LCs during the financial crisisWhat happened to the use of LCs and DCs during the 2007–08 financial crisis? Although we expect trade finance supply to decline in a financial crisis, the demand for LCs and similar products should increase because firms become more risk-averse and because counterparty risk increases during crisis periods, making risk-reducing instruments more attractive. Which of the two effects dominates? Figure 6 shows the ratio of LC messages sent over world exports from 2003 to 2012. The red dashed line represents the third quarter of 2008, when Lehman Brothers collapsed. First, there is a downward trend, which suggests that LCs and DCs have become less popular over time. However, after the Lehman collapse, the use of LCs and DCs picked up. LCs, which reduce risk by more than DCs, gained in relative terms, as one might expect.
Figure 6. Trade finance during the financial crisis
Note: The figure shows the use of LCs and DCs over time. Panel (a) depicts the ratio of LCs and DCs over real exports (nominal exports deflated with the US GDP deflator). The ratio is indexed to 1 in 2003q1. Panel (b) shows the 5-quarter moving average of the ratio of LC messages over the sum of LC and DC messages. The vertical line in both panels indicates 2008q3.
Future work on trade financeThe data from the SWIFT Institute provide unprecedented details on LCs and DCs around the world. Information on trade credit insurance, factoring, and other payment forms remains limited, however, and much remains to be done. The collection of data on payment choices by firms can provide a much more complete picture and is an important next step. More data will help further clarify the role of trade finance for international trade and inform policymakers on how to best promote trade in the future.
ReferencesAhn, J (2014) “Understanding trade finance: Theory and evidence from transaction-level data”, International Monetary Fund, mimeo, May.
Antras, P and C F Foley (2015) “Poultry in motion: A study of international trade finance practices”,Journal of Political Economy, 123(4).
Bank for International Settlements (2014) “Trade finance: Developments and issues”, Technical Report, Bank for International Settlements.
Demir, B and B Javorcik (2014) “Grin and bear it: Producer-financed exports from an emerging market”, University of Oxford and Bilkent University, mimeo.
Hoefele, A, T Schmidt-Eisenlohr and Z Yu (2016) “Payment choice in international trade: Theory and evidence from cross-country firm level data”, Canadian Journal of Economics, forthcoming.
Niepmann, F and T Schmidt-Eisenlohr (2015) “International trade, risk, and the role of banks”, November.
Schmidt-Eisenlohr, T (2013) “Towards a theory of trade finance”, Journal of International Economics, 91(1): 96–112.
Endnotes[1]See also Ahn (2013) and Demir and Javorcik (2013) who exploit data on payment forms used for Chilean and Colombian imports and Turkish exports, and Hoefele et al (forthcoming), who analyse World Bank Enterprise Survey data.
[2] The best summary of worldwide data to date is contained in a report by the Bank for International Settlements (2014) that combined different data sources on trade finance.
[3] Trade finance was also discussed in the context of the new Basel III regulations. There was a worry that larger capital weights could adversely affect the provision of letters of credit and thereby restrict international trade.
[4] Our letter-of-credit information comes from message type MT 700. Every time a letter of credit is issued, the issuing (importer’s) bank sends an MT 700 message to the receiving (exporter’s) bank. For documentary collections, we rely on message type MT 400 (advice of payment), sent by the collecting bank to the remitting bank.
[5] Firms can also decide to trade without an LC or DC and agree on pre-delivery payment (cash-in-advance) or post-delivery payment (open account). Open account can be combined with trade credit insurance, which transfers the risk of counterparty default to an insurance company. See Schmidt-Eisenlohr (2013) for details.
[6] Under open account, the exporter first delivers and then the importer pays. The key risk, hence, is that the importer may not pay. If the destination has a strong rule of law, this risk is low.
[7] Under cash-in-advance, the importer first pays and then the exporter delivers. This payment form thus avoids any risk that the importer may not pay and, hence, becomes optimal for the riskiest destinations.
[8] In some cases, it may be possible to organise the LC through third countries. However, such a detour comes at additional cost. In the extreme case, either an LC cannot be used or the actual goods need to be shipped through a third country.
[9] Know your customer rules, where banks or firms are required to better screen their counterparties, have become prominent in recent years in the context of anti-terrorism and anti-money laundering.