Unblocking the arteries of trade

As The Banker went to press, the International Monetary Fund (IMF) was forecasting the first full-year slump for the world’s developed economies since the Second World War. What had until recently been a credit crunch for banks has become a corporate crunch. Nothing highlights the pitiable state of the world economy more than ships lying dormant in ports across the globe. The world’s trade arteries are slowly clogging as manufacturers struggle to finance their trade and demand dries up.

By early November, the Baltic Dry Index, a benchmark for shipping costs and indicator of global economic activity, had hit its lowest point since 2002. Across the world insolvencies are on the rise. The most recent data from the UK’s Insolvency Service showed that in the third quarter of 2008 company administrations increased by more than 7% on the previous three months, and by almost 51% on this time last year.

It is not just in the UK; across the developed world companies are being forced to slash their 2009 forecasts and desperately seek out liquidity from within their own balance sheets.

Finance costs soaring

Mattel, the US’s largest toy manufacturer, warned in late October its suppliers were feeling the strain of the credit crunch. The group’s chief executive, Bob Eckert, warned that retailers were reluctant to make inventory bets and that it would be hard for some of the firm’s customers and vendors to obtain the funds they needed to buy inventory and raw materials. Suppliers are being squeezed across the globe, not only by credit constraints, but also by customers.

One of the world’s biggest supermarkets, the UK-based Tesco, caused a storm among its suppliers last month when it announced that it was extending its payment terms from 30 days to 60 days. It is also negotiating heavily over prices. Many of Tesco’s smaller suppliers feared this could lead to insolvency because they would no longer hold sufficient working capital to fund the business.

“There is a lot of game playing taking place at the moment and the buyers are for once in the driving seat,” says Michael Burkie, Bank of New York Mellon’s head of EMEA cash management business development.

Counterparty risk has turned on its head. Whereas once upon a time buyers analysed the credit risk of their suppliers, now they worry about the reliability of their suppliers’ banks. As a result, the cost of funding for the world’s manufacturers has soared over the past year. Letters of credit, the life blood of global trade finance, have become far harder to come by, more expensive and, crucially, less trusted.

“There is a need for suppliers to raise working capital and if they don’t have letters of credit – it’s been very hard to do this,” says Lawrence Webb, HSBC’s global head of trade, supply chain and cash-flow management. “Because of the lack of trust now in the banking system, even between banks themselves, the letters of credit system has fragmented somewhat. There has been a great increase in requests for confirmations.”

What this ultimately means is suppliers need to approach their banks in order to obtain documentary evidence that they have secure financing, before the buyer will accept their invoice and the goods can be shipped. “Goods are not being shipped because buyers are asking for a letter of guarantee from their suppliers,” says Mr Burkie. “We have the bizarre situation of a vast amount of goods sitting in docks, waiting for ships to transport them.”

It is a vicious circle. If suppliers cannot get their invoices accepted by their buyers, they will be unable to access credit, working capital dries up and it becomes impossible for the business to operate. Add to this conundrum the fundamental lack of trust between banks due to the credit crunch, and it becomes hard to see how the arteries of trade can possibly open up again.

Freeing up liquidity

This view, however, is overly negative. Recent and dramatic interest rate cuts by central banks across the world, combined with government guarantees to banks on their loans, has begun to free up the flow of capital again. The question remains, however, how can companies and banks prevent this situation from occurring again?

The answer lies in supply chain finance. It is not a new concept, but it is a concept that is growing in popularity among the corporate world. Supply chain finance attempts to change fundamentally the relationship between suppliers, buyers and their banks. What the recent liquidity crisis has shown clearly is the lack of trust between suppliers and their buyers. In the good times, the letter of credit system operates without flaw. In leaner years, however, the system quickly grinds to a halt because it does not allow for effective communication between counterparties.

As an example, a buyer in the UK that imports goods from a supplier in Turkey has little knowledge of the company it is dealing with or indeed the viability of its financing. As such it is loath to accept the Turkish supplier’s invoices and will demand to see documentary evidence of its letter of credit. This clogs up trade flows and leads to soured relationships. The supplier is relying on its customer to accept the invoice so that it can access its financing in order to continue production.

Supply chain finance, also known as open account trading, aims to bring both sides of the supply chain together. Rather than two banks operating at each end of the supply chain, one bank operates on both sides of the transaction. This opens up lines of communication and gives the buyer and supplier solid guarantees that financing is in place. It is a more flexible system than letters of credit and ultimately more efficient.

Deepening relationships

Joe Juliano is chief executive of Prime Revenue, a company that provides platforms and technology for banks and corporates that wish to put in place supply chain finance programmes. He says that such systems allow big buyers to push out their payment terms, as Tesco has done, while at the same time safely financing the supplier without the need of a costly letter of credit.

By developing deeper relationships with both the supplier and the buyer, banks can get a guarantee that the buyer will accept the supplier’s invoice and therefore can provide financing to the supplier. Effectively, the bank is financing smaller suppliers but with the risk profile of the larger corporate buyer. Everybody wins. The supplier gets financing and the buyer is guaranteed that goods will be shipped without delay. The bank benefits because rather than lending directly to a large buying conglomerate at low rates, it can lend indirectly to a smaller supplier at higher rates, but with the same risk as if lending to a large buyer.

“If you look at most of the supply chains that exist, 65% to 70% of suppliers are non-investment grade and have a higher cost of credit than a large buyer,” says Mr Juliano. “If the supplier is factoring or using his receivables as collateral, the price and risk is all based on the supplier. If you change that paradigm a little bit and say ‘ok, once the buyer approves the invoice – you can transfer risk from the supplier to the buyer’. What that does is substantially lowers the cost to the supplier.”

The reason this is so important for large-scale buying enterprises is that they cannot afford for their suppliers to go bust. At the same time as wanting to squeeze out better terms and push out payment schedules, buyers also need to be careful a strategic supplier does not go under. A prime example of this was the experience of UK vehicle manufacturer Land Rover in 2001. The company’s sole supplier of chassis, UPF Thomson, went bankrupt and almost forced Land Rover to suspend its production of the profitable Discovery range of cars. This would have resulted in huge losses, wide-scale job cuts and possibly threatened Land Rover itself.

Eventually Land Rover was forced to come to the rescue of UPF Thomson by paying off its debts. All this could have been avoided if an effective supply chain finance platform had been in place.

According to HSBC’s Mr Webb, big buyers are learning to deepen their relationships with suppliers, while at the same time consolidating the buyer-supplier relationship. “A buyer might have had hundreds of suppliers in the past. They are now looking to decrease that to a smaller number of strategic suppliers,” he says. “The risk and trust issues that exist when you have lots of smaller suppliers disappear. It leads to a stronger buyer-seller relationship, which in turn encourages open account trading.”

Stunted development

Open account trading, however, is not without its limitations. Supply chain finance is still very much in its infancy and despite strong growth in recent years, the liquidity crisis has stunted its development. “While supply chain financing helps once the invoice has been accepted – it is not the complete picture,” says Mr Webb. “What the supplier really wants is financing at the time of shipment or even pre-shipment [of goods]. If a bank did that, however, it would be before the invoice was accepted and therefore the risk is on the small supplier. And that is the quandary that banks are facing now.”

The difficulty for banks is again one of trust. With a deep and established relationship between both buyer and supplier, the bank is able to mitigate supplier risk. Without this element of understanding supply chain finance cannot work. The bank needs to be present on both sides of the transaction, rather than just one leg of it.

“You can’t suddenly offer a solution to clients you don’t have a good track record with,” says Mr Webb. “You need to bank both. Most banks only bank one leg of the transaction, which makes it very hard for them to mitigate risk in the current environment. This is why, at the moment, we are seeing a diversion back into letters of credit where possible.”

In the longer term, however, there can be no doubt that the future of trade finance lies in open account trading. It is a more efficient system, more transparent and ultimately will increase revenues for banks.

Businesses realise this. A recent survey of more than 250 companies by US-based research firm Aberdeen Group found that 70% were investigating or already putting supply chain finance programmes in place. “Just-in-time inventory was the big thing for manufacturers in the 1990s... supply chain finance is the financial equivalent of that,” says Mr Burkie. By putting a bank in between the buyer and the supplier it allows the buyer to optimise its terms, without putting the supplier out of business.

For Mr Juliano, it is ultimately in big buyers’ best interests to ensure their suppliers have adequate access to financing. “We have lots of clients who contact us because they don’t want their suppliers to go out of business because of working capital,” he says. “Inventory control cannot be a zero-sum game. The buyers and the suppliers cannot afford the ‘I win, you lose’ situation – because they all lose. That is what we’re trying to eliminate – the zero-sum game.”