Letters of Credit (LOCs) are the crucial lubricant without which the wheels of international trade cannot turn. Here’s how John Mauldin explains them:
If you are a manufacturer of a product and want to sell to someone outside your borders, you typically require a letter of credit from the buyer before you load any cargo at a port. A letter of credit from a prime bank is considered to be proof of your ability to pay. It not only can be a source of ultimate payment, it can be a source of inventory financing while goods are in transit.
And if you are a business which is buying a product, you do not want to release money until you know the product is on the way. There are buyer’s and seller’s agents who make sure these things happen seamlessly, and world commerce had grown because of it.
Just one problem: it looks like LOCs may be no more immune from the credit crunch than any other form of credit. Here, for instance, is Canada’s Financial Post on Wednesday last week:
The credit crisis is spilling over into the grain industry as international buyers find themselves unable to come up with payment, forcing sellers to shoulder often substantial losses.
“There’s all kinds of stuff stacked up on docks right now that can’t be shipped because people can’t get letters of credit,” said Bill Gary, president of Commodity Information Systems in Oklahoma City. “The problem is not demand, and it’s not supply because we have plenty of supply. It’s finding anyone who can come up with the credit to buy.”
As Alan Beattie reported in the FT on Saturday, Brazil has now offered a blanked guarantee for all trade credit involving its companies, which will commit fully a tenth of its foreign exchange reserves. WTO Director-General Pascal Lamy, meanwhile, has announced that he’ll convene a summit on the issue next month: here’s an excerpt from his speaking points on Friday –
The financial crisis may also be having an impact on developing country access to financing of imports and exports. As you know we have held a number of meetings on this issue at the WTO with both multilateral institutions and private banks, the last one last April, to check availability of trade financing at affordable rates. Up until then, the situation seemed to be stable with volumes and rates at normal levels. But just this week Brazil brought this issue to the forefront.
Given the deterioration of the financial landscape, and despite the welcomed announcement yesterday by the World Bank IFC of an increase in its trade financing programme by $ 500 million, I have today convened major providers of trade finance to a meeting on 12 November to examine this issue and find ways to alleviate the situation if it was to deteriorate.
Bottom line? Naked Capitalism quotes an email from “a well connected international investor not prone to alarm”:
At the end of the day, if every counterparty is bad then you don’t have a market and you don’t have an economy. I spoke to another friend of mine this afternoon, whose father has been in the shipping business forever. Pristine credit rating, rock solid balance sheet. He says if he takes his BNP Paribas letter of credit to Citi today for short term funding for his vessels, they won’t give it to him. That means he can’t ship goods, which means that within the next 2 weeks, physical shortages of commodities begins to show up.
Update: more on this from Alan Beattie, yesterday:
The credit crisis sweeping around the globe is drastically curtailing shipping activity as shippers cancel contracts with shipowners because of the mounting difficulty of obtaining trade finance. Dry bulk shipping – the movement of large quantities of coal, iron ore, wheat and other bulk commodities – has also seen its problems exacerbated by the unwinding of speculative activity surrounding the sector.
The Baltic Dry index, a measure of shipping costs for commodities, suffered its biggest drop on record on Friday, falling 11 per cent to 2,221. The index is 81 per cent down from its peak five months ago.
Although it is traditionally regarded as one of the safest forms of financial activity, rates for trade credit have risen sharply in recent months as banks have withdrawn facilities to bolster liquidity. Similar interruptions to trade credit have occurred in the past in times of great financial market stress such as the 1997-98 Asian financial turmoil …
Shipowners who have struck long-term charter deals with shippers are largely unaffected, but those who trade mainly in the short-term spot market, where vessels are chartered on a voyage-by-voyage basis, are finding little work.
Update 2: Javier Blas has more today (Oct 14):
…with financial institutions hoarding cash, credit for trading is scarce. Michael Carter, director of credit risk solutions at Triple Point, a US-based company that designs trading software for commodities companies, says that people have discovered with shock that “credit lines for trading could vanish overnight”.
The lack of credit is curbing liquidity in oil markets, making trading and price discovery more difficult – “hence the more volatile price swings”, according to the International Energy Agency, the western countries’ oil watchdog.
The problems are exacerbated by the fact that banks – which five years ago had a relatively small presence in the commodities markets with Goldman Sachs and Morgan Stanley as the only significant players – are today profoundly involved, both in number and in the depth of their financial and physical operations.
The combination of factors, coupled with the collapse earlier this year of Semgroup, a large player in the US physical oil market, and Bear Stearns and Lehman Brothers, has left commodities traders edgy.