The interconnectedness of the global economy means that the effects of geopolitical and macroeconomic events are evermore widespread. At Demica, we keep a close eye on how the market reacts to these events to uncover the potential implications for trade and supply chain finance.
To understand what may lie in store, given the turbulent economic environment, we have looked at how trade finance fared during recent major economic downturns: the Global Financial Crisis of 2008-2009 and the COVID-19 Pandemic, and what considerations we can apply today.
2021: A bountiful year for Trade Finance
World trade values have nearly trebled over the course of the last 75 years [WTO] and the value of global trade reached a record level of $28.5 trillion [UNCTAD] in 2021 (up 25% from 2020 [UNCTAD]).
This positive trend in international trade throughout 2021 was largely due to abating pandemic constraints, a robust recovery in demand due to economic stimulus packages, and higher commodity prices.
The record level of trade was a boon for the world’s banks. It translated into a consolidated revenue from trade finance operations of $6.3 billion [S&P Global Market Intelligence] for the world’s 10 largest transaction banks[*], up c.11% from 2020, and exceeding pre-pandemic levels. In the second half of 2021 alone, trade finance revenues for this group grew by 13% year on year, as reported by S&P Global Market Intelligence.
[*] Bank of America Corp., Barclays PLC, BNP Paribas SA, Citigroup Inc., Deutsche Bank AG, HSBC Holdings PLC, JPMorgan Chase & Co., Société Générale SA, Standard Chartered PLC, and Wells Fargo & Co.
2022: Looming recession?
Looking at the current year, it is evident that banks and businesses must navigate a myriad of complex challenges. World trade growth is expected to decelerate in 2022, affected by slower than expected economic growth. Some of the main contributing factors include the withdrawal of fiscal and monetary policies, supply chain disruptions such as lockdowns in China, and reduced household purchasing power. According to the International Monetary Fund’s World Economic Outlook Update July 2022, the baseline forecast is for world GDP growth to slow from 6.1 percent last year to 3.2 percent in 2022 and 2.9 percent in 2023.
Recession fears have stirred global markets, and as Russia’s prolonged invasion of Ukraine sent commodity prices up earlier in the year, central banks, including the European Central Bank and the U.S. Federal Reserve, have reacted by increasing rates in efforts to curb inflation. Whereas 2020 saw panic rate cuts, two years down the line the world is witnessing panic rate hikes, hoping to tame the high levels of persistent inflation.
It is increasingly likely that many countries will enter a recession despite their best efforts to cool inflation without sacrificing growth. As corporate earnings are squeezed, there are likely to be widespread cost-cutting initiatives, redundancies, and delays in capital expenditures, with all of this ultimately lowering consumer confidence. At this point in same time, both the US and UK economies have entered a technical recession by shrinking for a second-straight quarter.
Despite these challenges, some remain optimistic. JP Morgan’s Jamie Dimon and Morgan Stanley’s James Gorman both recently expressed positive sentiments. “The consumer right now is in great shape, so even if we go into a recession, they’re entering that recession with less leverage and in far better shape than they did in 2008 and 2009. And jobs are plentiful” said Dimon [Bloomberg].
“The consumer right now is in great shape, so even if we go into a recession, they’re entering that recession with less leverage and in far better shape than they did in 2008 and 2009. And jobs are plentiful”
Jamie Dimon, JP Morgan
Another sign that may add some relief can be found in data around corporate debt. According to S&P Market Intelligence, both non-investment grade and investment grade corporates in the US boosted their cash positions on the onset of the pandemic, benefitting from low interest rates and extensive liquidity in the credit markets, provided by quantitative easing programmes. Low levels of maturing debt in the near-term mean that companies should be somewhat protected from the consequences of sharply rising borrowing costs. This is supported by the exceptionally weak volumes of US corporate debt issuance seen in 2022, in pace to be the lowest since 2008. Fitch Ratings reports a drop of 78% for high-yield bond issuance in H1 2022 compared to H1 2021.
Nevertheless, as big banks unveiled second quarter earnings it is evident that they are increasing provisions for credit losses for the first time since the pandemic.
World Trade and Supply Chain Finance During Major Economic Downturns
Trade Finance involves a wide spectrum of lending structures and is generally considered a low-risk asset class given its short-term maturity, self-liquidating nature, low market correlation, and historically low default rates. According to the World Trade Organization, Trade Finance is the backbone of international trade for businesses of all sizes, and c.80-90% of the world trade depends on it [WTO], along with relevant insurance and guarantees. Historically, world trade typically tends to drop more than GDP in periods of recession, and bounces back quickly as depicted below. [Economics Observatory]
While looking back at world trade and trade finance behaviour during the latest major economic downturns may offer certain insights, it is worth noting that the current environment and the ones surrounding the global financial crisis of 2008-2009 and the COVID-19 pandemic are fundamentally different. In the Great Recession, irresponsible lending led to unparalleled numbers of loan defaults and the failure of many undercapitalised financial institutions, on the other hand, the COVID-19 pandemic and its shutdown measures caused the global economy to temporarily plunge into the worst recession since World War II.
Trade & supply chain finance during the global financial crisis (GFC) of 2008-2009
According to the European Central Bank, a stunning aspect of the GFC was the highly synchronised collapse in world trade throughout countries. Between Q3 2008 and Q2 2009, world trade volumes plummeted roughly 15%, much more sharply than world GDP, which sank c.2% during the same period.
Market share of Trade Finance arrangements at the time are believed to have been dominated by open account trade and bank-intermediated trade finance. Evidence collected from the role of Trade Finance during the 2008-09 trade collapse, published in the World Bank’s Economic Premise No.66, suggests that the share of world trade supported by bank-intermediated trade finance appears to have increased during the crisis.
It’s also worth noting that in 2009, world leaders and multilateral development banks acted decisively to kickstart international trade. During the 2009 London Summit, the G20 leaders agreed a $250 billion trade finance deal in the form of guarantees and insurance to support trade flows over the next two years. On the other hand, multilateral development banks responded to the decline in Trade Finance by significantly enhancing existing or creating new Trade Finance Facilitation Programmes.
A bumpy ride: COVID-19 & the impact on supply chain finance
The impact of COVID-19 on world trade was sudden and substantial. Even prior to 2020, global trade had been losing momentum, but the pandemic slowed it to a crawl. According to the International Finance Corporation:
“In line with early predictions, global trade volume fell dramatically in 2020, exceeding even the decline observed during the 2008-2009 global financial crisis. The primary drivers of the trade slump are the effects of virus containment efforts on both global demand and supply, as countries have found both their capacity to produce goods and to export them curtailed during the pandemic.”
the International Finance Corporation
When the International Chamber of Commerce (ICC) assessed the impact of the Covid-19 crisis they identified that different trades and economies have been differently affected by the pandemic and are recovering at different rates.
In 2020, as demand for goods and commodities grew with consumers remaining in their homes, capacity constraints and shipping congestion saw rising shipping prices with longer lead times. The inter-dependence of global economies on each other for seamless cross-border trade was highlighted by the stressors of the pandemic. This resulted in increased discussion around the potential to relocate strategic activities, such as moving production sites or procuring strategic materials and inventory from regional players as opposed to more distant locations, which would help to lower the reliance on global shipping. The cost of doing so, however, is significant, and many companies are looking into alternative ways of increasing their global supply chain resilience before embarking on more capex-intensive projects such as moving their production sites.
2020 saw a decrease in demand for short-term trade finance, as both trade loans and import letters of credit, decreased in demand by 23% and 29%, respectively, according to the ICC. Since then, demand appears to be rising again.
Demica’s Benchmark Report for Banks in Trade Finance shows that banks have seen a marked increase in demand for working capital solutions as seen below on reported asset growth.
Despite drastic changes in market conditions, trade finance remained a relatively low-risk asset class for funders during recent major economic downturns as evidenced by default rates. The default rate of short-term trade finance[*] as a percentage of total exposure reached 0.3% in 2020 compared with over 6% for global non-performing loans.
[*] Short-term trade finance products on these metrics include payables finance, financial guarantees, import letters of credit, export letters of credit, loans for import/export, performance guarantees.
Conclusion
Recent events have shone a spotlight on the weaknesses in global supply chains, consequently, businesses are embarking on strategic projects to improve their resilience. As trade growth decelerates and normalises in 2022, it is being met with predictions of an increasingly likely recession in the short term across multiple economies. Given the expected economic turbulence, here are a few key considerations for corporates and banks, based on the learnings from recent economic downturns.
Considerations for corporates:
Previous recessions have provided tough lessons on working capital management, a key metric that is firmly related to supply chain efficiency. Optimising working capital by shortening the cash conversion cycle increases liquidity and should be a key priority for CFO’s and treasurers, especially in the wake of deteriorating economic conditions where interest rate hikes are placing additional pressure. Optimised working capital and cash flow will enable companies not only to meet current liabilities but to seize potential opportunities that can occur while most other businesses may be struggling.
Demica enables large companies to improve their cash conversion cycle by using supply chain finance programmes. Our structuring, product and distribution experts design tailored financing solutions, giving you access to a wide network of funders. Once funding is lined up and project scope is defined, our implementation and project management teams take the weight off your treasury team to deliver projects on time and within budget.
Considerations for banks:
History tells us that trade finance remains a relatively low-risk asset class for funders, mainly due to its short-term maturity, self-liquidating nature, low market correlation, and historically low default rates. This has been confirmed during the recent major economic downturns where the share of world trade supported by bank-intermediated trade finance appears to have increased. Demica’s Benchmark Finance Report for 2022 shows that banks are already expecting a marked increase in demand for working capital solutions evidenced by reported asset growth for the next twelve months.
With many banks around the world still reliant on inflexible legacy technology and heavy spreadsheets, the Demica Platform is supporting the transformation of banks’ supply chain finance programmes. Continuous product development over 20 years, in partnership with global banks, has given the Platform market-leading functionality for trade finance structures. Our intuitive, cloud-based technology allows banks to host transactions with Demica and automate as much of their programme as suits them, safely and efficiently. Set automatic limits and margins with eligibility criteria, customise supplier onboarding for different territories and currencies, and white label the platform to maintain consistently strong customer relationships at every stage of the customer journey.
Demica’s 2022 Benchmark Report for Banks in Trade Finance
What’s in a name? Why the definition of supply chain finance matters
