naked capitalism: Confirmation of the Role of Financing Difficulties in Collapsing Trade Volumes

One of our pet themes in recent weeks is that the fall in trade traffic, indicated and possibly overstated by a dramatic fall in the Baltic Dry Index, is due at least in part to difficulties in arranging and getting other banks to accept buyers' letters of credit.

For those new to this topic, international trade depends to a large degree on letters of credit. While they can help finance shipments, an even more fundamental role is that they assure the shipper that he will be paid for the cargo sent. Without banks using letters of credit as the means to send payment to exporters, parties that are new to each other or conduct business with each other infrequently could never trade with each other (one type, a documentary letter of credit, requires that forms, often a very long and elaborate set of them, verifying that the goods have been inspected and certified, that customs, have been cleared and all relevant charges and duties paid, be presented and vetted before payment is released).

Some readers scoffed at the idea that a fundamental element of trade could be breaking down and yet attract more notice; a few argued that the L/Cs were being used as an excuse for buyers to break commodities deals struck when prices were higher.

However, as has been discussed in gruesome detail, banks are reluctant to take credit exposures to other banks on the most plain vanilla. short term exposures, namely interbank lending. It has been a struggle for central banks to get banks to lend to each other for longer than overnight. Trade financing is a backwater, operationally intensive, low profit area that simply does not register on senior managements' or regulators' radars. And problems in this area would have virtually no impact on banks, so even acute problems here would simply not register, particularly in comparison to all the other fires that central banks are struggling to smother.

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naked capitalism: More on Trade Woes: "Firefighters better scramble to save letters of credit"

In a bit of synchronicity, it seems that some mainstream commentators are starting to to take interest in a topic we've commented on in recent weeks, namely, how the difficulty in getting letters of credit is playing a significant role in the contraction in international trade (see our related post earlier today).

John Dizard in today's Financial Times provides a useful long-form treatment which we hope will start to get this topic on the official radar screen. There is only one aspect of the story we quibble with. He calls letters of credit "plain vanilla". That isn't an accurate characterization.

Now if nothing rates as complex unless it involves very fancy math and lots of market risk, then yes, L/Cs are plain vanilla. But they have a lot of operational complexity. Financial letters of credit are pretty simple, but a second type, which is vital for the conduct of a lot of types of trade, documentary letters of credit, are not.

When an international seller is unsure that he will be paid, and an international buyer worries that he might receive something quite different than what he was promised, a documentary L/C is the answer. The buyer's bank must release the funds once certain DOCUMENTARY requirements are met, hence the name. Some of them relate to the national tax and customs requirements of the port of origin and port of arrival; there may also be port-specific requirements. And there are a whole host of documentary requirements particular to the goods shipped (third party verification of quantity/weight and grade, in some cases multiple quality validations). So the requirement are in fact very complex: and vary with the port pair and the goods involved, and there may be additional wrinkles depending on buyer stringency.