL-GHAZALY H. and CONTESSI S., “The Trade Collapse: Lining Up the Suspects”. Federal Reserve Bank of St. Louis, The Regional Economist, Vol. 18, No. 2, April 2010. - INTERNATIONAL MONETARY FUND and BANKER’S ASSOCIATION FOR TRADE FINANCE, “IMF-BAFT Trade Finance Survey: A survey Among Banks Assessing the Current Trade Finance Environment”. FI metrix, March 2009. - LEVCHENKO A., LEWIS L., and TESAR L., “ The Collapse of International Trade During the 2008-2009 Crisis: In Search of The Smoking Gun”. National Bureau of Economic Research, NBER Working Paper Series, Working Paper 16006, Cambridge, May 2010. - MANOVA K., “Credit Constrains, Equity Market Liberalizations and International Trade. Journal of International Economics, Issue 76, 2008. - MCKINNON R.I., et al., “Collapse in World Trade: a Symposium of views”. The Magazine of International Economic Policy, Washington D.C. Spring 2009. - SCHMIDT-EISENLOHR T., “Towards a Theory of Trade Finance”. University of Oxford, January 2012. - WORLD TRADE ORGANISATION, “Trade Finance and the WTO”. WTO E-Learning, March 2013.

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