When the pendulum swings

Difficult market conditions in Latin America have caused a pronounced slowdown in forfaiting activity and a corresponding reduction in market participants, leaving importers and exporters without adequate financing as trade volumes continue to increase. Until the pendulum swings back in favour of forfaiters, the key to survival is specialisation, suggest Jose E. Gonzales and Jaime Medina.

Trade finance in Latin America has exhibited some peculiar behaviour lately. While trade to and from the region has more than doubled between 1990 and 2002, exports and imports have grown 1.7 and 2.4 times, respectively, and GDP of the whole region has grown by 39%, financing for trade has contracted systematically.

Since 1990, Latin America’s share in world merchandise trade has increased from 4% in 1990 to the 6% forecast for 2002. Its share in exports has grown from 4.2% in 1990 to 6.1% expected in 2002, while the share in imports has grown from 3.7% to 6%. In the same period, banks’ net foreign claims, as reported by the Bank for International Settlements, have grown from a positive peak of US$65bn by the end of 1997 to a negative low of US$39bn. At the end of 2002, total foreign credit outstanding for Latin America stood at US$449bn, which is the equivalent of 54% of total goods and services traded from and to the region (a total of US$819bn in 2002). These conditions were reflected by forfaiters doing business in Latin America, who generally agree that current market conditions resemble those of 1982’s debt crisis.

Actually, current market conditions might not be as bad, but the recent wave of debt defaults and restructuring, banking crises, economic slowdown and political shifts in the region have made it difficult for banks and other traditional financial institutions doing business in Latin America. The result of Argentina’s 2001 debt default has been a shift towards better credits in some Latin American countries, such as Mexico, Brazil and Chile, with “refuge” allocation in some Central American countries. The balance, however, is one of across-the-board reduction when it comes to taking

cross-border risk. Even the Dominican Republic, which provided some relief from the current slowdown, has now been affected by Baninter’s fraud case.

In terms of forfaiting, both the primary and secondary markets have experienced slowdowns since there is less appetising trade paper floating around. Either good credits have tightened to unattractive levels or transactions that were considered acceptable from a risk perspective have now become “exotic”, reaching double digits or even distressed-level returns. This has brought a reduction in market participants, with fewer banks willing (or able) to book cross-border risk, particularly within the corporate sector. The environment has turned quite conservative and this is demonstrated by increased interest in secured, structured, guaranteed and insured transactions.

This setting has created a challenge and an opportunity for forfaiters. The challenge lies in servicing exporters and importers that have been left out in the cold by their traditional sources of financing, as well as by new or increasing headquarter guidelines related to cutbacks in receivables financing. In many cases, exporters are having some difficulty discounting corporate risk or even getting help with structuring.

While the use of insurance and other credit-enhanced structures got a lot of attention in recent years, it seems evident that they fall short in solving the needs of a large segment of the trade-finance market. In fact, political risk insurance has not been as effective as expected in delivering coverage, whether real or perceived. The Argentine default is just such an example.

These issues are exacerbated further when considering importers in the region, especially those in need of spare parts and raw materials and who, in many cases, do not have adequate local credit limits or even access to it. This is in spite of increased local liquidity, associated with the economic slowdown, and an ever-globalising banking sector, with some opinions indicating that globalisation of the banking sector might be part of the problem.

Supplier credit has been reduced significantly in some sectors, as exporters are required to unload risk in order to export since carrying receivables is now a limited option for many exporters. Although there is a tendency to return to traditional correspondent-banking products and to require the use of US-confirmed letters of credit, this may result in the issuing bank having to put up to 100% in cash collateral to the confirming bank, while requiring the importer to prepay the letter of credit, probably placing significant pressure on its working capital. While this is particularly evident with medium and smaller-size importers, it is also evident with big companies in countries perceived to be of high or unacceptable political and transfer risk.

In this difficult environment, forfaiters have to be very niche driven because it will be difficult, especially for smaller forfaiters, to be everything to everybody. Specialisation in a few industries, as well as structuring capacity, can generate significant comparative advantages vis-a-vis other forfaiters and even traditional banks or financial institutions. Delivering exporters a product that includes advice, counsel, structuring, placement and underwriting is required for survival. Cross-selling an existing client base with related group products, such as securitisations and structured trade products, while identifying non-traditional sources of funding, can determine the ability to close profitable deals in the primary market.

The current market environment, one characterised by expanding activity, an increasing need for funding and constrained credit availability, is widening yields for emerging-market trade paper, particularly for corporate trade paper – a phenomenon that has started attracting private money to trade finance through specialised hedge funds in search of high yields amid historically low interest rates in the Organisation for Economic Co-operation and Development. However, this in no way makes up for the liquidity shortfall associated with the current low-risk tolerance levels of traditional sources of trade financing. But while the private sector might be locked, for the time being, by risk aversion, the issue of trade-finance scarcity has been one of concern at the World Bank and Inter-American Development Bank, with the World Bank, through the International Finance Corporation, leading efforts to revitalise financing with its support of Brazilian institutions and the Inter-American Investment Corporation actively contemplating available alternatives. At a national level, the Banco Nacional de Desenvolvimento Econômico e Social in Brazil has already appointed a task force to study the possibility of creating a US$1bn trade-finance fund to finance bilateral commerce with Argentina.

Multilateral initiatives indicate that the systemic increase in trade volumes associated with the expansion of Nafta within other regional trade agreements, such as the recent agreements with Central America and Chile, will place even more pressure on funding requirements at a time of heightened conservatism within global financial institutions. This brings back the issue of a potential resurgence in the relevancy of regional institutions such as Bladex, Andean Development Corporation and Bank of Economic Integration, as well as private funds, in promoting trade and providing liquidity for trade flows in Latin America. In addition, local banking systems must continue to consolidate and bank supervision must be strengthened in order to bring back confidence and, hence, relative liquidity.

In the long run, political and institutional consolidation, along with economic growth and integration (which is, in fact, taking place despite the current bumps), will provide an increase in the volume of transactions and the much-needed funding requirements. The market seems to be at an impasse until the pendulum starts to swing back in favour of forfaiters.

Jose E. Gonzales is managing director of LW Asset Management in New York. Jaime Medina is president of LW Forfaiting in Miami.