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Fostering Development Through Trade Finance

Fostering Development Through Trade Finance
Photo credit: AfDB

18 Jun 2015

Trade finance in support of Africa’s development

“We need to ensure that Africa is not left out of mainstream trade markets because of a lack of trade finance.” – Donald Kaberuka, President of the African Development Bank

Trade is a fundamental driver of economic development. Nowhere is this more relevant today than in Africa, which has the world’s highest proportion of low income countries and accounts for only 3.3 per cent of global trade. Because of the lack of affordable trade finance, Africa has not been able to take full advantage of new opportunities offered by the changing global economic landscape.

Following the financial crisis of 2008-09, global trade dipped due to falling demand and a lack of liquidity in the international financial system. The global economy has now rebounded and liquidity levels improved but the African continent is still involved in far too little International trade.

Africa trade AfDB 2015The financial crisis precipitated enormous shifts in the direction and balance of trade around the world. Africa found that new markets in Asia, to some extent, offset declines in Europe and North America. However, the continent’s exporters are yet to fully exploit emerging opportunities in neighbouring countries.

Africa and world trade

Export growth in most African economies plus a rebalancing of the global economy, are changing the face of African trade. Low levels of growth, high unemployment and economic uncertainty persist across the European Union, while other developed markets have struggled to return to their pre-crisis highs.

The relative decline of Africa’s traditional export partners in the industrialised world has been speeded up by continued strong growth in much of Asia. This has fostered rapidly rising trade volumes between Asia and Africa, plus much greater Asian investment in Africa.

The value of Sino-African trade grew by an average rate of 14% a year between 2000 and 2012, while Indian, Malaysian, Singaporean and Thai companies are also making major investments. New sources of new trade are not restricted to the Far East, as Brazilian and Turkish companies are becoming much more heavily involved in the continent.

Africa merchandise exports by region AfDB 2015

Perhaps more importantly, buoyed by internal dynamics – its urbanising, growing population and improving political stability – Africa itself is becoming a driver of economic growth. However, many African countries have not fully capitalised on their neighbours’ growth. While trade with Asian markets has increased rapidly, intra-African trade remains a relatively small proportion of total African trade – around 13.5 per cent according to WTO figures.

For years intra-African trade has been constrained by the historical configuration of infrastructure, by the political hangovers of the Cold War era and by the failure of many African economies to move from primary commodity production to manufacturing, and in particular to the manufacturing of products tailored for African markets.

These factors, in addition to the relatively easy money to be made in supporting primary exports to existing markets, have contributed to a lack of investment in mechanisms – both physical and financial – for intra-African trade.

Stronger intra-African trade could act as a catalyst for growth. While Africa’s exports are 80% raw commodities and 20% processed goods, intra-African trade accounts for 40% of the former and 60% of the latter. International trade was at the heart of the economic boom in Asia, driving the creation of productive employment, in particular in manufactured goods, as developed markets took advantage first of labour arbitrage and then of the increasing sophistication of the production capacity in Asia. Larger numbers of higher quality jobs moved millions of South Korean and Chinese people out of poverty.

Trade finance in global trade

If the role of development financiers is to deploy resources where both the need and potential impact is greatest, the financial crisis and ensuing economic downturn around the world created whole new areas for them to intervene in. One of these was the sudden requirement to put money into the global system of trade.

Multilateral Development Banks (MDBs) have been working to fill the gaps in trade for many years. Trade finance is a commercially viable business as long as the risks for commercial banks are managed and mitigated. MDBs, with their strong financial backing and credit ratings, are able to create facilities that can de-risk transactions for commercial banks and help to promote trade.

The European Bank for Reconstruction and Development began its Trade Facilitation Programme in 1999 in order to promote foreign trade in its countries of operation in Eastern Europe, the Middle East and the Mediterranean. The success of the model has been adopted by other international financial institutions, including the Asian Development Bank and Inter-American Development Bank. Development institutions also reacted to the drop in trade resulting from the global financial crisis by supporting trade finance through the Global Trade Liquidity Programme among other initiatives.

For development finance institutions, there are clear benefits to supporting trade finance. Low income countries and fragile states, which are considered high risk by commercial banks, are often the first to suffer in times of tightening credit supply. This is equally true of small enterprises in developing markets. Small businesses are very often the largest source of employment and job growth, and supporting their success has immediate and obvious development outcomes.

Global commercial banks are often reluctant to support trade in developing countries because of perceived high levels of risk, relatively weak banking systems and limited transaction data. The Basel II directive increased the amount of information required by regulators, creating greater caution among international banks.

The liquidity, capital and leverage requirements of Basel III could have an even greater impact. Like its predecessor, Basel III is designed to encourage banks to incorporate trade finance into their leverage calculations, by factoring in short-term contingent liabilities relating to trade finance. This could push banks with capital constraints out of the market. Limited support from international banks for African trade finance means that African banks must take the lead.

Trade finance default rates are higher in Africa than in the rest of the world, averaging 4% in comparison with a global average of less than 1%. This varies from an average of 1.1% in Southern Africa to 6.3% in West Africa. There is an obvious correlation between stability and access to trade finance. However, trade finance default rates are significantly lower than banks’ overall non-performing loans ratio. Average default rates for all assets are 4% in Southern Africa, ranging up to 12% in West Africa. Commercial African banks already generate 17% of their earnings from trade finance and only one out of every 14 African banks is yet to enter the trade finance market revealing substantial appetite for the sector. A report by the AfDB in December 2014 revealed that 72% of responding African banks expect to increase their trade finance activities in the immediate future but there are still many obstacles to overcome. These include low US dollar liquidity, regulation compliance, slow economic growth, and the inability to assess the credit-worthiness of potential borrowers. The requirement of confirmation of letters of credit (LCs) remains a major challenge for African banks as virtually all LCs issued by banks on the continent require confirmation when the counterparty is located outside the region. Given the limits on risk headroom by confirming banks for African issuing banks, a large number of the latter are highly constrained in providing needed trade finance.

Given these obstacles, governments and development finance institutions (DFIs) must continue to play a big role. In particular, trade facilitation programmes that address US dollar liquidity and relax constraints from binding risk are needed to meet the increasing demand of African firms for trade finance. Given this reality, the AfDB’s trade finance programme - backed by the AfDB’s AAA credit rating - is a welcome addition to on-going trade facilitation programmes instituted by a number of DFIs. An estimated US$340 billion – or a third of all African trade – is backed by bank-intermediated trade finance, although this proportion is higher in North Africa than in the rest of the continent. Just 18% of this US$340 billion comprises intra-African trade, although this a relatively high proportion in comparison with the contribution of trade between African countries to total trade flows on the continent. Intra-African trade accounts for 11% of the total value of African trade, equivalent to US$110 billion.

A great deal of the demand for trade finance comes from labour intensive industries, such as agriculture and agribusiness. Interventions in these sectors, which in African countries are typically the largest employers and contributors to GDP, are broad-based.

Trade finance AfDB 2015

Source African Development Bank
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Date 18 Jun 2015
 
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