The role of bank guarantees in international trade

The role of bank guarantees in international trade

Tim Schmidt-Eisenlohr, Friederike Niepmann

To reduce the chance of international commerce banks offer specific trade finance products, the most prominent being letters of credit. This column employs US banking data showing that reductions in the way to obtain such trade finance have considerable effects on the levels and patterns of exports, especially to small and poor countries and during times of financial distress.

International trade is a risky activity – importers might not pay after receiving the products and exporters might not deliver if they’re paid in advance. To lessen the chance of international commerce, banks offer specific trade finance products, the most prominent being letters of credit (LCs). Recently, policymakers have grown to be increasingly concerned that there can be a shortfall in the way to obtain trade finance. On the main one hand, they worry that banks may stop issuing and confirming LCs during times of financial distress.[1] Alternatively, they perceive a systematic insufficient trade finance in small and riskier destinations.[2] These concerns have resulted in a couple of actions. For instance, the G20 decided to increase its support of trade finance by $250 billion over an interval of two years amid the 2008/2009 financial meltdown. Many development banks run large trade finance program today; the International Finance Corporation, part of the World Bank Group supports the confirmation of LCs with about $5 billion each year with a particular concentrate on minimal developed countries.

Regardless of the large policy interest, little is well known about the relevance of LCs and similar trade guarantees for exporting, due mainly to too little data. Academic research has shed some light on the hyperlink between finance and trade recently but with a concentrate on general bank links and the role of credit for exporting firms. Amiti and Weinstein (2011), for instance, showed that, in Japan, firms associated with under-performing banks reduced their exports.[3] The consequences of reductions in the way to obtain trade-specific financial products, such as for example LCs, which usually do not mainly address firms’ financing needs but lower the chance of international transactions, have not been investigated.

Figure 1 illustrates how an LC works. A bank in the importing country issues an LC and sends it to the exporter. With the LC, the lender commits to paying the exporter if he presents a couple of documents, like the invoice, a certificate of origin and transport documents. Because there remains the chance that the issuing bank won’t pay ultimately, a bank in the exporter’s country typically confirms the LC and thereby underwrites the payment. Thus, an LC represents a warranty of payment for the exporter. Concurrently, the LC escalates the importer’s incentives to pay since he only obtains the documents from his bank right after paying, which he must fully employ the products. Moreover, the importer sometimes must deposit cash along with his bank or provide collateral to get the LC.

Figure 1 . What sort of letter of credit works

While letters of credit aren’t common in domestic transactions, they certainly are a key tool in international trade.[4] According to data from SWIFT (the Society for Worldwide Interbank Financial Telecommunication), about 9 percent of U.S exports are settled with letters of credit. Firms will utilize this instrument when trading with risky destinations. While LCs are barely utilized by U.S. firms that ship to Canada, Mexico or Germany, for instance, thirty percent of U.S. exports to China employ letters of credit. Other destinations that LCs are central include Korea, Turkey, Pakistan and India.

If trading partners usually do not use a letter of credit, they have other options. The exporter can ask to stay the transaction on cash-in-advance terms, which means that the importer will pay for the goods prior to the exporter produces and delivers; the truth is, this is difficult as the importer may not have the money to pre-finance the purchase or he might doubt that the exporter will deliver the products ultimately. Alternatively, firms can trade on an open account, in which particular case the exporter delivers the products and the importer pays after receiving them. Selling on an open account is common however the exporter might need to bear a lot of risk. He can transfer the chance to an authorized by buying trade credit insurance. However, trade credit insurance is often too costly or unavailable for risky destinations. This discussion underlines that letters of credit represent a distinctive instrument to reduce the chance of a global transaction that cannot easily be substituted for. If firms cannot obtain LCs, they could trade less or not trade at all.[5]

In a recently available paper (Niepmann and Schmidt-Eisenlohr 2013) we exploit a distinctive dataset from the Federal Reserve Board to analyse the role of letters of credit for all of us exports. The dataset has information on the trade finance activities of most large US banks from 1997 to 2012. Predicated on these data, we construct a way of measuring the way to obtain trade guarantees by US banks for various export destinations and test if this measure predicts US exports.

Our empirical analysis follows a two-step estimation procedure.[6] First, we estimate by just how much each bank in the sample changed its way to obtain trade guarantees from quarter to quarter. In another step, we exploit the actual fact that banks specialise in the provision of LCs for different countries. If a bank reduces its way to obtain LCs overall, this will affect exports to countries more where the bank requires a larger share of the trade finance market. By weighing and summing the bank-level supply changes over-all banks that serve a US export destination, we get yourself a country-level way of measuring the way to obtain LCs.

Our analysis reveals that changes in way to obtain letters of credit by US banks have a causal influence on US export growth. If the way to obtain LCs to a destination declines by 17% (one standard deviation) from the prior quarter, US exports compared to that country fall typically by 1.5%. Effects double in times of financial distress and so are stronger for exports to small and poor countries. Throughout a crisis episode, the same decline in LC supply reduces US exports to small and poor countries by 5.8 percentage points. That is probably because firms are less ready to trade lacking any LC when shipping to risky destinations so when uncertainty throughout the market is high. Concurrently, firms could find it harder to acquire an LC from other banks when their house bank does not supply the service; these could be less willing to undertake additional risks and could have a harder time refinancing letters of credit on capital markets.

The trade finance business is highly concentrated. In 2012, the very best 5 banks held a lot more than 90% of most trade finance claims in america. Several counterfactual experiments illustrate the implications of the extreme market concentration. If a big US bank reduced it way to obtain trade finance by 42.6% (that is a large change however, not the largest seen in our data), aggregate US exports would decline by up to at least one 1.4 percentage points.

Table 1 shows what would happen around exports to different world regions if two different US banks cut their way to obtain trade finance to the same degree. The example is founded on the actual distribution of market shares in the trade finance data. A decrease in the way to obtain LCs by Bank A would reduce exports to Sub-Saharan Africa by 2.86%. The same cut in supply by Bank B could have a much smaller influence on this region but US exports to South Asia will be a lot more affected. This demonstrates individual banks usually do not only matter for the amount of trade also for trade patterns.

Table 1 . Letter of credit supply shocks of two large US banks

Researchers remain debating the factors that caused the fantastic Trade Collapse in 2008/2009. Our research shows that trade finance had a non-negligible effect. While trade finance was most likely not of first-order importance for trade between large and developed countries, firms were substantially constrained within their exports to poorer and smaller countries because of too little trade finance. Thus, through trade finance, financial distress may have spilled to countries which were at the periphery of the original financial turmoil. In light of the findings, the focus of development banks on small, poor and risky destinations and the general public provision of trade finance during times of financial distress seem reasonable.

Ahn, JaeBin (2013), “Estimating the Direct Impact of Bank Liquidity Shocks on the true Economy: Evidence from Letter-of-Credit Import Transactions in Colombia”, mimeo.

Amiti, Mary and David E. Weinstein (2011), “Exports and Financial Shocks,” The Quarterly Journal of Economics, 126 (4), 1841-1877.

Amiti, Mary and David E. Weinstein (2013), “JUST HOW MUCH do Bank Shocks Affect Investment? Evidence from Matched Bank-Firm Loan Data,”Working Paper 18890, National Bureau of Economic Research March.

Antràs, Pol and Fritz Foley, “Poultry in Motion: A REPORT of International Trade Finance Practices,” Journal of Political Economy, forthcoming.

Greenstone, Michael and Alexandre Mas (2012), “Do Credit Market Shocks affect the true Economy? Quasi-Experimental Evidence from the fantastic Recession and Normal Economic Times,” MIT Department of Economics Working Paper 12-27 November.

Niepmann, Friederike and Tim Schmidt-Eisenlohr (2013), “International Trade, Risk,and the Role of Banks,” Staff Reports 633, Federal Reserve Bank of NY.

Paravisini, Daniel, Veronica Rappoport, Philipp Schnabl, and Daniel Wolfenzon (forthcoming), “Dissecting the result of Credit Supply on Trade: Evidence from Matched Credit-Export Data,” Overview of Economic Studies.

Schmidt-Eisenlohr, Tim (2013), “Towards a theory of trade finance,” Journal of International Economics, 91 (1), 96 – 112.

Working Group on Trade, Debt and Finance (2014), “Improving the option of trade finance in developing countries: an assessment of remaining gaps,” Note by the Secretariat, World Trade Organization.

[1] One reason is these instruments are short-term and may be unwound quickly to boost banks’ liquidity conditions.

[2] See, for instance, Working Group on Trade, Debt and Finance (2014). Maintaining a network of correspondent banks is costly for individual banks and elevated homework requirements have reduced banks’ incentives to utilize foreign banks.

[3] Another paper, Paravisini et al. (forth.) discovered that reductions in the way to obtain credit to firms in Peru resulted in lower exports. Ahn (2013) also studies LCs in Colombia but targets the partnership between bank balance sheets and LC supply.

[4] Data supplied by SWIFT reveal that about 91% of most LCs are used for cross-border transactions. See Niepmann and Schmidt-Eisenlohr (2013a) for additional information about the usage of letter of credit in US exports.

[5] For additional information on the trade-offs that firms face whenever choosing between different payment contracts in international trade, see Schmidt-Eisenlohr (2013), Niepmann and Schmidt-Eisenlohr (2013a) and Antras and Foley (forthcoming).

[6] It builds on and extends the approach proposed by Amiti and Weinstein (2013) and Greenstone and Mas (2012).