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Chapter V: WEAKNESSES IN INTERNATIONAL FOOD TRADE FINANCING SYSTEMS


Credit relations have two components: who provides the finance; and who takes the risk. Thus, such relations can be constrained by two factors: finance capacity, and risk-taking capacity. This section discusses how the main forms of food finance discussed in the previous chapter are constrained in these two respects, particularly in the case of an increase of world food prices which, given certain import needs, would lead to larger financing requirements.

A. Trade driven by long-term corporate relations, on open account terms

In this case, the seller provides the finance to the buyer, and takes a risk on him, determined in the first instance by the size of the credit line he permits. Normally, these credit lines are limited, at most enough for one normal trading “cycle” - that is, the time that the food commodities are actually in the hands of the importer. The seller may be able to refinance himself, using promissory notes issued by the buyer, but the markets for such refinancing are shallow, even if the notes are discounted with recourse to the seller. Similarly, the seller has little possibility to lay off his risk; with the partial exception of US exporters who can use the Supplier Credit Guarantee Program of USDA to cover up to 65 percent of their credit risk. Moreover, in practice open account sales, when they concern developing country buyers, will not always go according to expectations, because of such factors as temporary disruptions outside the buyer’s control which slow down his “asset conversion cycle” (the time he needs to convert the commodities he imported into cash); temporary problems in converting local currency into the hard currency needed to continue importing; occasional losses due to market developments which require the seller to wait a bit longer for his money; and so on. All these are a normal part of open account business. The seller has to be willing to be flexible, while at the same time retaining his capacity to discern temporary disruptions and serious problems for his buyer.

Open account sales thus require the seller to have a real interest in continuing his commercial relationship with the buyer, and a strong trust in the buyer. Such relationships are not easily built, but once they are in place, they can take shocks (e.g. price shocks) up to a certain level. The constraint here is likely to be the cash position of the seller: given his own credit lines and other funding sources, can he afford to extend more credit to his buyers (and even if he wants to, will his bank allow it)? For some exporters, then, increased prices for the food that they export may mean that they can export less under existing open account terms, while for others it would be possible to increase credit lines to keep sales volumes stable.

B. Exports by state entities

While in some cases, the government export agency has a volume target or limit (in the case of Thailand, up to 500 000 tonnes of rice for sales under government-to-government contracts), in general, the state trading corporations have “credit ceilings”, set administratively in nominal terms. They may be able to lay off part of the risks with a separate credit insurance agency (e.g. AWB uses this mechanism), but such risk coverage may be limited or overly expensive.

Under normal circumstances, these entities could well be forced to reduce the volume of exports to countries deemed “risky” if grain prices increase, just to stay within their credit limits. In practice, these agencies can return to their governments to ask for extra risk cover. For example, a report by the Australian Government states that:

there may well be at certain times a ‘market gap’ in terms of the unwillingness of the private sector (individually or as part of a syndicate) to provide the total amount of capacity/risk/financing required to support wheat sales to a particular country. This will usually reflect the fact that the country concerned is felt to involve repayment risks of an unacceptable level. But since this will often not be of an ‘all or nothing’ nature, it could then be manifested in a shortfall between the cover/capacity required and that available.[16]

The report notes that this kind of market gap or market failure can be a reason for the “National Interest Account”, under which the Government can cover the risk of exports to particularly risky countries (the Government has made active use of this possibility). The “market gap” noted above is one which affects all food exporters and importers, but in the absence of a multilateral approach, only exporters whose government is willing to give a helping hand will be able to overcome it, which necessarily distorts trade patterns.

C. Transactions under Bilateral Payment Arrangements

In order to effect a purchase under a BPA, the importer has to open a letter of credit with a local bank, in local currency, for the value of the goods imported. While the BPA is unlikely to be greatly affected by the level of prices of the goods traded under it (unless price changes lead to a dramatic imbalance in bilateral trade), an importer’s ability to open such a letter of credit may be a constraint to food trade in the case of a price rise. Most developing country banks have no experience in the kind of structured finance techniques that would allow them to raise their credits in line with the value of a client’s underlying business. Rather, their credit limits are determined by the amount of traditional collateral, such as real estate or cash.

D. Private sector imports using warehouse receipt finance

Warehouse receipt financing is generally put in place to enable transactions in high-risk environments. The financing is normally done on the basis of the client’s “borrowing base”, which is the sum of the client’s physical inventory and his receivables (as long as they are controlled by the bank’s agent), with a certain discount for various risks. When food prices increase, so does the value of the inventory, and the receivables due from those who buy the client’s products.

With respect to bank credit lines, warehouse receipt finance does not imply any credit exposure to the client, nor, normally, for an international bank to the country because some mechanism to mitigate sovereign risk, such as insurance, is normally built in. This is even so for South-South trade. Thus, there are no constraints to the bank raising its credit lines when there is a need.

In other words, this financing mechanism provides sufficient flexibility to deal with food price increases. Unfortunately, it is still relatively unknown in most LDCs and NFIDCs.

Private sector imports on a letter of credit basis with deferred payment, facilitated by credit insurance

The constraints here are in two areas. Firstly, the importer has to open a letter of credit with a local bank acceptable to the foreign credit insurance agency. As has been mentioned above, local banks, who are often weak in commodity finance, will either require full collateral in the form of real estate or cash (thus, their credit line will not increase in line with the value of the goods imported), or give a credit line that is largely determined by traditional balance sheet analysis (and thus difficult to increase).

Secondly, the export insurance agency has to have sufficient country and bank risk ceilings to absorb an increased demand for coverage. Given that its ceilings are determined on an annual nominal basis (not in volume equivalent), and fall within a mandated total ceiling, such an adjustment can be very difficult.

Thus, this form of food trade, which is rather important, is vulnerable to world food price increases.

Private-sector imports on a letter of credit basis with deferred payment, without credit insurance

When traders agree on usance or deferred payment letters of credit (or for that matter, documentary collections using time drafts), they will normally discount these documents with the banking system. As noted by the Finance Director of the Canadian Wheat Board, “some credit sales are done using letters of credit with payment terms. Most exporters discount these when they negotiate their documents. The only time this is a problem is when the buyer's bank runs out of credit with the exporter's bank.”[17]

This aptly summarizes the problem which compounds the problem of the importer having to be able, in the first place, to open the letter of credit. The credit limits of developing country banks (expressed in nominal terms) with banks in developed countries are rather limited, if they exist at all. Many of the major European banks, for example, have credit limits with banks from less than a dozen African countries, and then often only to the extent that these African banks retain cash accounts with them. Moreover, they can be changed from one day to next on negative news from the country or even from its neighbours.

E. Imports through international traders’ local offices

This is intra-firm trade, and there is no reason to believe that such trade would be constrained by price levels. It is true that international trade houses have country ceilings set by a credit committee, but such ceilings are open to revision, and if the increased exposure is necessary to maintain normal trading volumes with a country, this should not be unduly difficult.

Imports by large corporate or government-owned entities on a cash-on-delivery basis

These entities raise their hard currency funds from local banks or, with a government guarantee, from international banks. In both cases, there are likely to be volume constraints. In the case of local banks, these may have both a lack of hard currency, and secondly, limits for lending to large clients, to avoid that these take up too large a part of their loan portfolio (although government importers may be able to override these concerns, in particular in dealing with government banks).

Even with government guarantees, international banks are constrained in their lending to countries by country ceilings, unless they can refinance themselves (and the refinancing market for obligations from LDCs and NFIDCs is not deep). Moreover, the country’s own ability to give government guarantees may be constrained by its obligations towards the International Monetary Fund, which frowns on such guarantees, and may even explicitly ban them as one of the conditions of a structural adjustment programmes).

F. Conclusion

Food trade involves large sums of money, and given the time that it takes food to go from the producer to the final consumer, the financing needs of food trade are great. There is a major difference in financing costs between developed and developing countries. So as far as North-South food trade is concerned, the commercial counterparties and financiers have an incentive to keep the financing burden in developed countries to the extent possible. Food does not flow into LDCs and NFIDCs in a single, uniform manner. If one way does not work well, there are incentives for importers to look for other ways. Similarly, when food finance meets obstacles, financiers will look for ways around the obstacles, and try to find a second-best, or even third- or fourth-best, solution.

Given the incentives to look for solutions to food trade, and food trade financing problems, it should come as no surprise that a whole range of food trade finance mechanisms can be found in LDCs and NFIDCs. However, it is somewhat surprising that despite these incentives, the financing of food imports into LDCs is often highly inefficient and, for significant parts of the trade chain, international finance is absent. To express it in another way, it is surprising that so much of the burden of food trade finance is on the importing countries, where the costs of capital are relatively high. Naturally, those involved in the food trade chain will not bear the associated costs. Rather, they will pass them on to final consumers, directly or through the government budget.

It is difficult to dissociate the inefficiencies or constraints in the current system of food trade finance form the ability or inability of the system to deal with price or volume shocks. To enhance the resilience of food trade finance to such shocks, the whole system of food trade finance needs to be upgraded. Otherwise, importers will not be able, for example, to use special new facilities to deal with sudden extra financing needs.

Figure 11: Likely constraints in the case of local bank avals

In the most common forms of food import finance, the major constraints are linked to credit ceilings. These are expressed in nominal amounts, so if food prices increase, existing limits will allow only a lower volume of food imports. Figure 11 illustrates this for the case of payment on the basis of local bank avals on buyers’ payment obligations. This is a major form of short-term credit in rice trade. The arrows indicate the main areas of constraints in the system which may make it difficult to adapt to larger food import needs.

Firstly, there are local constraints. The local bank may not accept to add its aval to the trade bills (expressing the obligation of the buyer to make a payment at a certain moment in the future) for all local buyers; and if it accepts these trade bills, it will be up to a certain credit ceiling, and up to a certain tenor. If the tenor coincides with the time that the buyer needs to sell the imported food, his own financing burden will be minimal. But if the tenor is less (as is commonly the case), the buyer will need to find funds somewhere else, e.g., using his own equity. Importers often have to give credit to their offtakers, and the burden on equity is generally strong. There is some flexibility in the system as importers often import a range of commodities and other goods, and will shift the use of their capital in response to shifting profit margins on trade. But in the end, there is only so much equity capital to go around, and if import prices increase, the importer may be constrained in his import volume.

The second bottleneck comes between the local bank and the international bank. First, not all local banks can provide acceptable avals. Only local banks that are highly regarded by international traders and banks can do so. By accepting a local bank’s aval, the trader as well as the international bank takes a credit risk on the local bank, and a risk on its country. In both cases, there are limits. These limits may be low, up to a million US dollars (for all exposures, including letters of credit, and for all transactions). In practice, one of the consequences is that international banks do not like longer-term exposures because this freezes up their risk capacity, preventing them from doing further business. So if they accept a local bank’s aval, it will normally be for short periods (one, or at most three, months). These limits are in nominal terms and are not adjusted to enable the continuing flow of a certain volume of food - thus, they will act as a constraint in the case of higher food prices. To some extent, though, these limits are influenced by the capacity of the local bank to meet its obligations under international payment arrangements. A local bank which can speedily process paperwork and respond to queries will have a better reputation in international circles, and can expect to see its credit ceilings rising. According to western bankers, there is still a lot of room for improvement in this domain).

International banks can of course lay off local bank risks on the secondary market, but here too, there are constraints. The market depth for any particular risk is limited, and the discounts on a country’s or a bank’s paper quickly increase once a certain volume of this paper is brought into circulation. Another way for international banks to lay off local bank risks is through their countries’ export credit agencies. In countries like Australia, Canada and the United States, governments clearly recognize the importance of credit lines for local banks, and they provide coverage on a bilateral basis (with a considerable budget: in the year 2000, more than US$2.5 billion was spent by the US Government on its main programme, GSM). While these countries may resist a multilateral solution to a problem that they are now resolving through a bilateral mechanism, they could perhaps consider how their programmes can be adapted in such a way that, in case of higher import needs, programme budgets are increased (although it could be argued that this would amount to yet more export subsidies, an issue that would not arise for a multilateral export credit facility).

Figure 12: Likely constraints in the case of Letters of Credit based finance

Similar constraints characterize credit systems based on letters of credit, the dominant form of payment and basis for financing for wheat, maize and vegetable oils trade (see Figure 12). In this case, a first constraint often relates to the ability of the local banking network to provide lines of credit to importers, under which they can open letters of credit. In many cases, banks now base such credit decisions on the real estate and cash collateral that the importers can provide. If prices increase, the credit limits to which the importer is imposed will force him to reduce his imports. An obvious, albeit medium-term, response is to provide advice and training to developing country banks on commodity financing techniques. Warehouse receipt schemes and related credit-support schemes could enable these banks to safely link credit lines to an importer’s financial needs. The other frequent constraint is the need to have the letter of credit confirmed by international banks. Like avals, such confirmations are limited by the credit ceiling that banks have on the country and the bank. It should be noted the confirmation adds to the cost of the import transactions. Confirmed letters of credit can also be discounted by the confirming bank in the secondary market, and the constraints are then similar to those described above for the ability of the bank to sell local bank risk on the secondary market.

The situation is somewhat different in the case of import financing arranged through warehouse receipt schemes. In this case (as for trade houses’ intra-firm trade), finance is hardly vulnerable to price increases. The main bottlenecks (shown by the arrows in Figure 13) in the case of warehouse receipt finance are linked to the physical availability of warehouse infrastructure, to the legal and regulatory environment for warehouse receipt finance, and to the skills of local and international banks and of local collateral managers. The only bottleneck in terms of nominal value is related to the availability of insurance coverage for goods in stock in a local warehouse: for some countries, such insurance is scarce.

In conclusion, to make the food import financing system for LDCs and NFIDCs more efficient, an integrated programme of interventions should be considered.

Providing general balance of payment support may in some cases have little effect, and even in the best of circumstances would be a crude and inefficient means of tackling food import finance constraints. One of the possibilities mentioned in the Marrakesh Decision, drawing “on the resources of international financial institutions under existing facilities [meaning in particular the IMF’s Balance of Payment facilities] in order to deal with short-term problems in financing normal levels of commercial imports”, would seem to be impractical. Even if these facilities were to reduce IMF conditionality, finance would still not be likely to come in time, nor would it be targeted at those who are actually able to undertake food imports. Targeted measures would be more appropriate.

Figure 13: Likely constraints in the case of warehouse receipt finance

Support should start with local capacity building, enabling local banks to become better counterparties for international banks (which would lead to higher credit ceilings), and making them familiar with warehouse receipt finance. This is the financing form most resilient to food price increases, and provides the largest scope for up-country finance for importers. Local banks should also be given more access to advice on matters related to commodity finance. International organizations, with support from the donor community, could consider substantially enhancing their advisory functions in this area, perhaps through a dedicated facility. Capacity building should help government officials to identify which rules and regulations hinder food import finance, and how these can be improved, and also include potential service providers such as collateral managers. Without capacity-building, even if the capacity of local banks to obtain offshore credit lines is enhanced, local importers may still not be able to meet the bank’s collateral requirements for, say, opening a letter of credit.

With a new, dedicated facility it would be possible to provide extra country risk capacity. One way of doing this is to provide extra insurance capacity, such as low-cost sovereign risk insurance for goods in stock (as African Trade Insurance, set up by the World Bank, does for a number of countries in eastern and southern Africa). Extra liquidity on the secondary market could also be supplied, providing for example forfeiting facilities, or buying food-trade-related paper from certain countries once the implicit margin on these purchases becomes particularly high. On the secondary market, paper is traded at a discount to its face value. The face value expresses the amount that will be paid when the paper matures, e.g. US$73 249 in three months time. The implicit interest rate can be calculated from the price the paper is traded at now. Thus, one can easily use the interest rate as a trigger factor for buying paper on the secondary market, for the purpose of providing liquidity. Another possibility is to provide currency convertibility risk coverage, which would protect the financier from the risk that, if sufficient local currency revenue were captured, he would be unable to convert this into hard currency and transfer it out of the country in reimbursement for his loan. On a bilateral basis, BPAs can shift country risks from an exporter to his government.

Such a new facility set up to facilitate food import finance could also provide extra bank credit risk capacity. For example, an international agency could add a guarantee to the avals provided by local banks, or provide insurance for local bank credit risk. One mechanism that most international banks now use to provide credit lines to local banks is to collateralize these credit lines, for example by keeping control over the offshore hard currency reserves and accounts of the local bank. The range of acceptable collaterals could perhaps be increased by new insurance facilities, which would, for example, allow a local bank to keep a local currency account with a branch of the international bank (or deposit local treasury bills) as acceptable collateral for a hard currency credit line. Furthermore, a greater effort could be made to familiarize western banks with developing country banks, so that they are more likely to open lines of credit.

In all these cases, actors work with the system - smoothing the path for certain forms of finance, opening the way for others. In many cases, leverage is used to good effect (relatively low-cost actions can make much extra finance available, or lead to considerable reductions in financing costs). It is not necessary to create completely new tools nor to introduce market-distorting practices. Rather, proven tools can be used, and the benefits of an efficient financial market extended to food importers in developing countries - and, by implication, to the hundreds of millions of food consumers in these countries.


[16] Australian Department of Foreign Affairs and Trade. 2000. International Developments in Export Credit and Finance Services. Section X: Agricultural Exports (available at http://www.dfat.gov.au/trade/efic_review/efic_report.pdf)
[17] Canadian Wheat Board. 1999. CWB defends credit sales for wheat. 16 February. (available at http://www.statpub.com/stat/open/422.html)

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