TRADE, INVESTMENT AND COMPETITIVENESS TRADE, INVESTMENT AND COMPETITIVENESS EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT Financing More Resilient Trade and Value Chains OCTOBER 2021 Authors: Arnaud Dornel Jakob Engel Mariem Malouche © 2021 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved. This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. 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Washington, DC: World Bank. Translations—If you create a translation of this work, please add the following disclaimer along with the attribution: This translation was not created by The World Bank and should not be considered an official World Bank translation. The World Bank shall not be liable for any content or error in this translation. Adaptations—If you create an adaptation of this work, please add the following disclaimer along with the attribution: This is an adaptation of an original work by The World Bank. Views and opinions expressed in the adaptation are the sole responsibility of the author or authors of the adaptation and are not endorsed by The World Bank. Third-party content—The World Bank does not necessarily own each component of the content contained within the work. The World Bank therefore does not warrant that the use of any third- party-owned individual component or part contained in the work will not infringe on the rights of those third parties. The risk of claims resulting from such infringement rests solely with you. If you wish to reuse a component of the work, it is your responsibility to determine whether permission is needed for that reuse and to obtain permission from the copyright owner. Examples of components can include, but are not limited to, tables, figures, or images. All queries on rights and licenses should be addressed to World Bank Publications, The World Bank Group, 1818 H Street NW, Washington, DC 20433, USA; e-mail: pubrights@worldbank.org. Cover design and layout: Diego Catto / www.diegocatto.com >>> Contents Acknowledgments 4 Abbreviations 5 Executive Summary 6 Why the financing of trade matters? 6 Demystifying trade financing 7 Trade financing during the COVID crisis 10 A trade financing policy agenda for developing countries 11 1. Introduction 13 2. Key Concepts and Quantification Challenges 14 2.1. How is trade financed? 14 2.1.1. Difference between trade credit and trade financing 14 2.1.2. Trade credit 15 2.1.3. Trade credit insurance 16 2.1.4. Trade-related financing 19 2.2. Quantifying and measuring trade finance flows 22 2.2.1. Trade credit 22 2.2.2. Trade credit insurance 23 2.2.3. Trade-related financing 23 3. Trade Financing during the COVID Crisis 25 3.1. Lessons from the global financial crisis 25 3.2. Dynamics during the 2020 COVID crisis 26 3.2.1. Impact on trade credit 26 3.2.2. Impacts on credit insurance 27 4. The Policy Agenda on Trade Financing for Developing Countries 29 4.1. Policy implications for trade credit insurance 31 4.2. Policy implications for the financial sector 32 4.3. Policy implications for interfirm credit 33 4.4. Access to trade credit and finance 34 4.5. Policies and interventions to improve access to trade credit and finance 35 References 36 Appendix: Overview of Financing Instruments Used in Trade 38 >>> Acknowledgments This report has been prepared as part the World Bank Group’s advisory services and analytics “Financing Trade and Value Chains” (P172547) and was funded in fiscal year 20/21 through the Umbrella Facility for Trade. The report is intended to support the World Bank Group’s en- gagement with governments on issues related to trade finance, especially in the context of the COVID-19 crisis. The report was prepared by a World Bank team led by Arnaud Dornel (Lead Financial Sector Specialist, EMNF1), Jakob Engel (Economist, ETIRI), and Mariem Malouche (Senior Economist, ETIMT) under the guidance of Caroline Freund (Global Director, ETIDR) and Antonio Nucifora (Practice Manager, ETIRI). Administrative and logistical assistance was provided by Tanya Cub- bins and Aidara Janulaityte (both ETIRI). The report draws on analytical inputs from consultants Patrick Blanchard, Jean-Michel Lafage, and Rocard Kouwoaye. Editing by Linda Stringer and Marcy Gessel, and design by Diego Catto Val is gratefully acknowledged. The report has benefited from comments, advice, guidance, and technical discussions from the following project concept note and decision report peer reviewers: Michael Ferrantino (Lead Economist, ETIRI), Safia Hachicha (Senior Financial Sector Specialist, EMNF1), Jean- Christophe Maur (Senior Economist, ETIRI), Vincent Palmade (Lead Economist, ETIRI), Susan Starnes (Senior Strategy Officer, CSEFI), and Makiko Toyoda (Senior Trade Finance Officer, CFGBD), as well as numerous other World Bank Group colleagues who provided input at vari- ous stages. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 4 >>> Abbreviations AfDB African Development Bank Afreximbank African Export-Import Bank AML Anti-Money Laundering ATI African Trade Insurance Agency BA Banker’s Acceptance BIS Bank of International Settlements EBRD European Bank for Reconstruction and Development EU European Union GDP Gross Domestic Product IBRD International Bank for Reconstruction and Development ICC International Chamber of Commerce ICISA International Credit Insurance and Surety Association IDA International Development Association IFC International Finance Corporation IMF International Monetary Fund JLGC Jordan Loan Guarantee Corporation KYC Know Your Customer LC Letter of Credit MENA Middle East and North Africa MNE Multinational Enterprise MSME Micro, Small, And Medium Enterprises OECD Organisation for Economic Co-Operation and Development SBLC Standby Letter Of Credit SMEs Small and Medium Enterprises SOE State-Owned Enterprise TA Trade Acceptance TFP Trade Facilitation Program WTO World Trade Organization EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 5 >>> Executive Summary Why the financing of trade matters? The COVID-19 crisis poses major challenges to global trade, value chains, and their fi- nancing. Firms are under financial and liquidity stress across sectors and countries because of unprecedented lockdowns and travel restrictions. It is also affecting the capacity of banks in emerging markets to supply trade finance and their customers’ access to it, particularly in the poorest countries and fragile states. This assessment is also supported by emerging evidence. An estimated trade finance gap of US$1.5 trillion already existed before the crisis (Starnes and Nana 2020) and more recent estimates from 2020 have now placed this gap as high as US$6.5 trillion (Wreford and Louat 2021). Across successive multinational enterprise pulse surveys carried out during the current COVID-19 crisis by the World Bank, availability of trade finance is consistently listed as “critically important” for most affiliate respondents (Saurav et al. 2021). However, even in “normal” times, the financing of trade and value chains is of major importance to developing countries. It affects a country’s competitiveness, its export per- formance, and ultimately its employment and growth. Yet this topic is prone to fall between the cracks because it cuts across different disciplines: financial inclusion, value chains, private sec- tor development, and trade facilitation, among others. Concerted efforts are needed to ensure that this important agenda is well understood and pursued comprehensively, at the country and multilateral levels. This report aims to improve the knowledge base on the financing of trade and related data, institutions, and instruments. An improved knowledge base can support interventions that strengthen the infrastructure and the flow of funds underpinning the financing of trade in the context of value chains in client countries and regions. First, it defines trade finance and other ways in which trade is financed. Second, it provides an overview of trade financing supply and demand dynamics, including during the two recent global economic crises: the 2008–09 finan- cial crisis and the 2020 COVID-19 crisis. Third, it discusses a policy agenda focused on how the World Bank Group and other international institutions and donors can more effectively support developing countries in meeting the growing demand in this area, including for (a) country-level technical assistance and diagnostic work, (b) improvement of the data infrastructure, and (c) global engagement and advocacy. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 6 Demystifying trade financing What do we mean by trade financing, and what is the suppliers based in developing countries to sell on open credit role of the financial sector and the government? A pre- terms. However, exporters are exposed to credit risk on their requisite to engaging in a meaningful policy agenda that fa- buyers. During severe market downturns (such as the current cilitates the financing of trade is to understand the different COVID-19 crisis), even reputable buyers and large firms may instruments, their roles, and responsible players. At the firm experience cash flow difficulties or even become insolvent. level, firms finance their trade activities in two major ways: Large retail chains in developed countries enjoy strong mar- (a) “interfirm trade credit,” meaning deferred payments from ket power and can impose credit terms (typically 60–90 days) buyers to suppliers, known as “trade credit”; and (b) “trade- on their suppliers in developing countries. These receivables related financing” from financial institutions. The working capi- weigh heavily on the exporters’ balance sheet and need to tal required by trade can also be financed from shareholder be financed by financial institutions. Advance payment helps funds and other long-term sources. Although important, these exporters but places them in a dependent position compared financing sources are not specific to trade and are not ad- with importers. In countries with weaker credit infrastructure dressed in this report. Like firms, value chains finance their and legal enforcement, trade credit may be predicated on in- activities in two major ways: (a) “internally,” through the credit formation, trust, or social enforcement flowing along family, that buyers and sellers extend each other; and (b) “external- clan, or ethnic lines. ly,” from funds raised from third parties, especially banks and other financial institutions. Value chains are reverse payment In many developing countries, payment delays from cus- chains: whereas value chain processes move goods from tomers are often the single largest source of mortality for upstream input suppliers through midstream transformers to SMEs, and public sector agencies and state-owned en- downstream customers, payments and cash flow circulate terprises (SOEs) are the main source of payment delays. from downstream consumers to upstream suppliers. Finally, in Slow payments from SOEs can create a negative ripple effect developed and emerging markets, trade credit—and to some on value chains and hit SMEs hardest, harming investment, extent trade-related finance—are often underpinned by trade employment, and business growth. Public sector payments credit insurance. may be slow because (a) state-owned agencies may be cash- strapped, (b) SOEs are typically larger than their suppliers and Trade credit, market power, and the are hard to sue for payment, and (c) payment processes in the public sector public sector are inefficient. Concerted efforts of the ministry Estimates indicate an aggregate volume of trade credit of finance and relevant line ministries are required to ensure at around 42 percent of world gross domestic product that public sector payables are settled on time. Where pay- (GDP), with most of it for domestic transactions (Boissay, ment delays have arisen, as a transitional measure it may be Patel, and Shin 2020). Aggregate trade credit is believed to possible to implement a suitable mechanism to have the bank- be approximately 80 percent domestic (buyer and seller in the ing sector refinance them. same country) and 20 percent cross-border. Moreover, the United Nations Conference on Trade and Development has As such, the mismatch between the supply and demand of estimated that approximately one-third of global trade is intra- trade financing results from both market failures and govern- group trade,1 and the rest is estimated to be trade between un- ment failures. related firms (most commonly in textiles, apparel, and leather products, and food and beverages) and gives rise to arm’s- Trade-related financing length trade credit (Lakatos and Ohnsorge 2017). and the role of the financial sector Financiers have two major types of roles in international Trade credit is a factor of international competitiveness trade. On the one hand, they provide “trade finance services” and often reflects the respective market power of buyers that do not involve financing: they effect payments between and sellers. Larger firms tend to benefit disproportionately buyers and sellers in the value chain, and handle and ensure from favorable payment conditions for both sales and pur- the integrity of the flow of trade documents required for pay- chases, whereas small and medium enterprises (SMEs) are ment. On the other hand, they provide trade-related financ- frequently squeezed. Buyers in advanced markets expect their ing: they fund working capital and take credit risk on trade 1 Trade credit arrangements in international trade include (a) “intrafirm” (also known as intragroup) trade credit and (b) trade credit between unaffiliated firms (“interfirm trade”). Intragroup trade refers to transactions arising between firms linked by a degree of common ownership and control (for example, different subsidiaries of the same group). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 7 transactions and counterparties. Financing can take the form The reasons for the large “trade finance gap” faced by of general banking facilities (not specific to trade but used to developing countries are both local and international and finance trade) and specialized financing instruments specific relate to both market failures and governance failures to trade—trade finance. The precise definition of trade finance (Auboin and DiCaprio 2017). Local constraints include in- may vary, but essentially banks provide three types of trade sufficient credit infrastructure, crowding out by public sector finance products. borrowing, conservative lending practices, unsuitable regula- tions, and so on. This situation leads to an undersupply (gap) 1. Corporate trade finance involves traditional trade fi- hampering SMEs versus what would be economically optimal, nance instruments in which the issuing bank takes a even though trade credit and finance are generally perceived credit risk, at least nominally, on a local firm. These in- to expose trade lenders and creditors to lower levels of risk struments include import letters of credit, bank guaran- compared with other types of finance. In addition, the financ- tees, bid and performance bonds, among others, which ing of trade is highly procyclical. During a downturn, liquidity mitigate the execution and payment risks between trading disappears and markets overreact so that trade credit and fi- entities. Besides imports, these instruments are also used nance may be unavailable, whatever the price, except to the to secure the performance of contractors in procurement strongest firms or financial institutions. Firms are, in turn, often transactions. crowded out by the public sector both through large-scale bor- rowing from the financial system and through late payments to 2. Financial institution trade finance, such as letter of their domestic suppliers. credit confirmations, in which a bank takes a credit expo- sure on other banks, in an effort to balance risk with mar- Compliance costs and risks associated with anti-money ket revenue potential. In particular, local banks confirm laundering (AML) and know-your-customer (KYC) re- letter of credits issued by foreign banks, which support quirements are leading global correspondent banks to export trade. curtail business relations with banks in poor and fragile countries.2 Even before the crisis, KYC and AML standards 3. Supply chain and other structured trade finance prod- led international banks to be wary of correspondent banking ucts, in which the security provided to the financier is “in- business with developing countries. This trend is likely to ac- ternal” or “organic,” that is, relates to the assets financed celerate for some poorer countries that may face foreign ex- (notably receivables). These products include factoring, change liquidity shortages because of smaller export volumes, in which sellers sell the receivables and outsource their lower commodity prices, or supply chain disruptions. Similarly, collection to factoring companies. some of the international banks may become more reluctant to extend the trade loans that banks in poorer countries need The International Chamber of Commerce’s Banking Commis- to provide trade finance and foreign exchange liquidity to their sion estimated the aggregate trade finance exposure between own clients locally. When credit and liquidity are constrained, 2008 and 2018 at around US$9 trillion and the global factoring banks may opt to retrench business with their SME clientele to market at around US$3.5 trillion (ICC 2019). continue serving their larger corporate clients. For many entrepreneurs in developing countries, access Rejection rates in SME applications for trade finance is often limited to basic trade finance services (payment are generally higher in poorer countries, partly because remittances, documentary collections), which do not re- of the difficulties faced by some SMEs in providing the quire banks to provide financing. By default, these entre- documentation that lenders require to meet KYC and AML preneurs finance their trade activities through general banking standards. In Africa, only a few countries (notably the Arab credit facilities—often a simple overdraft or a general-purpose Republic of Egypt, Cameroon, Nigeria, and South Africa) al- short-term loan secured by a mortgage on residential or com- low e-signature and electronic authentication of documents. mercial real estate (“external collateral”). However, mortgage The requirement for physical authentication of KYC, AML, loans can be expensive for borrowers and can increase the and transactional documents has become particularly burden- costs of switching to another bank. some in the pandemic.3 This burden leads to increased cost and rejection rates and slower processing of transactions. 2 AML regulations refer to a range of regulatory processes firms must have in place, whereas KYC is a component part of AML that consists of firms verifying their cus- tomers’ identity. 3 The International Finance Corporation conducts important advocacy and technical assistance in many of these areas. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 8 Trade credit insurance Overall, trade credit insurance underpins 15 percent of Credit insurance is procyclical. When faced by a deterio- world exports, and up to 20 percent in some countries, rated credit environment, private sector credit insurers and such as China and the Republic of Korea. Trade credit in- their reinsurers reduce their risk exposure. This action leads surance covers policyholders (insured sellers) against the risk to more-than-proportional reductions in trade credit (attrib- that their customers (buyers) might not pay for the goods or utable to the multiplier effect of credit insurance), squeezes services delivered to them. In 2019, the global trade credit in- working capital, and edges firms toward insolvency. Firms that surance industry covered flows estimated at more than US$5 continue deliveries on open credit terms without insurance will trillion (more than 6 percent of world GDP), split evenly be- face customer defaults and might no longer be able to use un- tween cross-border and domestic trade. In more advanced insured receivables as a borrowing base. Importantly, it takes markets, notably Europe, insured trade flows are on the order time to restore credit lines once they have been cut. Financial of 15 percent of GDP. Approximately 90 percent of the annual statements—on the basis of which underwriting decisions are cross-border credit insurance volume relates to short-term made—reflect the past situation of firms; it might take over a transactions (usually less than 180 days) and 10 percent sup- year until improvements are reflected in new financial state- ports trade in capital goods. ments. As a result, the credit scores of obligors will be lower than warranted, and credit limits might not be reinstated as Trade credit insurance has a multiplier effect on trade. For quickly as they should once a recovery is underway. firms, especially SMEs, trade credit insurance brings benefits beyond pure risk mitigation. It facilitates the exporters’ busi- Firms and value chains in developing economies need ness development and sales diversification, strengthens their better access to credit insurance. Whenever possible, ba- balance sheets (on average, trade receivables account for 40 sic credit insurance should be left to private sector insurers percent of the total assets of a company, and payment default to provide. However, trade credit insurance creates positive by large buyers is usually the single largest cause of SME externalities, and is a significant element of the credit infra- insolvency), and supports financial inclusion (sellers may use structure. For this reason, states have a vested interest in fa- receivables backed by credit insurance as a borrowing base). cilitating its provision, whether through structural policies, or in It facilitates trade integration by allowing firms to trade freely times of global crisis, through countercyclical interventions.4 with clients in other countries on open credit terms. Trade credit insurance stabilizes cash flows and enhances value added, market penetration, and geographic diversification. 4 The World Bank’s most significant involvement in credit insurance has been the financing of two successive Africa regional trade facilitation projects between 2001 and 2015. These projects developed the African Trade Insurance Agency, which provides trade credit and investment insurance in the agency’s 18-member countries. The World Bank occasionally includes an export development component in its export development projects and has conducted various diagnostics and technical assistance in Algeria, Jordan, Mongolia, and Tunisia. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 9 Trade financing during the COVID crisis Global downturns, such as the COVID-19 crisis, affect the the COVID-19 crisis, credit insurers—in cooperation with their demand and supply for trade finance in several ways. The regulators and professional associations—have undertaken riskier environment prompts exporters to secure a higher pro- a wide range of measures to cushion the impact of the pan- portion of their sales through letters of credit as security for demic on firms and to avoid the death spiral of reductions in borrowing. During previous crises, the proportion of cross-bor- trade credit insurance, trade credit, and trade flows. Measures der trade conducted through letters of credit—typically 10 per- include more flexible handling of defaults, shorter waiting pe- cent in normal times—rose to 30 percent of global trade flows. riods for the indemnification of claims, increased emphasis on Because of credit concerns, banks become more reluctant to amicable settlement, and fast-track approvals. extend unsecured lines. High-quality borrowers who may no longer access unsecured borrowing might migrate to forms of Governments in the European Union (EU) and the Or- trade finance secured by “internal” collateral (assets related to ganisation for Economic Co-operation and Development the transaction financed, such as receivables and inventory). (OECD) moreover have been intervening at a massive Commodity exporters may also migrate from clean unsecured scale to support credit insurance. France and Germany borrowing to structured finance, pledging future sales under have both implemented large state schemes (commitments long-term export contracts. of between 0.5 and 1.0 percent of GDP) to reinsure the main private sector credit insurers operating in their respective The trade finance gap becomes wider in poorer develop- national markets. Similar schemes have been implemented ing countries. The crisis generally increases the demand for in other countries, both within the European Economic Area trade finance and hampers its supply. On the import side, de- (Belgium, Denmark, Italy, the Netherlands, Norway, Slovenia, veloping country firms that previously enjoyed access to pur- and Spain) and outside (Canada, Israel, Turkey, and the Unit- chase goods or services on open credit terms will be required ed Kingdom). State reinsurance schemes leave management to switch to letters of credit issued by banks in the import- and underwriting in the hands of private sector credit insurers ing country and confirmed by banks in the exporting coun- but require them to maintain the overall level of credit lines. In try. Shrinking trade credit insurance covers will also prompt East Asia (notably in China, Japan, and Korea), state budget exporters in developed and emerging economies to require support is channeled through a dedicated national fund back- letters of credit from importers in developing countries with stopping the national export credit insurance agency. In Sin- lower credit scores. gapore, the government supports the credit insurance market by subsidizing the premium charged to SMEs. During the initial stages of the COVID-19 crisis, supply chain disruptions slowed down production processes Existing schemes in the EU and the OECD support credit and delayed the settlement of trade transactions between insurance in their home markets. Some of these schemes firms. This situation increased overall working capital needs can be expanded, or new schemes could be implemented, to and the demand for trade finance. Lower demand and levels support credit insurance in a manner that benefits poor coun- of activity in some of the global value chains may dampen tries. The types and focus of the interventions suggested in demand for trade-related financing. But overall, the demand this report vary, depending on the level of economic and insti- for trade finance is likely increasing because of the higher tutional development, the quality of credit infrastructure, and share of secured transactions in global trade. In response to the maturity of their respective credit insurance markets. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 10 A trade financing policy agenda for developing countries With globalization, the expansion of value chains, and 4. Traditional trade finance. On the international front, mul- the increased trade elasticity of economic growth during tilateral agencies and donor governments need to take the past three decades came rising financing volumes action to ensure that poorer, fragile developing econo- and credit exposure related to trade. The present crisis mies continue to be “plugged” into international trade fi- has brought to the fore the credit and finance vulnerabilities nance. A key part of this agenda is to ensure that banks in arising from longer global value chains. Unlike the previous these countries continue to have access to the credit lines global economic crisis, the COVID-19 crisis has hit the real (notably for the confirmation of import letters of credit), sector and trade directly, rather than working its way primar- foreign exchange liquidity, and correspondent banking ily through the financial system. This means that, even more services they need to carry out trade finance activities.5 than during the 2008–09 global financial crisis, countercycli- cal measures supporting trade credit and finance cannot be 5. Specialized trade finance. Policies can be pursued to limited to the financial sector. These policies need to address develop the use of trade receivables as a borrowing base, vulnerabilities in the real sector. including factoring (through regulations, establishment of registries of movable collateral, and so on). Other types Trade credit, credit insurance, and trade finance require of specialized secured lending can be developed, such a functioning enabling environment. This environment in- as inventory finance. Banking regulations may need to be cludes corporate governance, insolvency law, accounting sys- amended to recognize the value of internal collateral (col- tems, and credit bureaus. However, even in the most condu- lateral related to the transaction financed, such as receiv- cive environments, trade credit and finance are susceptible ables and inventory), besides traditional lending secured to market failures. Structural or countercyclical interventions by a mortgage on real estate assets. could be pursued in the following areas: 6. State schemes. To expand SME access to export finance, 1. Monitoring of trade credit and payment delays. This including preshipment export finance, state schemes can activity entails giving policy makers the ability to under- be established to complement general banking facilities stand the scale of issue, to spot problems earlier, and to and help SMEs in export value chains raise financing for more accurately assess the impact of measures taken. their production cycle and the procurement of inputs re- Monitoring would target government procurement, SOEs, quired for exports. In some cases, rapid-response facili- SMEs, and more broadly key national value chains. ties could be implemented to provide liquidity or risk shar- ing to encourage banks to provide certain trade-related 2. Trade credit discipline. Such discipline can be achieved financing to local firms, for example, for the refinancing of through regulation and oversight, and by encouraging overdues from state-owned enterprises. larger enterprises—starting with SOEs—to pay their SME suppliers on time. 7. Digitalization. On the banking side, national banking reg- ulations need to allow the digitalization of trade finance 3. Trade credit insurance. This may involve processes. Countries may fast-track their adoption of the a. facilitating the creation of national credit insurance Model Law on Electronic Transferable Records by the markets by establishing the required regulatory, insti- United Nations Commission on International Trade Law. tutional, and credit infrastructure building blocks; Among SMEs, the digitalization of accounts receivable b. deepening existing markets—for example, in small and payable could enable several positive developments, and nascent markets, pooled schemes could help such as (a) facilitating KYC and AML procedures, which state providers access international reinsurance, and have until now hindered SME access to trade finance; (b) during crises, countercyclical provision of state rein- facilitating the production of quick digital accounts, which surance may help cushion the reduction in trade credit can help lenders assess and monitor credit risk in real insurance lines in relatively mature markets; and time; and (c) employing credit scoring methodologies and c. incentivizing the downscaling of access to trade cred- other fintech solutions, which would allow SMEs to ac- it insurance by relatively smaller firms. cess new financing products. 5 This agenda is already being actively pursued by IFC (with the support of the International Development Association’s Private Sector Window), as well the commercial arms of other international development agencies. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 11 Countries or categories of firms at different levels of ac- Policy recommendations should reflect the specific situa- cess may require different types of public policy and state tion and challenges faced by target countries and should intervention instruments. As previously indicated, counter- be based on country diagnostics assessing the financing cyclical interventions might be possible and desirable in certain of trade and value chains. These diagnostics would identify categories of countries but might not be realistic unless cer- available information sources, review the relevant regulations, tain building blocks are in place (notably credit infrastructure). credit infrastructure and state schemes, and assess the mar- Structural policies and interventions would be required toward ket gaps for the country as a whole, and for different types this end. The report in turn details the types of domestic and of firms (informal SMEs, formal SMEs, small corporates, and international countercyclical and structural interventions that large corporates) and activities (import, export, public sector could be viable for both middle- and low-income countries. Fi- contracts, and so on). In turn, these diagnostics could be the nally, country-specific diagnostics are needed to assess the basis for a benchmarking exercise assessing the extent of suitability of different types of interventions depending on the market development and access across our developing coun- level of development and specific challenges faced by the tries, and the policy pursued in the respective markets. beneficiary countries. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 12 1. >>> Introduction The COVID-19 crisis poses major challenges to global trade, value chains, and their fi- nancing. A decade ago, in the wake of the global financial crisis, the international community scrambled to investigate the relationship between trade and its financing. The World Bank, for example, explored this topic at length in the flagship publication Trade Finance during the Great Trade Collapse (Chauffour and Malouche 2011). Even in “normal” times, the financing of trade and value chains is of major importance to developing countries because of its impact on competitiveness, export performance, and ultimately on employment and growth. Yet this topic is prone to fall between the cracks, both because of its technical complexity and because it cuts across different disciplines: financial inclusion, value chains, private sector development, trade facilitation, among others. This report aims to build on these foundations to improve the knowledge base on the financing of trade and related data, institutions, and instruments to support operations that strengthen the trade financing infrastructure in client countries and regions. The report explains these issues in terms understandable by nonspecialists focusing on key charac- teristics and data sources for trade credit, trade credit insurance, and trade-related financing. It then provides an overview of trade finance supply-and-demand dynamics during the two recent global economic crises: the 2008–09 financial crisis and the 2020 COVID-19 crisis. The report concludes with a policy agenda focused on how in particular the World Bank Group and other international institutions can more effectively support developing countries on this agenda. This report aims to identify the types of interventions that could be implemented to sup- port the financing of trade and value chains. Meeting the growing demand throughout the developing world for support in this area includes (a) country-level technical assistance and diagnostic work, (b) improved data infrastructure, and (c) global engagement and advocacy. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 13 2. >>> Key Concepts and Quantification Challenges 2.1. How is trade financed? 2.1.1. Difference between trade credit and trade financing Firms finance their trade activities in two major ways. They use (a) payment facilities from suppliers and prepayments from clients, known as interfirm trade credit (in short “trade credit”); and (b) credit facilities from banks and other financial institutions (“trade financing”). Interfirm trade credit is simply the deferred payment facilities that suppliers (sellers) grant to their custom- ers (buyers) to settle invoices in their sales of goods or services. Trade credit is an essential form of financing in both cross-border and domestic trade transactions. Access to trade credit and trade financing has major implications for financial inclusion and for the viability of small and medium enterprises (SMEs). Besides short-term credit facilities, the working capital required by trade can also be financed from shareholder funds and other long-term sources. Long-term sources are important for trade but are not covered in depth in this report. Similar considerations apply at the value chain level. Value chain processes move goods from “upstream” input suppliers through midstream “transformers” to “downstream” custom- ers. These processes involve a variety of stakeholders: producers and manufacturers, traders, wholesalers, forwarders, transporters, warehouse operators, custom authorities, retailers, and financiers, among others. Value chains may be domestic (for example, local production for local retail consumers, or local firms, or for the public sector) or cross-border, involving transit through one or more countries. In global value chains, raw materials are imported from various countries, or when production or assembly requires consecutive, increasingly complex stages, each is likely to take place in a particular country based on its international competitiveness. Value ad- dition along the value chain is split between various sellers and intermediaries, extending from upstream suppliers to downstream customers. Conversely, payments and cash flow circulate from downstream consumers to intermediary wholesalers, producers, and service providers, and ultimately to upstream suppliers. In other words, value chains are reverse payment chains. Typically, firms need to pay input suppliers and service providers before they can sell their goods and collect payments from their customers. Thus, supply chains are mirrored by trade credit chains between suppliers and customers. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 14 Much of the financing used in value chains does not insurance, globally the volume of insured international flows come from financial institutions, or only comes indirectly. is roughly similar to the volume of insured domestic flows, but Like firms, value chains finance their activities in two major in some countries the market consists mostly of domestic vol- ways: (a) “internally” (organically), through credit (that is, the umes, whereas in others export flows predominate. deferred payment terms) that buyers and sellers extend each other; and (b) “externally,” from funds raised from third par- Beyond financing (funding or guaranteeing) transactions, ties, especially banks and other financial institutions. In de- financiers also provide payment and documentary servic- veloped and advanced developing markets, trade credit is es that are essential for the completion of these transac- underpinned by trade credit insurance. External financing of tions. Such services include several key functions related to value chains—that is, their financing by banks and other finan- de-risking that are becoming increasingly essential to support cial institutions—provides liquidity, notably to producers and the provision of credit following a surge of regulatory activ- sellers, allowing them to (a) purchase and procure inputs, (b) ity since the 2007–08 financial and 2010–11 eurozone crises fund costs incurred during the production and manufacturing (Starnes et al. 2017). These reforms are intended to quan- process until the goods are sold (“preshipment,” also known tify systemic risk, promote greater transparency, and combat as “predelivery” financing), and (c) monetize the amounts money laundering and terrorism. invoiced (receivables) until buyers actually effect payments (“postshipment” financing, also known as “postdelivery” or “re- 2.1.2. Trade credit ceivable” financing). It also allows buyers to pay for the goods after delivery, which allows them, in turn, to provide credit pay- Trade credit in international trade ment facilities to their own clients. Different types of credit arrangements underpin global trade flows. They include (a) “intrafirm” (also known as in- Most international trade transactions involve not only tragroup) trade, (b) trade between unaffiliated firms (“interfirm cross-border trade financing, but also domestic financ- trade”) conducted on open credit terms, (c) interfirm trade paid ing. Exporters require export finance to fund both their pro- by cash in advance, and (d) trade transactions intermediated duction cycle before shipment and their trade receivables by financial institutions. after shipment. When bidding for construction and engineer- ing contracts, exporters often need a local bank to issue a Intragroup trade refers to transactions arising between performance bond, which will, in turn, be reissued by an inter- firms linked by a degree of common ownership and national bank in the importer’s country. Importers, among oth- control (for example, different subsidiaries of the same ers, need to find a local bank that is able and willing to issue group). The volume of intragroup trade is not tracked by import letters of credit, which will, in turn, be confirmed by the international statistics. As an indication of size, in 2016 the exporter’s bank overseas. Thus, the supply of finance for in- United Nations Conference on Trade and Development es- ternational trade may be constrained not only by international timated—based on a survey data set on US firms—that ap- factors (such as the local banks’ access to international corre- proximately one-third of global exports are intragroup trade spondent banking relationships), but also by domestic factors (UNCTAD 2016; cited in Lakatos and Ohnsorge 2017). The (such as the willingness of local banks to extend trade finance same survey indicates that intragroup trade has a higher inci- or related working capital facilities to local SMEs). dence in sectors such as transportation equipment, electron- ics, and chemicals. Intragroup trade nominally gives rise to In their principle, domestic and international trade fi- trade credit, but in practice the volume and terms of the credit nancing instruments are largely similar but their respec- arrangements are largely determined by the group’s internal tive prevalence may vary. For example, factoring services policies. The trade credit facilities that different subsidiaries may be available for domestic sales but not for export sales. grant to each other effectively net out once consolidated into Letters of credit are common in international trade, but rela- group accounts. Approximately 65–70 percent of global trade tively uncommon in domestic trade. Export transactions may is believed to be conducted between unrelated firms, most be perceived as riskier and more challenging than domestic commonly in textiles, apparel and leather products, and food transactions (to the extent they involve different jurisdictions and beverages (Lakatos and Ohnsorge 2017). Interfirm trade to ensure enforcement in case of default, and it may be more gives rise to “arm’s-length” trade credit. Trade credit usually challenging to access information on trade partners located takes the form of deferred payment facilities extended by sell- overseas). But the opposite can be true for sales to overseas ers to buyers on open credit terms. buyers with strong credit ratings. In the case of trade credit EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 15 Alternatively, buyers pay for purchases before shipment Trade credit in domestic trade (“sales on cash-in-advance terms”), which creates a re- Besides cross-border trade credit, countercyclical poli- verse trade credit from buyers to sellers. Trade on advance cies and interventions also need to focus on domestic payment terms often arises between firms with contrasting lev- trade. Indeed, the size of domestic trade is significantly larger els of market power. Sellers with strong market positions may than global trade. Although the volume of international trade be able to impose advance payments on weaker buyers over- is a fraction of global gross domestic product (GDP) (about seas. However, the opposite situation may also arise. Instead half), the volume of domestic trade is a multiple of GDP.6 of exacting open credit and differed payment terms, leading There are only a few very open economies in which external firms in global value chains with good access to finance are at trade is a multiple of GDP. Note also that global value chains times willing to prefinance (pay before delivery) trusted sup- combine firms and segments that finance their trade transac- pliers that do not have sufficient access to finance from local tions locally. banks or from their own suppliers. Advance payment arrange- ments help the finances of exporters, but also place them in a Ideally, buyers prefer to conduct their domestic trade dependent position compared with importers who provide this on open credit terms with differed payment facilities. financing. This is particularly the case in a credit crunch, such Alternatives for firms that wish to reduce their exposure to as the one arising from the COVID-19 crisis. credit risk—whether because the customer is not financially strong or because the parties don’t know each other well— Trade credit plays an essential role in global trade and include cash in advance or other types of security, such as value chains. This situation is especially true for the external postdated checks. trade of our client countries. Creditworthy buyers in the more advanced markets (such as Western Europe or North Ameri- Central bank data, when available, indicate that trade ca) typically expect their suppliers based in developing coun- credit conditions vary by sector and depend on firm size. tries to sell on open credit terms. When selling to advanced Typically, larger firms tend to be in a better position to benefit markets, the ability to offer trade credit is an important part of from favorable payment conditions for both sales and purchas- the exporters’ competitive offering. However, it creates major es. Trade credit arrangements also reflect the respective mar- challenges for exporters in developing countries. ket power of buyers and sellers. As pointed out by Fisman and Love (2003), in many emerging countries, credit information 1. Exporters are exposed to credit risk on their buyers and legal remedies are weak. As a result, trade credit tends to overseas. Generally, exporters may not be well equipped arise disproportionally in sales to large organizations. In coun- to assess the financial situation of their buyers in distant tries with weaker credit infrastructure and legal enforcement markets. During severe market downturns (such as the systems, trade credit may be predicated on information, trust, current COVID-19 crisis), even reputable buyers may ex- and social enforcement means flowing along family, tontine, perience cash flow difficulties or even become insolvent. clan, or ethnic lines. The default of a major client may in turn cause its suppli- ers to become insolvent. 2.1.3. Trade credit insurance Trade credit insurance is a risk management instrument 2. Exporters will need to grant deferred payment facili- that private insurance companies and national export ties to the buyers. Major importers in developed coun- credit agencies offer businesses. It covers policyholders tries (such as large retail chains) enjoy strong market (mostly sellers of goods and services) against the risk that power, and are able to impose credit terms (typically their customers (mostly firms buying goods and services sold 60–90 days) on their suppliers in developing countries. by policyholders) might not pay for the goods or services they Doing so will expand the size of accounts receivable on receive. The industry initially arose as a competitive business; the exporters’ balance sheet. This increase in assets will, however, over the years it has received considerable attention in turn, need to be financed by banks or other financial from policy makers because of the externalities it generates institutions. The associated challenges are discussed in and the market failures to which it is prone. This awareness section 2.1.4. led to significant state intervention in both developed and de- 6 Domestic trade includes the sum of wholesale trade and retail trade. Domestic trade is not as precisely or systematically tracked as international trade, but it can be estimated from (a) national accounting data (national output) and (b) aggregate enterprise accounts (enterprise sales). In the case of France, for example, the total sales of enterprises with turnover greater than €750,000 was approximately 2.8 times GDP. This figure is underestimated because it does not include the sales of the smallest enterprises. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 16 veloping economies. State intervention took place after World insurers, such as Lloyd’s of London, provide specific covers War I (the United Kingdom’s Export Credit Guarantee Depart- to more sophisticated clients (covering selected transactions ment established in 1919), during the Great Depression (US and risks rather than the whole sales turnover, under more Export-Import Bank in 1934), toward the end of World War II flexible risk-sharing arrangements that are not necessarily (Canada’s Export Development Corporation in 1944, France’s prorated); and (c) state agencies and schemes. All three types COFACE in 1946, Germany’s Hermes in 1949, and Japan’s of providers are reinsured by reinsurers specializing in credit export credit scheme in 1950). State intervention was also insurance, and at times by domestic reinsurers (notably to used as a tool to support the expansion of national exports comply with national regulations). (the Republic of Korea’s K-Sure in 1992 and China’s Sinosure in 2001) and regional trade integration (African Trade Insur- For firms, especially SMEs, trade credit insurance brings ance Agency in 2001 and Common Market for Eastern and benefits beyond pure risk mitigation: Southern Africa in 1994). 1. It facilitates the exporters’ business development and The global trade credit insurance industry covered flows sales diversification (credit opinions from credit insurers estimated at over US$5 trillion in 2019, of which approxi- can be a major market intelligence tool). mately half is in cross-border trade and half in domestic trade (Berne Union 2020c). Overall, trade credit insurance 2. It strengthens the balance sheet (on average, trade re- underpins 15 percent of world exports and up to 20 percent ceivables account for 40 percent of the total assets of a in China and Korea. In more advanced markets, notably Eu- company, and payment default by large buyers is usually rope, insured trade flows are equivalent to around 15 percent the single largest cause of SME insolvency (Dornel, Ait Ali of GDP (Dornel, Ait Ali Slimane, and Mohindra 2020). Approxi- Slimane, and Mohindra 2020). mately 90 percent of the annual cross-border credit insurance volume relates to short-term transactions (trade credit with 3. It supports financial inclusion, given that receivables maturities of less than 180 days, occasionally up to one year), backed by credit insurance may be used by sellers as a and about 10 percent supports trade in capital goods, such as borrowing base to raise finance without pledging cash or planes, ships, power plants, refineries, and heavy industrial fixed assets to their banks. equipment (Berne Union 2020c). However, trade credit insurance also comes with some Market penetration varies across regions and sectors. limitations. For example, it is not optimal for retailers as it Penetration is higher among developed countries than in only covers business-to-business accounts receivable and not developing countries. Among developed countries, market retail sales. Similarly, suppliers that sell exclusively to govern- penetration is highest in Europe and East Asia; among de- ments and those that do not sell on open account terms may veloping regions, credit insurance is least developed in Sub- not benefit from trade credit insurance. Furthermore, for many Saharan Africa. Box 2.1 outlines the credit insurance offering SMEs, trade credit insurance is often unavailable in low-in- and challenges arising in the Middle East and North Africa come countries. (MENA) region. Market penetration is also higher for manu- factured goods and agro-industry exports, but lower for hy- At country and value chain levels, trade credit insurance drocarbons and minerals. Credit insurance is less relevant for is a significant factor of trade integration; it allows firms intragroup trade flows except to cover the currency transfer to trade freely with clients in other countries on open and other state-related risks arising in the countries of the en- credit terms with limited exposure to credit risk. Notably, tities purchasing goods or services from other group entities. trade credit insurance has been a significant enabling factor The availability of trade credit insurance varies considerably in facilitating trade integration in Europe. Insuring receivables the developing world. against credit risk increases the stability and predictability of sales cash flows, thus reducing the likelihood of insolvencies Credit insurance is available from three main types of un- and their knock-on effect on the supply chains. Trade credit derwriters: (a) a handful of global, privately owned insurers insurance has positive implications on value added, market cover the trade transactions of insured firms on a “whole-turn- penetration, and geographic diversification. Econometric stud- over” basis (meaning that insured firms cover the value of total ies have estimated the short-term multiplier effect of credit sales over a specified time, such as one year); (b) specialized insurance on export trade within a range of 2.3 to 3.2 (van EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 17 der Veer 2015). The long-term multiplier effect of credit insur- lion supporting gross exposure of US$6.4 billion in trade and ance on export trade is estimated to be higher than the short- investment transactions in Africa.7 Besides African regional in- term multiplier. tegration, the World Bank also occasionally includes an export development component in export development projects. In The World Bank’s most significant involvement in credit Tunisia, the bank financed a pre-export finance scheme insur- insurance to date has been the successive Africa regional ing banks that finance SME exporters. This component was trade facilitation projects between 2001 and 2015. The two implemented by the national credit insurer. In Jordan, market projects financed US$150 million and provided technical as- penetration by the national credit insurer is one of the indica- sistance for the creation and development of the African Trade tors tracked by the bank’s developing policy loans. Besides Insurance Agency (ATI), which provides trade credit and in- lending, in recent years the bank has conducted various diag- vestment insurance in the agency’s 18 member countries. As nostics and technical assistance activities in Algeria, Jordan, of the end of 2019, ATI had shareholder funds of US$349 mil- Mongolia, and Tunisia. > > > B O X 2 . 1 - Trade Credit Insurance in MENA Countries Among the World Bank Group’s Middle East and North Africa (MENA) client countries, Morocco has a relatively deep and competitive credit insurance markets. About 600 firms in Morocco use trade credit insurance. Morocco has two international credit insurers, plus a partly state-owned domestic provider. Insured trade flows are equivalent to 7 percent of gross domestic product (GDP)—approximately half the level observed in Europe or South Africa. Insured trade flows are estimated at approximately US$5 billion in domestic trade (5 percent of GDP) and US$2 billion in export trade (2 percent of GDP). Among MENA countries, Tunisia ranks second, with an insured volume of approximately 4 percent of GDP—approximately half export and half domestic. The market is dominated by one partly state-owned player (Cotunace), which is, in turn, reinsured by a leading international credit insurer. Beyond Morocco and Tunisia, trade credit insurance is still nascent in other MENA countries. Egypt—with a market penetration estimated at less than 1 percent of exports—probably has the largest undertapped potential in the region. In Jordan, national authorities have identified credit insurance as a key step to enhance the competitiveness and growth of exports. The main provider, Jordan Loan Guarantee Corporation (JLGC), created in 1994, is 49 percent owned by the central bank. The JLGC has been upgrading its capabilities and has increased its market penetration in national exports to approximately 2 percent. Lebanon, before the current crisis, had an active local provider in which the International Finance Corporation initially had an equity stake. In addition to domestic providers, two regional agencies provide trade credit insurance across MENA countries: ICIEC (a subsidiary of the Islamic Development Bank, based in Saudi Arabia), and Dhaman (based in Kuwait). Several challenges are hindering the provision of trade credit insurance in MENA countries. They include rela- tively weak credit infrastructure, with regard to credit information, especially in the informal sector (to be insurable, firms must have acceptable governance, invoicing and accounting practices, and claims enforcement) and the relatively small size of entrepreneurs in developing MENA countries (credit insurers tend to target firms with annual sales of at least US$1 million). As a result, the size of national markets in developing MENA countries is at times too small to attract direct investment from international credit insurers. Smaller markets can be covered by domestic state-owned or private providers, but they also need a minimum scale of operation to cover operating cost, invest in systems, and attract qual- ity reinsurance. Sources: Dornel, Ait Ali Slimane, and Mohindra (2020); Dornel et al. (2018). 7 See ATI’s website (https://www.ati-aca.org/) for more information. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 18 2.1.4. Trade-related financing 3. Supply chain and other structured trade finance prod- This section summarizes the role played by financial in- ucts, in which the security provided to the financier is typi- stitutions in financing the trade and production cycles of cally “internal” or “organic,” meaning that it relates to the firms and value chains. Note that financing from banks is assets financed (notably receivables) instead of “external” intertwined with interfirm trade credit. Credit facilities extended collateral unrelated to the transaction financed, such as a by the financial sector can help make short-term funding avail- cash deposit or a real estate mortgage. Unlike traditional able to meet seasonal fluctuations or short-term obligations. In trade finance products, supply chain financing is usually turn, interfirm trade credit facilitates the transmission, through based on open account trading. Financing events (draw- the supply chain, of the bank financing received by the more down, risk mitigation, repayment) are triggered by under- creditworthy firms. Financiers play several major roles in trade lying transaction events in the supply chain (purchase or- transactions. Notably, they (a) effect payments between buy- ders, shipment, and so on). ers and sellers in the value chain, (b) handle and ensure the integrity of the flow of trade documents required for payment 4. Import letters of credit are issued by local banks and (“trade finance services”), (c) extend liquidity and funding, require cross-border global correspondents to confirm. and (d) take credit risk on trade transactions and counterpar- They represent the commitment of the bank, on behalf ties (“financing”). of an importer that guarantees payment to the exporter provided the terms and conditions specified in the import Entrepreneurs in many developing countries have limited letter of credit are met. access to trade finance instruments. Instead, they finance their trade activities through general banking credit facilities— 5. Structured trade and commodity finance is a flexible often a simple overdraft or a general-purpose short-term loan instrument that facilitates the financing of trade for critical secured by a mortgage on residential or commercial real estate commodities, especially in emerging markets. (“external collateral”). Mortgage loans can be expensive for borrowers and can increase the costs of switching to another The availability of trade finance products varies widely bank. Besides general banking facilities, entrepreneurs need from market to market. In advanced emerging markets, access to specialized financing instruments—trade finance— banks and specialized financial institutions offer a broad range to conduct cross-border trade transactions, participate in pub- of trade finance instruments; although in times of crisis, these lic sector procurement locally, and finance their trade and pro- products might become less widely available (or they might duction cycles. There are five types of trade finance products be available on very unfavorable terms). For many SMEs in that entrepreneurs may require (a more detailed description is MENA and Africa, access is limited to basic trade finance ser- included in the appendix). vices (payment remittances, documentary collections), which do not require banks to provide financing. In dealing with 1. Trade finance services, such as payment remittances SME importers, local banks often struggle to provide clean and documentary collections, which are necessary to no- (unsecured) credit terms when issuing import letters of credit tify, document, and settle trade transactions but do not because they lack sufficient information or do not perceive require banks to extend liquidity or credit. economic viability. Instead, they usually require full cash col- lateral as a prerequisite before they open a letter of credit for 2. Traditional trade finance instruments in which the issu- an importer. The cash deposit will remain blocked at least for ing bank takes a credit risk, at least nominally, on a local several weeks until the goods are shipped and paid for. Like- firm. These instruments mostly apply to import transac- wise, SME exporters in MENA seldom have access to export tions and consist of import letters of credit, bank guaran- finance. Domestically, SMEs need trade finance to meaning- tees, bid and performance bonds, and so on, which are fully participate in public procurement: when bidding for proj- designed to mitigate the execution and payment risks be- ects, they need to provide bid bonds, performance bonds, tween trading entities (the “applicant” whose performance advance payment bonds, and so on. Once awarded a pub- they guarantee, and the “beneficiary” of the guarantee). lic procurement contract, SMEs need to be able to finance or Besides imports, these instruments are also used to se- discount the receivables due from their public sector clients. cure the performance of bidders and contractors in pro- Table 2.1 summarizes the benefits and drawbacks of different curement transactions. They can also be used when a lo- payment terms and associated instruments. cal bank takes credit exposure on other banks, especially in the case of export trade. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 19 > > > T A B L E 2 - Typical Payment Terms and Associated Instruments Typical payment terms Pros Cons and instruments • Can be onerous for the buyer. It is the riskiest form, ties up working capital, and may require Is secured and simple and provides working Cash in advance buyer to borrow to finance the trade. The capital for the supplier. buyer may opt to transact with other suppliers that do not require cash in advance. Involves LC fees. • For import transactions, the bank may decline to open the LC for SME buyers, or may re- Provides security to the supplier by ensuring quire the buyer to deposit cash in advance. timelypayment. Serves as standard instrument Letter of credit (LC) • For export transactions, buyers in advanced in international trade for sales to distant or risky markets. markets prefer to avoid the cost and hassle of LCs and often favor suppliers able to transact on unsecured terms. Uncommon in domestic trade. Are less costly and more secure than LCs. For the supplier, riskier than an LC, unsuitable Documentary collections Are more widely available to SMEs from banks for the riskiest markets. than LCs. Are flexible and low risk for the buyer, have no transaction fees, and are administratively leastThe supplier takes credit risk on the buyer and cumbersome (and receivable management can incurs collection cost and loses working capital Open credit terms be outsourced to factoring, if available). in case of default (though this risk can be miti- Are preferred by buyers; make the supplier more gated by credit insurance if available). competitive. Source: World Bank. Note: SMEs = small and medium enterprises. Studies conducted by the International Finance Corpo- actions. Trade finance services provided by financial insti- ration (IFC) and regional development agencies point to tutions are essential to the processing and closing of trade the very large “trade finance gap” faced by firms—espe- transactions, regardless of whether these institutions actually cially SMEs—in developing countries. The factors causing finance traders or take credit risks on them. Aside from financ- these gaps are both local and international. Local constraints ing per se, trade finance services fall in two categories: (a) include insufficient credit infrastructure, crowding out by public effecting payments between buyers and sellers and (b) acting sector borrowing, conservative lending practices, prudential as trusted intermediaries for the transfer of trade-supporting requirements inconsistent with more advanced trade finance documents between sellers and buyers. products, and so on. Internationally, growing compliance costs and risks associated with anti-money laundering (AML) and Addressing this gap requires interventions on several know-your-customer (KYC) requirements are leading global fronts. In developing countries, more needs to be done to help correspondent banks to curtail or even terminate business re- local banks better serve exporters and importers (especially lations in poorer, smaller, or conflict-affected countries. SMEs) and the value chains in which they operate. Banks in developing countries also need support and facilitation to im- In addition, buyers and sellers require “trade finance ser- prove their access to international financing and trade finance vices” to settle, document, and secure their trade trans- services from their counterparts overseas. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 20 Key players in trade finance specialized local nonbank financial institutions include credit At the most basic level, banks in developing economies insurers that insure the domestic or export sales of local firms, provide only general bank financing (which can be used and the factoring companies that purchase the sales invoices to finance trade), in addition to trade finance services of local firms and manage their collection. (such as fund transfer or documentary collection). More- over, banks may also provide basic trade finance instruments International financial institutions play several major (such as opening letters of credit for local importers, confirm- roles. As “correspondent banks,” they are the domestic banks’ ing and collecting the proceeds of letters of credit for local overseas bankers and they maintain on their behalf accounts exporters, or issuing performance bonds for contractors). At in foreign currency, through which the domestic banks effect a more advanced level of market development, banks and the money transfers associated with their own clients’ import other financial institutions provide more sophisticated trade fi- or export business. Correspondent banks may provide cash nance or supply chain services, such as the discounting of ex- management facilities to the domestic banks, and may extend port bills, invoice factoring, warehouse receipt financing, and to them “trade loans,” that is, wholesale foreign currency fi- so on. nancing, allowing them to serve SMEs or other local clients that cannot be served by the international banks. Local export-import banks and similar state-owned finan- cial institutions may provide preshipment financing to International financial institutions also finance, secure, exporters or serve as guarantor, making it possible for or just handle the documentary flow for the international the importer to receive long-term international financ- leg of a cross-border trade transaction. If they are present ing when importing capital goods. Their mandate is to in both the exporting and importing countries, foreign banks expand the country’s exports, preserve or create manufac- may finance both sides of a cross-border trade transaction turing jobs, increase economic value added, and bolster the and multiple trade stakeholders in the overall value chain. In- international competitiveness of the host country. Instead of ternational players my include specialized institutions, such as intervening through a full-fledged “policy bank” offering trade export-import banks, factoring companies, forfaiting compa- financing and services to firms, states may also do so whole- nies, among others. Finally, some international financial mar- sale through export-import “schemes” tasked with facilitating kets and investors may be accessed to refinance or monetize the trade finance offering of regular commercial banks. Other trade finance portfolios. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 21 2.2. Quantifying and measuring trade financing flows 2.2.1. Trade credit Few developing countries publish data on trade credit. To assess the appropriateness and impact of counter- In Morocco, the central bank has conducted annual surveys cyclical trade credit policies, it is useful to measure the of payment delays since 2010, and in 2018 established an volumes of both trade flows and interfirm trade credit. Observatory of Payment Delays. Extrapolating from a sample Cross-border trade is well tracked by international statistics of 70,000 firms surveyed, the volume of interfirm credit in Mo- published by the World Trade Organization (WTO). In the case rocco can be estimated at more than 40 percent of GDP. This of domestic trade, statistical data are far less comprehensive. amount is comparable to the total banking sector credit—45 Key sources are, on the one hand, GDP input-output tables, percent of GDP—extended to nonfinancial enterprises, in- and, on the other hand, the aggregation of corporate data per- cluding financing unrelated to trade (Dornel, Ait Ali Slimane, formed by some central banks. In France, for example, do- and Mohindra 2020). In Tunisia, the central bank compiles mestic trade, as measured by the aggregate sales of firms accounting data on obligors of the banking system, which in- (excluding firms with revenues of less than €750,000), was clude data on payables and receivables. The World Bank is approximately 2.8 times GDP. conducting technical assistance in association with the central bank to map the cash flow generation and financing of value Interfirm trade credit is conveniently measured at the firm chains. As a starting point, the technical assistance focuses level, less so at the country or value level. At the enter- on improving the extraction, management, and interpretation prise level, trade credit is reflected in the accounts of sellers of trade credit data for a couple of pilot value chains. as trade receivables (measured as days of annual sales rev- enue); in the accounts of buyers, trade credit is reflected as Data from Morocco and Tunisia point to a deterioration trade payables (measured as days of annual cost of sales). of trade credit conditions for SMEs, even before the CO- The trade credit balance is the difference between the trade VID-19 crisis. In Morocco, the number of insolvencies tripled receivables and the trade payables, measured in days of an- during the past decade. About 40 percent of insolvencies are nual sales revenues. related to client payment delays or defaults, including late pay- ment in public procurement contracts. Slow payment from cli- In a recent pioneering analysis (Boissay, Patel, and Shin ents seems to be the single most critical factor hindering the 2020), the Bank of International Settlements (BIS) has at- ability of SMEs to access markets. In Tunisia, slow payments tempted to measure the extent of trade credit relative to from state-owned enterprises (SOEs) create a negative ripple global GDP on the basis of data from a sample of 13 Euro- effect on value chains and hit SMEs the hardest, harming in- pean countries, the United States, and Turkey. According vestment, employment, and business growth. to BIS estimates, aggregate trade credit comprises approxi- mately 80 percent of domestic trade credit and 20 percent of Further work needs to be done to update the data and cross-border trade credit. Total trade credit could be about 42 expand to other developing countries, as well as global percent of world GDP, of which aggregate receivables are on value chains cutting across several countries. One can the order of 22 percent of GDP, and aggregate payables about expect that the statistical data, once available, are likely to 20 percent (Boissay, Patel, and Shin 2020). In France, total indicate that the COVID-19 crisis has severely deteriorated trade credit (for firms with sales over €750,000) is approxi- the trade credit situation, not only in Morocco and Tunisia but mately 50 percent of GDP (Banque de France 2020). also in many (or most) developing countries. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 22 2.2.2. Trade credit insurance quirements. (b) The data are usually not published. (c) Data Trade credit insurance is tracked by various statistical pertaining to credit insurance are prone to be aggregated with sources; however, more work is required to combine other types of insurance activities (such as surety insurance). these data to form a meaningful comprehensive picture. (d) Insurance regulators tend view credit insurance as rela- Challenges to the compilation and interpretation of statistical tively unimportant because their professional focus is on sys- data include (a) confidentiality requirements (the credit insur- temic risk, not on trade or trade credit. Credit insurance has ance equivalent of banking secrecy requirements); (b) differ- a major impact on trade, but this aspect does not fall within ent concepts and methodologies used by different sources, the purview of national insurance regulators. With regard to which can be inconsistent and may evolve over time; and (c) balance sheet size and prudential impact, credit insurance lack of similar quality of information systems and reporting represents a relatively small percentage of the overall insur- practices by the players involved. ance sector. At the global level, the Berne Union (the global associa- Major international credit insurers extensively track com- tion of export credit and investment insurers) publishes mercial and risk data in their systems, but their annual data on total commitments and insured trade volumes reports often disclose only a very small part of this in- and claims. This information includes a breakdown by region formation. Their annual reports usually give an indication of and by type of product and maturity (for example, short-term the extent of their aggregate regional risks and of their top 10 and medium-term credit insurance, political risk insurance, country exposures. However, poorer countries, or the Sub-Sa- and other cross-border products). The top five countries with haran African region, represent only a relatively small part of new annual commitments are identified for each region. For the total risk exposure; hence, data are aggregated with other example, out of US$2.3 trillion in new short-term commitments parts of the world, such as MENA or Southern Europe. Data extended in 2019, US$59 billion (3 percent) went to Africa, on individual countries are often known to industry experts but where the top destinations were South Africa (US$12.7 billion, are not in the public domain. Reinsurers also track premium 22 percent of the regional total), Morocco (US$8.1 billion or 14 and exposures, which can be used to estimate market pen- percent), Egypt (US$6.7 billion or 11 percent), Algeria (US$5.3 etration and the level of market development in relevant coun- billion or 9 percent), and Tunisia (US2.9 billion or 5 percent) tries. This information is occasionally available. (Berne Union 2020c). 2.2.3. Trade-related financing However, this exercise has limitations: (a) The definitions In March 2009, the G-20 Summit noted that “the lack of of regions and products have fluctuated over time, making a comprehensive international data set for trade finance time comparisons difficult. (b) At least for short-term business, during the crisis has been a significant and avoidable new commitments are not necessarily used and do not all give hurdle for policy makers to make informed, timely deci- rise to new transactions. (c) Statistical data track exposures sions.” To help fill the data gap, the International Monetary on importers rather than export flows. (d) Domestic trade is Fund (IMF) and the Bankers Association for Finance and usually excluded (depending on geographies, domestic trade Trade conducted four surveys of banks between December usually accounts for 50–70 percent of business underwritten 2008 and March 2010 focusing on volume, prices, and drivers by private sector credit insurers. (e) Not all local credit insur- of the trade finance market and covering developments from ers are members of the Berne Union. Total trade credit com- year-end 2007 to year-end 2009 (Asmundson et al. 2016). mitments are reflected in BIS reports, and indicate for each During this time, the World Bank undertook an ad hoc survey importing country the size of short-term, medium, and long- of banks and firms in 14 developing countries (Chauffour and term (capital goods) commitments. The other main global as- Malouche 2011). These various initiatives provided broad use- sociation—ICISA (International Credit Insurance and Surety ful insights at the time but could not be integrated into a com- Association)—discloses the aggregate volume covered by its prehensive and consistent data set and were not continued members—almost US$3 trillion in 2020—but does not provide subsequently. a breakdown by country.8 The measurement of trade financing volumes is chal- At the country level, insurance regulators collect data that lenging for a variety of reasons: (a) non-trade-finance in- could be useful to track market development; however, struments (general banking) are used extensively to finance these statistics pose various problems: (a) State-owned trade in developing countries but are not recognized as “trade credit insurers are often exempt from insurance reporting re- finance”; (b) “trade finance” products are diverse, relate to dif- 8 See ICISA’s website (https://www.icisa.org/icisa/). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 23 ferent stages of the production and trade cycle (for example, flect risk indicators—specifically the probability of default, and preshipment versus postshipment), may be unfunded (for ex- loss given default—which can feed into the Basel cap. The ample, letters of credit), and are not considered balance-sheet most recent annual report, published in May 2020, provides items; and (c) trade finance instruments may or may not in- data up to year-end 2018. Data for 2020, reflecting the impact volve ownership transfer (invoice financing versus invoice fac- of the COVID-19 crisis, might not be available until the 2021 toring), which might be treated differently in different jurisdic- report, expected to be published in May 2022. tions and involve various types of domestic and international players (for example, importers, exporters, banks, fintech, and At the global level, other than the ICC Trade Finance Reg- other nonbanks) that may use different accounting methodolo- ister, SWIFT—the Society for Worldwide Interbank Finan- gies, in addition to other reasons. cial Telecommunication—tracks transaction and credit volumes pertaining to letters of credit. However, it only Considerable methodological challenges also arise when publishes limited information pertaining to the number of mes- attempting to measure the “trade finance gap” in develop- sages flowing through the system related to letters of credit. ing countries. The methodologies to measure this gap need Data published by the BIS on cross-border financing provide to be further developed and applied in developing countries, country-level totals for export credits, but for the most part do but as an order of magnitude, the Asian Development Bank, not identify whether the financings are associated with trade. IFC, and WTO estimated the annual volume of unmet demand for “trade finance” at US$1.5 trillion in 2019, of which US$700 FCI (formerly Factors Chain International), the largest billion was in developing Asia, and US$82 billion was in Af- factoring association, publishes on its website the glob- rica. In addition, the IFC estimated the global gap in supply al volume of its members, including for each individual chain finance in emerging and development countries at more country, the volume of domestic and cross-border factor- than US$900 billion (WTO and IFC 2019). This gap increased ing and the number of factoring companies. The global dramatically in 2020, with the International Chamber of Com- factoring market is estimated to be approximately US$3.5 merce estimating a global trade finance gap of up to US$6.5 trillion, equivalent to 4.3 percent of global GDP (FCI 2019). trillion, though with a wide range (ICC 2020). This topic is dis- In Western Europe, factoring volumes are around 15–20 per- cussed in more depth in sections 3.2. and 4. cent of GDP. For a sense of the disparity between developed and developing countries, among MENA countries—besides Morocco where factoring volumes are close to the world av- In the wake of the global financial crisis, the International erage—factoring is barely available in other client countries Chamber of Commerce’s Banking Commission initiated (for example, volumes in Tunisia and Egypt are less than 0.5 the ICC Trade Register. This extensive database compiles percent of GDP). data on the trade finance business conducted by major inter- national banks (now numbering 25). Instruments tracked by At the national level, central banks typically report the ex- the ICC Trade Register include (a) traditional trade finance posure of the financial institutions they supervise to trade products—import and export letters of credit, letter of credit finance products, such as import letters of credit, confir- confirmations, trade loans (for import or export), performance mation or discounting of export letters of credit, export guarantees, and standby letters of credit; (b) supply chain pay- prefinancing loans, performance bonds, and trade loans able finance; and (c) export finance backed by export credit that local banks may receive from international banks. agencies. For 2018, the ICC database reflected aggregate Some countries might be interested in cooperating with the exposures of US$1.96 trillion (estimated to represent 28 per- World Bank or other multilateral agencies to work out a sys- cent of the total market for these products and 11 percent of tem to track and interpret these data more systematically. global trade volumes), of which US$600 billion in import or ex- Similar arrangements could also be implemented with national port letters of credit (estimated to support 3 percent of global or regional development finance institutions engaged in trade trade) and US$1.36 trillion in other trade finance products (es- finance, such as the African Export-Import Bank or the East- timated to support 7 percent of global trade) (ICC 2019). The ern and Southern African Trade and Development Bank to ICC Trade Register covers a very large volume of transactions track not only trade finance volumes, but also the underlying across relevant types of trade finance and related products. Its volume of trade facilitated by trade finance products. first intent is not to monitor market volumes, but rather to re- EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 24 3. >>> Trade Finance during the COVID Crisis 3.1. Lessons from the global financial crisis Global downturns, including the current COVID-19 crisis, affect the demand and supply for trade finance in several major ways. Generally, the riskier business environment prompts exporters to secure a higher proportion of their sales through letters of credit. During previous crises, the proportion of cross-border trade conducted through letters of credit—typically 10 percent in normal times—rose to 30 percent of global trade flows. Because of credit concerns, banks become more reluctant to extend unsecured lines, especially for large amounts and over- long maturities. Good quality borrowers who can no longer access unsecured borrowing mi- grate to forms of trade finance secured by “internal” collateral (assets related to the transaction financed), such as receivables and inventory). Borrowers, such as commodity exporters, may also migrate to more structured forms of trade finance, in which lenders take security over long- term export contracts and future sales that will arise under these contracts, rather than existing assets. At the lower end of the spectrum of obligors, some borrowers deemed to have a high credit risk might find it more difficult, if at all possible, to access trade finance. In the years since, significant research has been looking at trade finance supply-and-de- mand dynamics during the global financial crisis, as well as the impact of these dynamics on firms. Of 16 articles reviewed by Starnes and Nana (2020) on the “great trade collapse,” 12 attributed it at least in part to financial constriction, accounting for as much as 15–20 percent of the trade decline. This conclusion is also supported by sector- and firm-level analysis using Belgian, Colombian, French, and US data. A comprehensive volume by the World Bank distilled key lessons from the crisis related to trade finance (Chauffour and Malouche 2011). It found, among other things, that trade finance was not the main driver of the 2008 trade collapse but it did contribute significantly, with SMEs being particularly vulnerable. The authors furthermore highlight the swift response by the international community to the crisis, supporting both large commercial and multilateral banks. Finally, the lack of data capturing types of trade finance was a major constraint toward policy formulation, and it recommended investments in data collection capacity building on the ICC’s new Trade Finance Register. As discussed in sections 3.2 and 4, many of these lessons remain salient to today. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 25 3.2. Dynamics during the 2020 COVID crisis 3.2.1. Impact on trade credit This trend is likely to accelerate b the poorer countries may During the initial stages of the COVID-19 crisis, supply be deemed riskier, and some of them face foreign exchange chain disruptions slowed down production processes liquidity shortages due to smaller export volumes, lower com- and delayed the payment of trade transactions between modity prices, or supply chain disruptions. Similarly, some of firms. Initially, this outcome increased the overall working the international banks may become more reluctant to extend capital requirement and the demand for trade-related financ- the trade loans that banks in poorer countries need to provide ing from the financial system. Eventually, lower demand and trade finance and foreign exchange liquidity to their own cli- levels of activity in some of the global value chains dampened ents locally. demand for trade-related financing, although overall the de- mand for trade finance seems to be increasing because of the When credit and liquidity are constrained, banks may opt higher share of secured transactions in global trade. to retrench business with their SME clientele to contin- ue serving their larger corporate clients. Rejection rates The trade finance gap has become steeper in poorer de- in SME applications for trade finance are generally higher in veloping countries as firms are squeezed by a combi- poorer countries, partly because of the difficulties faced by nation of higher demand, lower supply, and operational some SMEs in providing the documentation that lenders re- challenges brought about by the COVID-19 crisis. The cri- quire to meet KYC and AML standards. Traditionally, trade fi- sis generally increases the demand for trade finance. On the nance involves paper-intensive, person-to-person processes. import side, developing-country firms that previously enjoyed In developed countries, digital processes have gained more access to purchase goods or services on open credit terms acceptance with regulators and banks in recent years. In Af- will be required to switch to letters of credit issued by banks in rica, only a few countries (notably Cameroon, Egypt, Nigeria, the importing country and confirmed by banks in the export- and South Africa) allow e-signature and electronic authentica- ing country. Shrinking trade credit insurance covers will also tion of documents. The pandemic has made the requirement prompt exporters in developed and emerging economies to for physical authentication of KYC, AML, and transactional require letters of credit from importers in developing countries documents more burdensome. This effect increases rejection with lower credit scores. On the export side, some of the com- rates, increases the cost, and reduces the speed of trade fi- modity producers who previously had access to unsecured nance provision. bank loans may need to migrate to structured trade finance. During the initial stages of the COVID-19 crisis, supply Prudential rules applicable to banks may also have a pro- chain disruptions slowed down production processes cyclical impact on the supply of trade finance. The riskier and delayed the settlement of trade transactions between environment generally deteriorates the credit ratings of bor- firms. This situation increased overall working capital needs rowers, thus increasing the risk-weighted assets and capital and the demand for trade finance. Lower demand and levels consumption under Basel III rules. To meet prudential ratios, of activity in some of the global value chains may dampen de- some banks may have to look for quick ways to reduce their mand for trade-related financing, but overall, the demand for overall credit exposure. Since cutting down on existing stocks trade finance is likely increasing because of the higher share of long-term loans takes time, some banks may find it expedi- of secured transactions in global trade. ent to cut down on trade finance first since the maturities tend to be short term. This outcome is also supported by emerging evidence. Before the crisis, an estimated trade finance gap of US$1.5 Meanwhile, the crisis has also dampened the supply of trillion already existed (Starnes and Nana 2020) and has been trade finance to firms in poorer countries. Even before estimated to be as high as US$3.4 to US$6.5 trillion in August the crisis, KYC and AML standards led international banks to 2020, and is growing (Wreford and Louat 2021). Across suc- be wary of correspondent banking business with developing cessive multinational enterprise (MNE) pulse surveys carried countries. Compliance requirements represent a very real fi- out by the World Bank, availability of trade finance is consis- nancial risk and have driven up costs, while Basel III capital tently listed as critically important for most respondents. In the requirements have increased the acceptable level of return on most recent survey in March 2021, 73 percent of the most capital. As a result, banks are facing increased costs and risk affected MNE affiliates and 66 percent of the least-affected while also having less capital to deploy. In many cases, that MNE affiliates listed government trade finance as critically im- makes it infeasible to do business in smaller, riskier markets. portant (Saurav et al. 2021). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 26 3.2.2. Impacts on credit insurance Importantly, it takes time for credit insurers to restore During the global financial crisis, policy makers in devel- credit lines once they have been cut. Among other factors, oped countries, especially Europe, became aware that the financial statements on which underwriters must rely to countercyclical interventions might be needed to support make credit decisions are backward-looking. These financial the credit insurance market. However, because of the time statements reflect the financial situation of firms during the required to conduct diagnostics and design new schemes, previous accounting period, and it might take another year few interventions were actually implemented, and those until improvements are reflected in new financial statements. interventions (notably in France) were implemented on a As a result, the credit scores of obligors might be lower than modest scale. As a result of the COVID-19 crisis, policy warranted, and credit limits might not be reinstated as quickly makers in developed countries revived, updated, and imple- as they should once a recovery is under way. mented the concepts they had mooted a decade earlier. Rich countries are now intervening on a massive scale to preserve In response to the COVID-19 crisis, credit insurers and the aggregate volume of trade credit insurance and avoid a the key states in which they operate, together with their possible death spiral in trade credit. These interventions sup- regulators and professional associations, have under- port trade credit in the respective national economies of the taken a wide range of measures to cushion the impact of developed world. Could similar schemes be implemented in the pandemic on firms and avoid the death spiral of re- developing economies? What could be done to support trade ductions in trade credit insurance, trade credit, and trade credit insurance in IDA (International Development Associa- flows. These measures are detailed in recent publications of tion) countries? the Berne Union, ICISA, and the Organisation for Economic Co-operation and Development (OECD) and include on the As illustrated by the global financial crisis a decade ago, one hand, (a) measures benefiting policyholders and their credit insurance is a procyclical activity. When faced by customers, and on the other hand, (b) state budget backstop an economic crisis and a deteriorated credit environment, the to ensure that public and private credit insurers continue to standard response of private sector credit insurers, similar to service firms and facilitate trade. banks, is to reduce their overall risk exposure. In part, this reaction is a consequence of the Solvency II model (the insur- Measures benefiting policyholders and their customers ance industry’s equivalent of the Basel II prudential framework (mostly the firms buying the goods and services sold by used by banks), which requires insurers either to set aside policyholders) include (a) more flexible handling of defaults, more capital (typically unavailable during a major crisis) or to claims, and waivers, including less stringent requirements for reduce their exposure so as to be able to face an anticipated the notification of potential defaults; (b) shorter waiting periods increase in risk and claims. Credit insurers are also under for the indemnification of claims; (c) more emphasis on ami- pressure to reduce their risk exposure because of the reduced cable settlement and less on legal enforcement; (d) discretion- capacity in the global reinsurance market, since the reinsurers ary powers granted to policyholders to extend the payment themselves expect to face massive losses and need to cut terms of buyers beyond the maximum credit period mandated their risk exposure. by the insurance policy; and (e) fast-track approvals. These measures are generally industry-neutral, but they often aim Reductions in trade credit insurance covers lead to re- to favor SME exporters, since they are particularly vulnerable ductions in trade credit (which can be more than propor- in a crisis. tional because of the multiplier effect of credit insurance). This decline squeezes the volume of working capital, which In addition to policy management measures benefiting firms need for their production and trade cycle, and increases firms, various European Union (EU) and OECD coun- the likelihood of firm insolvencies within value chains. In turn, tries have committed considerable backstop budget sup- this squeeze in working capital and increase in insolvencies port to the credit insurance industry so that it continues are likely to saddle credit insurers with additional losses, trig- to underwrite credit risks and enable trade despite un- gering further reductions in insurance covers. Firms that opt precedented levels of risk and likely losses. Indeed, claims to continue deliveries on open credit terms without insurance paid by the global credit insurance industry will likely be a mul- cover will face levels of credit risk that they might be unable to tiple of the premium received from policyholders. In the case absorb on their balance sheets, and might be unable to use of the Berne Union (2020b), preliminary estimates place ag- uninsured receivables as a borrowing base to raise special- gregate claims in the range of two to six times the gross an- ized financing from banks. nual premium). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 27 Under normal circumstances, the OECD and EU rules the United Kingdom). In Norway, for example, the national require states to refrain from intervening in the most credit insurance agency GIEK reinsures the four largest credit competitive segments of the credit insurance market insurers (accounting for nearly 99 percent of the national mar- (short-term export trade to low-risk countries—so-called ket) under a three-tranche risk-sharing structure: credit insur- marketable risks) to keep a level playing field among coun- ers carry only 10 percent of the gross risks they underwrite tries, and between private and state-owned providers. To until claims reach a limit of NKr 1.8 billion (US$215 million). avoid a rapid contraction of credit insurance, the EU adopt- Credit insurers are then 100 percent reinsured up to an ag- ed a temporary framework in March 2020 allowing member gregate claims limit of NKr 20 billion (US$2.4 billion), and bear states to intervene either directly through provision by a state 100 percent of the risks over that limit. The level backstop agency or indirectly through state reinsurance or private sec- budget support committed by the Norwegian state is equiva- tor providers. Among other measures, all short-term commer- lent to approximately 0.5 percent of GDP, similar to France in cial and political export risks are now temporarily considered relative terms. “nonmarketable” risks. To ensure regulatory convergence and consistent treatment of credit insurance across jurisdictions, These state reinsurance schemes leave management, risk the EU regulator (the European Insurance and Occupational management, and underwriting decisions in the hand of Pensions Authority) recommends that state interventions take private sector credit insurers, but require a commitment the shape of risk sharing reflected as reinsurance for the cal- from them not to shrink the overall level of credit lines. In culation of solvency capital requirements under the Solvency East Asia (notably in China, Japan, and Korea), state budget II prudential framework (EIOPA 2020). support is channeled through a dedicated national fund back- stopping the national export credit insurance agency. Typical- Many OECD countries have implemented large state ly, these national credit insurance funds cannot be accessed schemes. Germany has committed up to €35 billion (roughly by private sector insurers. In Singapore, the government sup- equivalent to 1 percent of GDP), and France has committed ports the credit insurance market by subsidizing the premium up to €12 billion (roughly equivalent to 0.5 percent of GDP) charged to SMEs rather than through a reinsurance scheme. to reinsure the main private sector credit insurers operating All these schemes aim to support the provision of credit insur- in their respective national markets (OECD 2020a, 2020b, ance in the respective national or regional markets. However, 2020c). Similar schemes have been implemented in other as will be discussed in the next section, scope exists for these countries both within the European Economic Area (including schemes to be reoriented or expanded or similar concepts Belgium, Denmark, Italy, the Netherlands, Norway, and Spain) could be implemented to support credit insurance in a manner and outside (including Canada, Israel, Slovenia, Turkey, and that benefits developing economies. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 28 4. >>> The Policy Agenda for the Financing of Trade and Value Chains in Developing Countries Firms and value chains in developing economies need better access to trade credit and finance. The severe challenges brought about by the COVID-19 crisis require concerted action to cushion the impact on developing countries and shorten the recovery period. Some “coun- tercyclical” measures are temporary; others are more “structural”: they may take more time to produce their effects and will need to address market gaps beyond the immediate crisis. This agenda has two essential legs: international and national. On the international front, multilateral agencies and donor governments need to take ac- tion to ensure that poorer, fragile developing economies continue to be integrated into international trade finance. A key part of this agenda is to ensure that banks in these countries continue to have access to the credit lines (notably for the confirmation of import letters of credit), foreign exchange liquidity, and correspondent banking services they need to carry out trade fi- nance activities. This agenda is already actively pursued by the IFC (with the support of the IDA private sector window), as well the commercial arms of other international development agen- cies (see box 4.1). Further adjustments or complementary actions may be required to address some of the remaining gaps. For example, the IFC can assist private sector banks but not state banks, even though state banks may be the single largest providers of trade finance to domestic firms. Further analytical work and advocacy, in cooperation with the ICC, would be helpful to avoid unintended adverse consequences of Basel III on the provision of low-risk trade finance in developing economies. A parallel agenda could also be developed for trade credit insurance. A corresponding agenda needs to be pursued at country level to facilitate provision of trade credit insurance, trade finance and interfirm trade credit. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 29 > > > B O X 4 . 1 - Response to the COVID Crisis by Multilateral Development Banks The world’s large multilateral development banks already had substantial trade finance programs that—much like during the global financial crisis—were able to increase support considerably during the most recent crisis. For example, the Trade Facilitation Programme (TFP) of the European Bank for Reconstruction and Development (EBRD) has existed since 1999 to promote foreign trade to, from, and within EBRD regions through a range of products, including guarantees and trade-related cash advances. From January 2020 to September 2020, TFP financing reached a record volume of €2 billion, with a particular focus on supporting trade in critical goods, including medical products and energy and food commodities through the program. Among African institutions, both the African Development Bank (AfDB) and, in particular, the African Export-Import Bank (Afreximbank) have provided trade finance. In the case of the AfDB, it started with the Trade Finance Initiative in 2009, which became the Trade Finance Program in 2013. This program has supported 53 projects across 324 financial institu- tions with US$8 billion in underlying flows. As of December 2019, the Afreximbank has supported more than US$81 bil- lion as part of its trade finance programs, which were launched in 1993. Both have significantly expanded their support in the past year. In the case of the AfDB, a US$10 billion COVID-19 Rapid Reaction Facility was set up; whereas the Afreximbank introduced the US$3 billion Trade Pandemic Impact Mitigation Facility, with the view toward alleviating the impact of COVID-19 on member countries. Finally, the World Bank Group has likewise stepped up its support during the ongoing crisis. The International Finance Corporation (IFC) has invested over US$80 billion to date through its trade finance programs, with a significant increase during the past year. Overall trade and commodity finance programs have supported over 400 financial institutions and US$145 billion in global trade. In 2020, responding to the COVID-19 crisis, the IFC developed an US$8 billion, Fast- Track COVID-19 Facility, supported by the International Development Association’s Private Sector Window. The IFC is also in the process of partnering with the Multilateral Investment Guarantee Agency to support state-owned banks. Sources: AfDB 2020; Afreximbank 2021; Starnes and Nana 2020. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 30 4.1. Policy implications for trade credit insurance The development of trade credit insurance aims to facilitate interventions could take the form of reinsurance schemes and stabilize access to interfirm trade credit. It may involve similar to those already implemented in OECD countries. (a) facilitating the creation of national credit insurance markets Other than China and Turkey (which already have their own by establishing the required regulatory, institutional, and credit schemes), a dozen developing economies could fit in this cat- infrastructure building blocks where they do not already exist; (b) egory, including some upper-middle-income countries (such deepening existing markets (deepening can be measured by the as Brazil, Colombia, Malaysia, Mexico, Peru, or South Africa) ratio of premiums or insured flows to GDP or market penetration and a few lower-middle economies (such as India or Morocco), in exports); in small and nascent markets, pooled schemes could but probably not IDA countries. If required, the funds needed help state providers access international reinsurance; counter- for such interventions could be financed by a loan from the In- cyclical provision of state reinsurance in markets that are suf- ternational Bank for Reconstruction and Development (IBRD). ficiently mature may help cushion the reduction in trade credit Such schemes would support credit insurance facilitating the insurance lines in times of crisis; and (c) incentivizing the down- domestic or export sales of local firms.9 scaling of access to trade credit insurance by relatively smaller firms (for example, through a premium subsidy scheme). Countries in the second (next-to-best) category have credit insurance markets that are not yet fully mature. In these Whenever possible, provision of basic credit insurance markets, insured firms (policyholders) are engaged in do- should be left to private sector insurers. However, trade mestic or export trade, whether local subsidiaries of global credit insurance creates positive externalities, and is a sig- firms already insured at group level or locally owned firms. nificant element of the credit infrastructure even though it has These markets may not be ripe or large enough for the types limitations, as discussed in the previous section. For this rea- of countercyclical interventions that have been used in EU or son, states have a vested interest in facilitating its provision, other OECD countries, but could warrant structural interven- whether through structural policies or, in times of global crisis, tions. For these markets, priorities for the public policy agenda through countercyclical interventions. may include downscaling market access so that smaller firms are served by insurers; facilitating competition in the insurance The suitability of countercyclical or structural interventions market so that firms can choose their provider; using credit in- in developing countries depends on their level of economic surance to encourage sector (for example, capital goods), prod- and institutional development, the quality of their credit in- uct, or geographic diversification of exports; or creating more frastructure, and the degree of maturity of their respective synergies between credit insurance and trade financing. credit insurance markets. The level of maturity of a credit insur- ance market can be assessed from two main perspectives: (a) This second category includes markets that are too the ability of local firms to access credit insurance as obligors in small—or whose credit infrastructure is not sufficiently import transactions (that is, is the country risk acceptable, and developed—to warrant direct investment by international how many local entities can be considered creditworthy by inter- credit insurers or attention from international reinsurers. In national credit insurers) and (b) local availability of credit insur- these markets, credit insurance is often provided by a national ance to support domestic or export sales (which can be mea- agency as is, for example, the case in Egypt or Jordan. These sured by indicators such as the number of local policyholders, agencies often lack underwriting know-how, risk management the aggregate premium collected by domestic credit insurers, or systems, and access to reliable information on domestic or the estimated volume of insured sales relative to GDP). On the overseas buyers. Two outcomes need to be avoided: (a) some basis of these criteria, developing countries could be classified agencies may underwrite risks without sufficient know-how and into four categories, depending on their market size, and the ex- systems, and accumulate unsustainable losses; (b) other agen- tent to which firms are acceptable as policyholders (sellers), are cies follow prudent approaches to risks but have no business acceptable as obligors (buyers), or altogether are not served by or development impact. For markets that are too small to attract credit insurers, whether as policyholders or as obligors. a sufficient level of interest and quality service from one of the major international reinsurers, one could explore the feasibility Developing economies in the first (highest) category have of a scheme to pool reinsurance across several smaller mar- a substantial credit insurance market in which countercy- kets to achieve the necessary scale. clical interventions could be possible and desirable. Such 9 Regarding credit insurance for export trade, one might need to check the possible legal ramifications of the proceeds of an IBRD loan’s being used to indemnify losses because of a credit default arising in another country. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 31 In the third category of countries, the market might not 1. Monitoring. Central banks require financiers to periodi- be ripe yet for the domestic provision of credit insurance. cally report their aggregate commitments (whether fund- This situation could be attributable to a weak credit infrastruc- ed or unfunded) outstanding per broad type of facility ex- ture: poor credit information, unreliable enforcement of credit posure and any defaults, new net facility approvals over claims through the legal system, and so on., but it may be the period, average usage of facilities, number of clients, considered marginally creditworthy for import trade. At the risk provisions made, and so on. This reporting is usually most basic level, only a handful of enterprises (typically local broken down by sector and maturity. These data are usu- subsidiaries of international groups, SOEs, or banks backed ally tracked from a risk supervision perspective, but could by a ministry of finance or central bank guarantee, or a major also be used from a development perspective—both for national mining or hydrocarbon exporter) can be underwritten the country as a whole and for different types of firms. by international credit insurers. For these importers, an inter- Comparing aggregated data across a few countries would national credit insurer overseas grants a credit limit and in- make it possible to initiate an international benchmarking. sures the overseas exporters against the risk that the importer might not pay for the goods or services it has purchased. 2. Digitalization. Traditionally, trade finance relies heavily on manual, paper-based processes. Processes in the For the second and third categories of countries, the ag- back offices of banks need to progressively become pa- gregate volume and number of obligors that international perless to facilitate the validation of documents and re- credit insurers can cover may shrink dramatically during duce unnecessary delays. If this is not already the case, a global crisis. For such countries, multilateral arrangements regulations may be revisited to eliminate the requirement could be considered to help cushion reductions in credit insur- for trade documents to be in hard-copy format. Countries ance limits. These arrangements could take the form of risk- may fast-track their adoption of the Model Law on Elec- sharing schemes with reputable international credit insurers. tronic Transferable Records of the United Nations Com- In some of the more challenging of these markets, the country mission on International Trade. risk might be perceived as relatively high, and fronting by a multilateral agency might be a prerequisite without which pri- 3. Specialized secured trade lending. This agenda is vate credit insurers will not consider taking a credit exposure. already actively pursued by the IFC and could be more systematically supported by the IDA. Its aim is to foster The fourth and lowest category consists of fragile and the use of trade receivables as a borrowing base or col- conflict-affected countries, which are least ripe for credit lateral, to expand the availability of factoring services and insurance because of their high levels of perceived coun- finance (through regulations, establishment of registries try risk and limited institutional capability. In some cases, of movable collateral, and so on), and to facilitate other under current circumstances schemes that could facilitate im- specialized forms of secured trade lending, such inven- ports covered by letters of credit or central bank or ministry tory finance. of finance guarantees may be more suitable or feasible than raising credit insurance for imports on open credit terms. 4. State schemes. To expand SME access to export finance, including pre-shipment export finance, state schemes can be established to complement general banking facilities to 4.2. Policy implications help SMEs in export value chains raise financing for their production cycle and the procurement of inputs required for the financial sector for exports. Such schemes can be implemented directly by a state agency—such as an export credit agency or an export-import bank (“retail” model also known as “di- Developing countries can improve the availability of trade rect” or “secondary”)—or competitively through the finan- financing through general financial sector policies. This cial system (“wholesale” model, also known as “indirect” includes reducing crowding out, improving the credit infra- or “secondary”). In some cases, rapid-response facilities structure through the creation of credit information bureaus, could be implemented to provide liquidity or risk sharing to and improving enforcement by the legal system. More spe- encourage banks to provide certain trade-related financ- cific measures could include the following: ing to local firms, for example, for the refinancing of over- dues from state-owned enterprises. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 32 4.3. Policy implications for interfirm credit Trade credit, credit insurance, and trade finance require although to comprehensively enforce their provisions through an enabling environment, including corporate gover- the legal system alone may prove challenging. Where pos- nance, insolvency law, accounting systems, and credit sible, other means (for example, corporate responsibility) can bureaus, among others. However, even in the most condu- be sought to encourage larger, more prominent enterprises to cive environments, trade credit and finance are susceptible to pay their SME suppliers on the due date. market failures, which call for specific state intervention to fa- cilitate access to trade finance and credit for firms, in particular In many developing countries, delays from customers are for SMEs. Policy measures can be pursued in various areas. often the single largest source of SME mortality, and pub- lic sector agencies and enterprises are the main source of Policy makers need tools to monitor trade credit and pay- payment delays. Reasons for slow payments from the public ment delays. Monitoring tools are necessary to understand sector include (a) the fact that state-owned agencies are of- the scale of the issue, to spot problems promptly, to identify ten cash-strapped, a situation made even more acute by the the weakest or most critical links in value chains and the as- COVID-19 crisis; (b) market power—SOEs are typically larger sociated trade credit chains, and to assess the impact of the than most of their suppliers, and in many countries, it is at policy measures taken by public authorities. Monitoring needs best difficult to sue them for payment; and (c) inefficient pay- to be conducted at several levels. Within the public sector, the ment processes in the public sector. Concerted efforts of the ministry of finance, in coordination with the respective line min- ministry of finance and relevant line ministries are required to istries, needs to monitor the payment terms of the state-owned ensure that public sector payables are settled on time. Where enterprises and the other public entities they supervise. In payment delays have arisen, as a transitional measure it may some countries (such as Morocco), the parliament and external be possible to implement a suitable mechanism to have them stakeholders are apprised of the financial situation of all state- refinanced by the banking sector. owned enterprises, including the size of accounts payable and receivable, through a comprehensive annual report. In an eco- Policies can be pursued to develop the use of trade receiv- nomic crunch, the ministry of finance and line ministries may ables as a borrowing base or collateral, thus expanding also require a more detailed monthly or quarterly report flagging the availability of factoring services. This can be achieved, any payment delays of the SOEs they supervise. for example through regulations or the establishment of reg- istries of movable collateral. Beyond receivable finance, other More comprehensively, payment delays can be monitored forms of specialized secured lending can be developed, such as part of the databases maintained by the central bank or as inventory finance. Banking regulations may need to be an observatory of payment delays. Some countries already amended to recognize the value of internal collateral (collater- have a statistical apparatus in place and collect information al related to the transaction financed, such as receivables and that would allow them to monitor payment delays by firms, inventory) besides traditional lending secured by a mortgage but do not use these data systematically. As a first step, these on real estate assets. agencies can undertake a pilot project focusing on selected value chains. This approach, for example, is currently followed Among SMEs, the digitalization of accounts receivable in Tunisia as part of the World Bank’s technical assistance to and payable enables several positive developments. They the central bank. Government may also refer to reports peri- include (a) accelerating and facilitating KYC and AML proce- odically prepared by leading international credit insurers ana- dures, which until now have hindered SME access to trade fi- lyzing payment across different sectors, and benchmarking nance from financial institutions; (b) facilitating the production against the delays arising in other countries. of quick digital accounts, which can help lenders assess and monitor credit risk in real time; and (c) applying credit scoring Payment discipline can be sought through several chan- methodologies and other fintech solutions, allowing small en- nels. They include regulations on trade credit and measures trepreneurs to access new financing products. instructing public sector agencies to pay their suppliers and contractors on time. Regulations on trade credit—at times in- The potential for using e-commerce platforms to facilitate spired by the practice followed in the EU—are already in place access to trade credit and finance can be further explored. in some countries, and mandate the maximum allowable con- Besides e-commerce giants such as Amazon and Alibaba, tractual credit terms and the extent of delay permissible in dif- other large players having access to transactions and sup- ferent sectors of the economy. These regulations are desirable ply chain data of ministries of small and medium enterprises EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 33 (MSMEs) are entering the lending realm: logistics companies Level 3—advanced access. Firms access a wide range interested in financing their customers, thereby fueling their of specialized trade finance products, both from banks own business. This measure may help expand and diversify (for example, nonrecourse discounting of receivables, the financing of MSMEs and supply chains. warehouse receipt financing) and nonbanks (for example, domestic and export factoring). Receivables can be used The credit infrastructure is another essential aspect. as a borrowing base and create a potential for financial in- Credit infrastructure spans corporate governance, insol- clusion going beyond what would be possible with general vency law, accounting systems, credit bureaus, and so trade finance. Banks can tailor their facilities on the basis on. These aspects are covered elsewhere and are beyond of the trade cycle of their clients and offer transaction-spe- the scope of this report. Finally, trade credit can be facilitated cific financing instruments, in addition to standard, gen- and supported on the one hand by trade credit insurance, and eral banking facilities. The trade credit insurance market on the other hand by banks and related financial institutions. is well-developed, not only for imports but also for exports and domestic sales. This market allows SME sellers to insure the risk of payment default on their domestic trans- 4.4. Access to trade credit actions. Cross-border transactions are usually conducted on open credit terms. The export use of letters of credit is and finance limited to the riskier or newer markets or counterparties. In practice, of course, firms need not have the same level A firm’s degree of access to trade credit, trade credit in- of access across trade credit, trade credit insurance, and surance, and trade-related financing can be classified in trade-related finance. Also, the extent of access varies ac- broad-brush terms into four typical categories. These range cording to the size of the firms, and whether they operate in from “no access” (level 0) to “advanced access” (level 3). the formal or informal sector. Also, as trade finance markets are less stable than typical financial markets, level of access Level 0—no access. At the lowest level, firms have vir- can change rapidly. A similar framework could be used to tually no access to bank finance. Interfirm trade credit, assess and compare the level of access to trade credit and if any, is largely based on personal trust along kinship, finance across different countries. For example, in a given family, or patronage lines; other transactions are paid in country, firms in the informal sector might not have access cash on delivery. Trade credit insurance is unavailable. to trade credit insurance but might have access to general This situation typically prevails for small entrepreneurs in bank finance secured by residential collateral; most firms in less advanced markets. the formal sector might have access to general trade finance products (import letters of credit) but not supply chain finance. Level 1—basic access. Firms access some interfirm A few large exporters might have access to bill discounting, trade credit, although SMEs are squeezed by large firms factoring, or the global forfaiting market. and SOEs in this market. Sellers are exposed to sub- stantial credit risk on buyers, which they cannot insure Countries could be compared on the basis of the diagnos- in the absence of a local trade credit insurance market. tics undertaken as part of technical assistance assessing Bank credit is typically not in the form of trade finance, but the financing of trade and value chains. These diagnostics rather as overdrafts or other general short-term facilities would identify available information sources; review the rele- extensively secured by mortgages on real estate assets. vant regulations, credit infrastructure, and state schemes; and Trade finance products are limited to basic services, such assess the market gaps for the country as a whole, and for dif- as payment remittances and documentary collection. This ferent types of firms (informal SMEs, formal SMEs, small cor- is a typical scenario for SMEs in intermediate markets, or porates, large corporates) and activities (import, export, public for corporates in less advanced markets. sector contracts, and so on). In turn, this analysis could be the basis for a benchmarking exercise assessing the extent of Level 2—intermediate access. Entrepreneurs can ac- market development and access across our client countries, cess some basic trade finance instruments, notably letters identifying the gaps faced by different types of entrepreneurs of credit for imports, albeit secured by external collateral and the policies followed by national authorities to address (cash deposit or mortgage). Firms can access trade credit these gaps, and making appropriate policy recommendations. insurance as obligors (buyers) rather than policyholders (sellers) and insured flows mostly relate to imports. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 34 4.5. Policies and interventions to improve access to trade credit and finance Countries or categories of firms at different levels of access may require different types of public policy and state in- tervention instruments. As indicated in earlier sections, countercyclical interventions might be possible and desirable in certain categories of countries, but might be unrealistic unless certain building blocks are in place (notably credit infrastructure). Struc- tural policies and interventions would be required toward this end. Tables 4.1 and 4.2, respectively, summarize different types of domestic and international countercyclical and structural interventions that could be supported, including by the World Bank. Country-specific diagnostics will be needed to assess the suitability of different types of interventions, depending on the level of development and specific challenges faced by the beneficiary countries. > > > T A B L E 4 . 1 - Financing Trade and Value Chains: Domestic Interventions Benefiting IDA Countries Trade credit Trade credit insurance Trade-related financing Structural Structural Structural Improve credit infrastructure Develop the provision of domestic trade credit Support digitalization to reduce paper and in-person Monitor trade credit practices (payment delays) insurance to processing starting with selected pilot sectors and value • better credit infrastructure Revisit enabling regulations (for example, movable chains • revisit regulations affecting credit insurance collateral, RWA, supply chain finance) Regulate payment delay standards • facilitate the reinsurance of state providers Conduct diagnostics to identify hurdles to trade Discipline the payment practices of large firms, (technical assistance, incentives) finance and other bank financing of trade, whether especially SOEs specific or nonspecific (for example, availability of Develop digital infrastructure in domestic and Countercyclical foreign exchange, crowding out by public sector international trade Possible in IBRD countries with relatively developed borrowing) credit insurance markets, less so in IDA countries; Countercyclical can be done through Forbearance and flexibility in enforcing • risk sharing (reinsurance) with domestic Countercyclical insolvency regulations providers to cushion the shrinkage of credit Central bank refinancing of specified domestic trade State facilitation of bank schemes to refinance lines finance instruments delayed SOE payables • forbearance and flexibility in policy • Flexible implementation of Basel III risk- • Support SME access to credit insurance management (for example, notification of weighting requirements and supply chain finance (see next claims) columns) • subsidized credit insurance premium charged to SMEs Source: World Bank. Note: IBRD = International Bank for Reconstruction and Development; IDA = International Development Association; RWA = risk-weighted asset; SMEs = small and medium enterprises; SOE = state-owned enterprise. > > > T A B L E 4 . 2 - Financing Trade and Value Chains: International Interventions Benefiting IDA Countries Trade credit Trade credit insurance Trade-related financing Structural Structural Structural Develop tools and surveys to monitor trade Extend technical assistance to national providers Continue IFC initiative to support correspondent credit in global trade Support national providers in small and incipient banking (for example, in relation with KYC markets operating below scale via reinsurance management) for banks in IDA countries captives pooling capacity across markets Countercyclical Countercyclical Ongoing IDA PSW support for IFC support of trade Developed states have now massively reinsured and financing for the exports and imports of IDA effectively nationalized the domestic provision of countries (first-loss facility). trade credit insurance. This support could be supplemented by World Bank One could complement these schemes by credit schemes for types of transactions not eligible limits or risk sharing for trade with IDA countries. for IFC support (for example, with state-owned Indicatively, this could take the form of an IDA banks). first-loss facility for credit insurance, similar to the facility implemented by IFC for trade finance. Source: World Bank. Note: IDA = International Development Association; IFC = International Finance Corporation; KYC = Know Your Customer; PSW = Private Sector Window. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 35 >>> References AfDB (African Development Bank). 2020. “COVID-19 Pandemic: Potential Risks for Trade and Trade Finance in Africa.” African Economic Brief 11 (6): 3–5. Afreximbank (African Export-Import Bank). 2021. Survey of Impact of COVID-19 on African Trade Finance. Cairo: Afreximbank. Asmundson, Irena, Thomas Dorsey, Armine Khachatryan, Ioana Niculcea, and Mika Saito. 2016. “Trade and Trade Finance in the 2008–09 Financial Crisis.” Working Paper 11/16, International Monetary Fund, Washington, DC. https://www.imf.org/external/pubs/ft/wp/2011/wp1116.pdf. Auboin, Marc; DiCaprio, Alisa. 2016. “Why Do Trade Finance Gaps Persist: Does It Matter for Trade and Development? WTO Staff Working Paper ERSD-2017-01, World Trade Organization (WTO), Geneva. Banque de France. 2020. “Rapport de l’Observatoire des délais de paiement 2019.” Berne Union. 2020a. Export Credit Insurance Industry Response to COVID-19. London: Berne Union. Berne Union. 2020b. 2019 State of the Industry Report. London: Berne Union. Berne Union. 2020c. Yearbook 2020. London: Berne Union. Boissay, Frederic, Nikhil Patel, and Hyon Song Shin. 2020. “Trade Credit, Trade Finance, and the COVID-19 Crisis.” BIS Bulletin 24, June 19. Chauffour, Jean-Pierre, and Mariem Malouche, eds. 2011. Trade Finance during the Great Trade Collapse. Washington, DC: World Bank. Dornel, Arnaud, Meriem Ait Ali Slimane, and Komal Mohindra. 2020. “Facilitating Trade Credit and Finance for SME Entrepreneurs in MENA.” MENA Quick Note 180, World Bank, Washing- ton, DC. https://openknowledge.worldbank.org/handle/10986/34898. Dornel, Arnaud, J. Hegeman, A. de Malherbe, and G. Ismail. 2018. “Export Credit Insurance in Jordan—Strategic Review.” World Bank, Washington, DC. EIOPA (European Insurance and Occupational Pensions Authority). 2020. “Supervisory State- ment on the Solvency II Recognition of Schemes Based on Reinsurance with Regard to CO- VID-19 and Credit Insurance.” Press release, July 21. Fisman, Raymond, and Inessa Love. 2003. “Trade Credit, Financial Intermediary Development and Industry Growth.” Journal of Finance 58 (1): 353–74. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 36 ICC (International Chamber of Commerce). 2019. ICC Trade Register Report 2018: Global Risks in Trade Finance. Paris: ICC. ICC (International Chamber of Commerce). 2020. ICC Trade Register Report 2019. Paris: ICC Banking Commission. ICISA (International Credit Insurance and Surety Association). 2020. “Overview of COVID19 Policy Developments—December 2020.” Amsterdam. IMF (International Monetary Fund). 2019. Financial Inclusion of Small and Medium-Sized Enter- prises in the Middle East and Central Asia. Washington, DC: IMF. Lakatos, Csilla, and Franziska Ohnsorge. 2017. “Arm’s-Length Trade: A Source of Post-Crisis Trade Weakness.” Policy Research Paper 8144, World Bank, Washington, DC. OECD (Organisation for Economic Co-operation and Development). 2020a. “Insurance Sector Responses to COVID-19 by Governments, Supervisors and Industry.” OECD, Paris, July 2. OECD (Organisation for Economic Co-operation and Development).. 2020b. “Trade Finance in Time of Crisis—Responses from Export Credit Agencies.” OECD, Paris, May 25. OECD (Organisation for Economic Co-operation and Development). 2020c. “Working Party on Export Credits and Credit Guarantees: Summary of the Responses to the Survey on Export Credits and the Coronavirus (COVID-19) Pandemic.” OECD, Paris, September 1. Saurav, Abhishek, Peter Kusek, Ryan Kuo, and Brody Viney. 2021. “The Impact of COVID-19 on Foreign Investors: Evidence from the Quarterly Global MNE Pulse Survey for the Fourth Quarter of 2020.” World Bank, Washington, DC. Starnes, Susan, Michael Kurdylla, Arun Prakash, Shengnan Wang, and Ariane Volk. 2017. “De- Risking and Other Challenges in the Emerging Market Financial Sector.” IFC Insights, September. Starnes, Susan, and Ibrahim Nana. 2020. “Why Trade Finance Matters—Especially Now.” International Finance Corporation, Washington, DC, November. https://www.ifc.org/wps/ wcm/connect/be423213-dd33-418f-b41a-09882f529cff/Trade-Finance-matters-COVID-19. pdf?MOD=AJPERES&CVID=nnxGNyA. UNCTAD (United Nations Conference on Trade and Development). 2016. “World Investment Report 2016 Investor Nationality: Policy Challenges.” United Nations, Geneva. Van der Veer, Koen J. M. 2015. “Loss Shocks and the Quantity and Price of Private Export Credit Insurance: Evidence from a Global Insurer.” DNB Working Paper 462, Netherlands Cen- tral Bank, Amsterdam. Van der Veer, Koen J. M. 2010. “The Private Credit Insurance Effect on Trade.” DNB Working Paper 264, Netherlands Central Bank, Amsterdam. Republished in 2014 in Journal of Risk and Insurance 82 (3): 601–24. Wreford, Matt, and Nathalie Louat. 2021. “The Digital Transformation of Trade Finance: An Urgent Present and a Bright Future.” Trade Post, March 2. https://blogs.worldbank.org/trade/ digital-transformation-trade-finance-urgent-present-and-bright-future. WTO and IFC (World Trade Organization and International Finance Corporation). 2019. Trade Finance and the Compliance Challenge: A Showcase of International Cooperation. Geneva: WTO. https://www.wto.org/english/res_e/booksp_e/tradefinnace19_e.pdf. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 37 >>> Appendix A: Overview of Financing Instruments Used in Trade This appendix describes key instruments used in trade finance.10 Most of them have been used for a very long time. Although the contractual features and risk profiles have not fundamentally changed, progress has been made on (a) the standardization of the legal documentation,11 (b) the digitalization of the commercial paperwork, and (c) the automatization of payment flows. Open Account When the seller is sufficiently comfortable with a buyer and is not looking for third-party risk pay- ment mitigation, the seller may decide to ship the goods on an open account basis, meaning that the seller takes both the goods’ transport risk and the buyer’s payment risk. The role of the financier is then limited to handling payments and crediting the sales proceeds to the seller’s account, once received from the buyer’s bank. Although no credit risk is taken (or funding made) by the financier, this type of transaction (as long as payments are made on time) builds up the financier’s confidence in the seller’s business and thus the financier’s willingness to extend gen- eral credit facilities to the seller. The seller may, under certain conditions, monetize these open accounts using factoring facilities from specialist financiers (see ”Factoring”). Documentary Collections and Remittances If the seller is not fully confident in the buyer, the seller may ask the financier to send the buyer’s bank the following documents, usually called a documentary remittance, for collection: a bill of lading (the document of title of the goods issued by the goods’ carrier), a detailed invoice, and a draft (or bill of exchange), which is an irrevocable order drawn by the seller on the buyer direct- 10 This appendix is adapted from the background paper prepared by Patrick Blanchard, “Financing Trade and Value Chains: A Primer for Non-Specialists,” August 2020. 11 This is particularly the case for letters of credit, under the Uniform Customs and Practice for Documentary Credits, 2007 revision, International Chamber of Commerce Publication No. 600. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 38 ing the buyer to pay the face amount of the draft to the seller’s bank cannot avail itself of the defectiveness of the goods to bank. The buyer’s bank is instructed by the seller’s bank to void its payment commitment under the LC. remit the documents to the buyer only upon either (a) full and immediate payment of the draft amount (this is a “sight” remit- In cases where the seller and its bank are not confident in the tance) or (b) the buyer’s acceptance of the draft, which is a issuing bank’s creditworthiness, the seller’s bank may ask a commitment to pay within a certain time after the acceptance third-party financial institution to “confirm” the payment obliga- date (this is a “usance” remittance). tion of the issuing bank under the LC. The confirming bank may be willing to backstop the issuing bank for the following Under such a trade arrangement, the seller’s bank is the re- reasons: familiarity with the issuing bank’s risk profile and on- mitting bank, and the buyer’s bank is the collecting (or pre- going bank-to-bank relationship or (if the confirming bank is a senting) bank. A usance remittance would typically allow the bilateral or multilateral financial institution) general importing buyer (for example, a wholesaler) to resell the goods to its country support considerations (the confirming bank may sep- retailers and use the proceeds to honor the usance draft by arately secure a government counterguarantee if the issuing its due date, without having to borrow money from its bank in bank is state-owned). If the seller’s documents conform with the meantime. Timely processing and payment of such remit- the LC’s requirements and if the issuing bank is financially tances—whether on the basis of a documents against pay- unable to pay the LC amount offshore in the designated cur- ment or documents against acceptance—give confidence to rency, the confirming bank will have to step in and pay the both banks about the creditworthiness of their respective trad- beneficiary directly. ing clients. Commercially, the seller may have to accept delayed pay- ments from the buyer after the submission of conforming doc- Documentary Letters of Credit uments. Just like for remittances, there are usance LCs, under which the issuing bank makes payments to the advising bank several months after the acceptance date of the documents. Buyers cannot be forced to accept and pay remittances, thus The beneficiary of the LC may also apply for a packing loan potentially exposing the seller to the risk of having to sell the from the advising bank to fund all costs incurred in connection shipped goods to another buyer at a loss, or to return the with the goods before shipment, using the LC as collateral. goods, which may be extremely costly for transborder transac- tions. A documentary letter of credit (LC) places the seller in a In contrast to the usance LC, the red (or green) clause LC al- position of strength and is mostly used for international trade. lows the buyer to make advance payments to the seller before However, depending on the buyer’s bargaining power and on shipment. This instrument is particularly suitable in situations competitiveness issues, the seller may have no choice but to where (a) the buyer has few options to source the goods at sell on a remittance basis to “close the deal.” The LC is issued acceptable prices, and (b) the seller has limited financial re- by the buyer’s bank upon receiving an application from the sources and needs ad hoc funding to manufacture or deliver buyer. Under the LC, the issuing bank irrevocably12 commits the goods. to pay the LC amount to the seller’s bank upon submission of precisely defined documents, including a “clean” bill of lading. In situations where the buyer and the seller are mutually inter- The LC is separate from any underlying sale and purchase ested in a prolonged relationship and not just a one-off trans- agreement between the buyer and the seller. Once the docu- action, a revolving LC can be issued to cover multiple ship- ments have been received, reviewed, and accepted, the is- ments of the same types of goods over a longer period than suing bank can then immediately debit the buyer’s account in that of a sight LC. Once the first shipment has taken place and its books. This is the standard, “sight” LC. The LC is valid for the payment has occurred, the LC is automatically reinstated a predetermined time (typically, a few months), long enough by the issuing bank to cover, consecutively, a second ship- for the seller to prepare the documents and ship the goods. A ment, a third shipment, and so on. documentary LC is, therefore, a quadripartite arrangement be- tween a buyer (the applicant), its bank (the issuing bank), the A back-to-back LC is a trade finance instrument under which a seller (the beneficiary), and its own bank (the advising bank). trader’s bank issues an LC in favor of a supplier on terms and The issuing bank’s payment obligation under the LC may be conditions identical to those of a “master LC” already issued voided if the documents submitted by the seller through the by its buyer’s bank for a larger amount. The trader’s bank may advising bank feature so-called discrepancies. The issuing take comfort in the fact that (a) the documents that the sup- 12 A documentary LC may also be “revocable,” that is, it may be amended with the prior formal approval of the seller (beneficiary). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 39 plier will send under the back-to-back LC can be used under credit directly to the importer, which the national export credit the master LC, thus reducing credit or operational risk; and (b) agency or import-export bank guarantees (or insures) against the transaction is intrinsically profitable for the trader. the payment of a risk premium. Export credits allow export- ers to offer long-term, deferred payment terms to importers, Another type of LC is the standby LC (SBLC), whereby the in line with the economic life of the goods. The guarantee (or submission of documents triggering the payment by the issu- insurance) covers political and commercial risks, that is, the ing bank is limited to the presentation of a certificate prepared risk that the importer may be unable or unwilling to repay the by (preferably) an independent third party designated in the export credit for the following reasons: (a) financial difficulties SBLC. This certificate may simply state that the issuer has faced by the importer and (b) adverse political or macroeco- failed to comply with the terms and conditions of the underly- nomic events in the importer’s country, making it impossible ing sale and purchase contract. SBLCs are irrevocable and to access and transfer foreign currency abroad to meet debt can be used as a substitute for performance guarantees. service obligations under the export credit. Residual risks, that is, those without cover, remain with the commercial banks and the exporters. Factoring For each transaction, the amount of the export credit depends on the national content portion, and may include some local Factoring is a form of trade finance whereby the seller sells content. In member countries of the Organisation for Eco- his open account receivables to a trade financier (the factor) nomic Co-operation and Development (OECD), terms and at a discount. Factoring relieves the seller from the manage- conditions of the export credit must be in line with the Arrange- ment of invoice receivables and generates working capital. In ment on Officially Supported Export Credits (nicknamed the the case of nonrecourse factoring, the seller passes to the Consensus), a gentleman’s agreement meant to ensure that factor the risk of incurring bad debts. In turn, the factor may exporters compete on quality and prices, rather than inter- seek credit insurance to cover the credit risk in the invoices it est rates, risk premia, repayment schedule, tied aid, or the purchases. The factor makes a profit if the buyer’s payment guaranteed or insured portion of the credit. The Consensus exceeds the discounted value plus factoring and other associ- broadly defines what such terms and conditions should be, ated costs. depending on the importing country’s risk classification; it also includes seven sector-specific “understandings.” Forfaiting Most OECD countries and an increasing number of non-OECD countries have their own national export credit schemes. Export credits may also be directly provided and funded by Forfaiting is similar in some ways to factoring, but (a) it applies specialist, government-owned, financial institutions, in lieu of to the export of capital goods; (b) transactions are larger, typi- commercial banks. Export credits are often provided in the cally on stronger buyers; and (c) durations are longer, giving form of trade credit insurance, described next. importers more time to pay for the capital goods. Financiers may also purchase sellers’ receivables, with recourse, for their whole face value. This allows sellers to monetize these receiv- Trade Credit Insurance ables as soon as the goods are delivered but, should buyers not pay amounts due in full and on time, the seller will have to refund the shortfall to the financier. Various private and publicly owned insurance companies, in tandem with reinsurers, cover sellers (the policyholders) against the risk that buyers (the obligors) might not pay for Export Credits goods or services they receive, whether because of political risk or the credit risk or bad faith (“commercial risk”) of the buyer. Risk premia charged are freely set by the market, de- An export credit is a trade finance instrument supported by pending on the insurer’s appreciation of the buyer’s and the the exporter’s national government. Typically, the exporter’s country’s financial standing. Most of the trade credit insurance commercial bank (or syndicate of banks) provides an export market relates to short-term day-to-day transactions (less EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 40 than 360 days) covered on a whole-turnover basis, although case, goods may have to be placed in bonded warehouses a specialized market also exists covering individual transac- controlled by a third party acting as collateral manager, and tions, including medium- and long-term transactions. Credit may be registered in the financier’s name. If so, the financing insurance indemnifies sellers up to the insured percentage cost for the seller may be lower than that of a trade working (usually between 85 percent and 95 percent) of the loss, with capital facility. residual risks kept by the seller. Trade Acceptances Supply Chain Financing A trade acceptance (TA) is a short-term (less than six months), Some financiers also provide bilateral financing programs to negotiable instrument drawn by a seller or exporter and ac- key suppliers of trading clients (provided these clients have a cepted by a buyer or importer, which may be sold by the seller strong, durable relationship with their suppliers). This arrange- to a bank or a financial investor at a discount, thus becoming a ment has the following benefits: (a) it allows clients to lower marketable money market instrument. The TA may be accept- their own working capital requirements, (b) administrative ed by a bank, in which case it is called a banker’s acceptance costs are lower (since the same financier “banks” both sides (BA). Backing documents required as proof of the underlying of the transaction), and (c) the bank develops a better under- trade transaction include invoices and bills of lading, stamped standing of its clients’ business and, in the process, diversifies “accepted” by the bank. Although they represent a big and liq- its risks. The development of this type of trade finance has uid market, the BAs do not trade on exchanges, but through resulted in LCs playing a lesser role in international trade. large banks and securities dealers. Trade Working Capital Finance This type of trade finance facility is used by small and me- dium-sized manufacturers to purchase materials, pay labor, and fund inventories of finished goods. The facility must be repaid by the date when the buyer or buyers pay for the fin- ished goods. Financiers providing such facilities often require non-trade-related collateral (such as personal guarantees and property mortgages) on top of high-value receivables (materialized by a purchase order from an acceptable buyer or an LC). These facilities are provided either on a program- matic basis, covering multiple buyers, or on a transactional basis (for a single large sale). Variations of such short-term facilities include preshipment finance and warehouse finance, which is particularly suited for (soft) commodities. In the latter EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 41