Chapter 9. Trade Finance Support from Multilateral Development Banks During Crisis: New Tools and Priorities

Jian-Ye Wang, and Márcio Ronci
Published Date:
February 2006
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Martin Endelman52

Multilateral development banks (MDBs)—including the Asian Development Bank (ADB), the European Bank for Reconstruction and Development (EBRD), the Inter-American Development Bank (IDB), and the African Development Bank (AfDB), as well as the International Development Association (IDA) and International Finance Corporation (IFC) of the World Bank Group—offer a variety of guarantee, loan, and investment products or “tools” that can help keep domestic and international trade finance available to importers and exporters in crisis-affected countries.

During previous periods of financial crisis, some have argued that these tools focused on “bailing out” the government of the crisis-affected country through more conventional hard-currency loans. This helped restore foreign exchange reserves and international confidence, and enabled continued servicing of existing foreign exchange debt owed to public sector financial institutions and private sector banks—including some that were overexposed to the crisis-affected country or were undercapitalized.

More recently, some MDBs have experimented with (i) lines of credit directly to local banks to ensure access to foreign exchange and thus increase liquidity; (ii) guarantees supporting local bank obligations to pay under documentary credits; and (iii) risk-sharing arrangements that allow local banks to provide more domestic trade credit and other financing to a wider variety of borrowers than their capital base would otherwise allow.

Looking ahead, MDBs can play a more effective role in supporting access to trade finance during periods of crisis. By improving and mainstreaming their available tools, MDBs can more quickly and economically use them in a number of markets well before a crisis starts. MDBs can also focus on filling market gaps that might come up so that private-to-private and cross-border country and bank limits can stay open and domestic intermediation can continue.

The end result will allow MDBs, both in the run-up to and during a crisis, to use the least amount of intervention possible, prioritizing tools that help maintain private-to-private flows, and leaving the public-to-public foreign exchange loan alternative as a last resort.

This chapter summarizes how these tools are or can be used by MDBs, and argues for the need to prioritize their use by highlighting the strengths and weaknesses of each tool in keeping trade finance available to importers and exporters in crisis-affected countries. The chapter also looks at some related policy issues that need to be addressed for these MDB tools to be fully effective.

MDB Tools

To support access to trade finance during periods of crisis, MDBs potentially can intervene through domestic private support to maintain and encourage local credit intermediation; international or cross-border private support to keep country and correspondent bank limits open; and cross-border public support to maintain international confidence in the host government.

Domestic Trade Finance Support through the Private Sector

An MDB can encourage local credit intermediation by sharing loan portfolio risk with local banks, making local currency loans to local banks for onlending, making local currency loans directly (or channeled through others) to local borrowers, and injecting equity into local banks.

First, by sharing loan portfolio risk with local banks through partial credit guarantee facilities, MDBs can share the risk associated with an agreed portfolio of loans provided to targeted borrowers. These loans can be in local or hard currency, and include trade finance in the form of a (i) letter of credit opening, advice, confirmation, and discount; (ii) pre- and postshipment finance; and (iii) bid, performance, and advance payment bonds.

MDBs can share risk on, for example, a 50/50 pari pasu basis, allowing the MDB to leverage off local banks’ due diligence and local knowledge. Meanwhile, the local bank can extend twice as much credit to the targeted borrower class with nearly the same amount of risk-taking capital. This arrangement allows MDBs and local banks to work in partnership. However, local banks must have some risk-taking capital and the ability to understand, measure, and price the agreed-upon portfolio risk. Liquidity must exist within the country and government borrowing should not crowd out private sector borrowing. On the other hand, the MDB would need to act in a more commercial manner, delegating a part of its approval process and loan management to others.

Second, MDBs can make or guarantee local currency loans to local banks for onlending. This would allow local banks to offer longer-term, fixed-rate, or floating-rate loans matching both the longer-term and interest rate base of the MDB loan/deposit and, perhaps more importantly, the needs of local borrowers and their cash flows. An MDB may also consider accepting a below-market return from local banks to encourage or force lower onlending interest rates.

However, the below-market return accepted by the MDB may distort the market for deposits taken by local banks. The MDB becomes responsible for picking “winners and losers” in the local bank market. Also, making or guaranteeing local currency loans to local banks for onlending assumes that selected local banks have risk-taking capital available to accept additional deposits and extend additional loans, albeit guaranteed.

Third, by making local currency loans directly or channeling them through others to local borrowers, MDBs may force liquidity into the local banking system and bypass local banks, which are unable or uninterested in making “risky” loans. However, this means that the MDB must have access to equal or better credit knowledge than local banks and have the ability and desire to act commercially.

Finally, MDBs can inject equity into local banks, making available the new risk-taking capital needed to jumpstart local intermediation. Such investments can be seen as a vote of confidence in one or more local banks, giving other investors the comfort of the MDB’s “halo.” Again, this makes the MDB responsible for picking winners and losers in the local bank market. Moreover, the involvement of the MDB must genuinely add value to the local bank, while ensuring that the MDB does not get embroiled in internal management matters. And, in any event, the equity investment may not change the local bank’s risk aversion or ability to attract deposits needed to fund additional loans and trade finance facilities.

Cross-border Support through the Private Sector

During periods of crisis, MDBs can keep country and bank limits open and help maintain foreign exchange reserves by providing cross-border support to the private sector through political-risk guarantees for letters of credit issued by local banks, and through comprehensive guarantees for letters of credit issued by local banks (Figure 9.1).

Figure 9.1.Partial Credit Guarantee (PCG) Support for Imports via Trade Finance Program (TFP)

First, MDBs can provide limited guarantees for letters of credit, documentary credits, and other foreign exchange obligations owed by local banks, to help keep country limits open. Guarantees limited to foreign exchange conversion and transfer blockage can stabilize the political risk component in confirmation fees and interest margins, while posing little risk to the MDB, given the charter and other protection normally enjoyed by MDBs against foreign exchange conversion and transfer blockage.

Political risk guarantees, however, do not cover commercial and other risks associated with the local bank issuing the letter of credit, which could also be of concern to the confirming bank during periods of crisis.

Second, through the provision of comprehensive credit guarantees, MDBs can cover not only political risk but also commercial and other risk associated with local banks issuing letters of credit. This avoids the need to provide direct equity or foreign exchange loans to local banks and helps keep both country and bank limits open during the period of crisis. These guarantees can complement existing letter of credit confirmation insurance schemes provided by public and private sector export credit agencies. They should not distort market pricing if guarantee fees are a percentage of market-driven confirmation fees determined by confirming banks.

For such guarantee support to be effective, however, local banks must still have risk-taking capital available and be willing to intermediate and provide domestic trade finance. Further, the MDB is again responsible for picking winners and losers in the local bank market. Also, some question what ranking MDB-supported trade finance should have if a host government reschedules as a result of a financial crisis.

Cross-border Support through the Public Sector

MDBs can extend foreign exchange direct loans and provide guarantees to crisis-affected governments (Figure 9.2). These are the conventional tools used by MDBs, and they are well understood by ministries of finance and the market. Such public/public support can help maintain or restore international confidence by increasing foreign exchange reserves and requiring structural changes and policy reforms as conditions to disbursement.

Figure 9.2.Cross-Border Support through the Public Sector via Exim Bank

However, when compared with the previous forms of private support, foreign exchange loans and guarantees to crisis-affected governments have limited value when it comes to trade finance, in light of the following:

  • Short-term emergency support can turn into long-term dependence, if needed structural changes and policy reforms do not take place;

  • Governments may not be able to properly price the loans they subsequently make to local banks, and may interfere with the pricing of the trade finance provided by the local bank to borrowers, causing further distortions in the local market;

  • Foreign exchange loans made by MDBs to governments do not create risk-taking capital for local banks, unless the government retains all or some of the borrower risk.

A collapse of confidence resulting in the reduction or cancellation of country and bank limits can occur quickly, while the public/public response by MDBs can sometimes take time.

Policy Issues and Conclusions

For the MDB tools discussed above to achieve full effectiveness in ensuring access to domestic and cross-border trade finance during periods of crisis, the policy issues below need to be addressed.

Host governments need to play a major role in improving the creditworthiness of the local bank and nonbank financial sector through better supervision, improved corporate governance, and by cleaning up nonperforming loans. Governments need to work toward improving the legal system and the ability of local banks to enforce security, encourage competition from international and local banks in trade finance, and promote the establishment of local credit rating agencies to rate banks and their customers.

Whenever possible, governments should also encourage the private sector to provide export credit insurance to help exporters safely sell to new buyers in new countries and increase the quality of trade receivables held by exporters.

Local banks need to acknowledge that well structured trade finance is less risky and is good business. Maintaining or improving their credit rating systems will result in lower cost of letter of credit confirmations and interbank debt. These institutions should nurture correspondent banking relationships, since these will become strained during times of crisis. Local banks must also take advantage of export credit insurance offered by leading international credit insurers, official or private.

International and regional banks should consider revisions to country and bank limits only when based on reliable information, and not merely as a knee-jerk reaction to unfolding events. They should also take advantage of cross-border risk mitigation products such as political risk insurance and trade credit cover from both private and public sector political risk insurance providers and export credit agencies. And if necessary, they can also take advantage of the political risk and credit guarantee programs offered by MDBs.

Multilateral development banks need to build confidence among host governments, local banks, and international banks by using carefully-targeted products or tools. But they should do so only when the market is unable to fill a demand gap. MDBs need to keep host governments focused on what they need to do, through policy support and capacity building.

MDBs must continue to recognize that trade finance plays a critical role in helping developing countries increase exports and ultimately earn more foreign exchange, which is needed to service and repay foreign debt and also create employment and reduce poverty.

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