How do you get your goods from the factory or farm to your local shop? Of course, trucks, ships, airplanes, and sophisticated logistics are all involved. Trade credit and finance are also essential. The wheels of commerce could come to a screeching stop without them – just as they nearly did during the global Financial Crisis 2008.
Despite their importance, academics and policymakers pay little attention to trade credit and financing. This is especially true for emerging and developing countries. A recently published paper from the World Bank aims to fill the knowledge gap. It describes these flows, identifies access obstacles, and proposes potential solutions.
Trade credit can take on many different forms. It could be a simple short-term loan, such as using your credit card for groceries. Sellers of goods and services extend trade credit to their customers. Sellers need to have financing to extend credit. It can be a loan or credit card from a relative, bank, or supplier. Using more complicated instruments, such as letters of credit, may also be necessary. Buyers may sometimes advance money to suppliers to finance production.
Trade finance is essential for both domestic and international transactions. Cash flows the other way whenever a container ship steams from Singapore toward Rotterdam. We’re not just talking about finished products. Trade credit could be given to a cotton farmer in Uzbekistan or a textile manufacturer in Bangladesh. It could also go to a Hong Kong clothing factory. It is the same for the dozens of companies that make computer chips, display screens, and other parts of mobile phones. Trade credit can be viewed as a reversed value chain.
These are huge sums. Some estimates claim that the total domestic and international trade credit volume is over 40% of global GDP or US$35 trillion. The majority of this credit involves trade within countries. In developed economies like France, the total amount of inter-firm credit is more than half of GDP.
It should not be surprising that trade finance and credit are vital to developing countries’ economic health and competitiveness. This includes their employment and growth. Trade finance disruptions, such as the COVID-19 pandemic, can cause companies to leave business and result in job losses. They also damage the economy by reducing employment and investment and eroding purchasing power.
Due to the perception of high default risk, developing countries are particularly vulnerable to disruptions to trade finance. Small and medium-sized businesses will most likely fail due to customer payment delays. Payment delays are a problem for firms, especially in domestic trade. This is because large state-owned enterprises and government agencies cause the most problems. Why? Some might be using their relative financial power. Some may need help with their own cash shortages or inefficient payment system. Despite being the most vulnerable group, payments to SMEs are often given the least priority.
The global “gap” in trade finance – the difference between the money available and the optimal amount required by businesses – was estimated to be US$1.5 trillion for developing countries in 2020. With the pandemic, the shortfall grew – one estimate put the gap at US$6.5 billion in 2021. These estimates are to be taken cautiously as the data is insufficient to assess trade finance demand and supply accurately.
The challenges facing developing countries, especially those relying heavily on exporting a limited number of commodities, are numerous. Export earnings can be affected by a drop in commodity prices, a decrease in demand, or a disruption of supply chains. In times of economic distress, big international banks might stop doing business with poorer and riskier countries. In financial trouble, big international banks may stop business in poorer and more dangerous countries.
Trade credit insurance can help. This type of insurance protects sellers against loss if customers do not pay. Trade credit insurance in 2019 covered flows of more than US$5 trillion or approximately 6 percent of world GDP. This was evenly split between domestic and international trade.
Small and medium-sized businesses in developing countries, which are a significant source of jobs, have difficulty getting trade credit coverage. Most are too small. Insurers tend to focus on firms that have annual sales exceeding US$1,000,000. Smaller firms, such as retailers, often do not keep the records required. In challenging economic times, insurers reduce their losses to minimize risk, making it harder for firms to obtain insurance.
How can policymakers in developing countries increase the availability of trade credit for their citizens? Our report outlines some of the steps to take:
- Trade credit and payment delay monitoring will help you to identify problems early and determine their impact on government policies.
- Improve the regulation and supervision of State-owned Enterprises to monitor their arrears which can affect their ability to pay Suppliers on time.
- State programs can be established to share risk with private lenders.
- Establishing the necessary infrastructure, including accounting systems, credit bureaus, and insolvency law, is essential to the creation of national markets for credit insurance.
- Ensure that the banking regulations permit the digitalization of trade finance processes such as receivables and payables.