Long haul truck transporting goods
What does it take to get goods from the farm or factory gate to your local store? Trucks, ships, and airplanes are involved, of course, along with sophisticated logistics. But there are other essential ingredients: trade credit and finance. Without them, the wheels of commerce would come to a screeching halt – as they almost did during the 2008 global financial crisis.
Despite their importance – especially for emerging and developing economies – trade credit and finance get little attention from academics and policy makers. A recent paper by the World Bank seeks to start filling the knowledge gap by describing these flows, identifying hurdles to access, and proposing some potential solutions.
Trade credit and finance take many forms, including simply as a short-term credit, like using your credit card to buy groceries. Sellers of goods or services extend trade credit to buyers, their customers. To extend credit to their customers, sellers also need financing. This can come in the form of a loan from a family member or a bank, or trade credit from their own suppliers. This may also involve more complex instruments such as so-called letters of credit. In some cases, buyers may also advance funds to help suppliers finance production.
Both domestic and cross-border transactions rely on trade finance. Every time a container ship steams from Singapore to Rotterdam, cash flows in the opposite direction. And we’re not only talking about finished goods. A cotton grower in Uzbekistan, a textile producer in Bangladesh, and a clothing factory in Hong Kong – all might be recipients or providers of trade credit. The same is true of the dozens of companies involved in making computer chips, display screens, and other mobile phone parts. Think of trade credit as a reverse value chain.
The sums involved are staggering. According to some estimates, the aggregate annual volume of both domestic and international trade credit comes to over 40 percent of world GDP, or US$35 trillion, most of it involving trade within countries. In a developed economy like France, total inter-firm trade credit exceeds half of the country’s GDP.
So, it should come as no surprise that trade credit and finance are essential to the economic health of developing countries – their export competitiveness, employment, and growth. A disruption in trade finance –as happened during the COVID19 pandemic – can drive companies out of business, resulting in job losses and further damage to the economy as employment and investment shrink and buying power evaporates.
Developing countries are especially vulnerable to disruptions in trade finance due to the perceived high risk of default. Payment delays from customers are the single biggest source of insolvency for small and medium-sized enterprises. Especially for domestic trade, large state-owned companies and government agencies are the source of payment delays to firms. Why? Some may be taking advantage of their relative financial muscle. Others may be hampered by cash shortages of their own or inefficient payment systems. Even though they are the most vulnerable, payments to SMEs are then often the lowest priority.
Globally, the trade finance “gap” – the amount of money available versus the optimal amount needed by businesses – was estimated at US$1.5 trillion in 2020 for developing countries. The shortfall expanded with the pandemic – another estimate put the gap at US$6.5 trillion in 2021. However, these estimates should be treated with caution, as there are significant data constraints for assessing the precise scale of trade finance supply and demand.
Developing countries – especially those that rely on exports of just a few commodities -- face myriad obstacles. Export earnings may shrink if commodity prices fall, demand wanes, or supply chains are disrupted. Big international banks may stop doing business in poorer, riskier countries in times of economic trouble. Increasingly stringent regulations aimed at fighting money laundering and other financial crimes make those same banks more hesitant to do business with smaller counterparts and customers in the developing world.
Trade credit insurance can help. Sellers who hold this type of insurance are protected against losses if their customers fail to pay. In 2019, trade credit insurance covered flows estimated at more than US$5 trillion, or about 6 percent of world GDP, divided evenly between domestic and cross-border trade.
Unfortunately, small and medium-sized firms in developing countries – a major source of jobs -- have trouble getting trade credit insurance. Many are simply too small – insurers tend to target firms with annual sales of at least US$1 million. Often, smaller firms like retailers don’t keep the kinds of records that are required. And in difficult times, insurers tend to reduce their risk of losses, so insurance becomes harder to get just when firms need it most.
How can policy makers in developing countries improve the supply of trade credit? Here are some steps outlined in our report:
- Monitor trade credit and payment delays to spot problems as they develop and understand their scale and the impact of government measures;
- Improve regulation and supervision of state-owned enterprises to monitor the build-up of arrears, which can impact their ability to pay suppliers on time;
- Expand access to export finance for small and medium-sized enterprises; state programs can be set up to share the risk with private lenders.
- Facilitate the creation of national credit insurance markets by setting up the required infrastructure, which includes accounting systems, credit bureaus, and insolvency laws;
- Ensure that banking regulations allow the digitalization of trade financing processes, such as accounts receivable and accounts payable.
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