Leaders of the G20 countries gathered at an Economic Summit in Washington, over the weekend, decided to launch a process to implement reforms of the international financial system. A similar effort is underway at the UN to convene a summit next year. With so much attention focused on the response to the global financial crisis, it would be easy to assume trade issues will take a backseat to financial ones.
For developing countries, this approach would be a tragedy. As the financial crisis continues to unfold, events are making it painfully clear that trade is the main channel by which the financial crisis will make its impacts felt on them, especially on their real economies. This does not come as a surprise after years of reforms that have placed export-led growth as the central paradigm in a context that did not give an equally central place to mechanisms for ensuring the financial gains of exports accrue to developing countries. The events are also a reminder that the fate of developing countries in the trade system does not lie so much in the achievement of enhanced market access as on meaningful reforms to the international financial architecture in which context such trade is pursued. Yet, this is an aspect typically ignored in trade negotiations, which traditionally tend to focus exclusively on exchanges of market access concessions. On the other hand, the trade dimensions and impacts of financial reforms are neither appreciated nor factored in attempts at financial reforms, either domestic or global.
The scarcity of trade finance
One very obvious way the credit crunch will project onto the developing economies is the impact it has on trade finance, this is, the different mechanisms by which typically a bank or financial institution, for a fee, guarantees payment of shipments by an importer. The deterioration of availability and terms of trade credit was already being felt earlier this year, but the situation significantly worsened since September, with the collapse and defensive stances taken by major international banks. This was in evidence in a statement made by Brazil last October in the WTO: “Exporters from developing countries who seek trade finance find themselves in the odd situation of being among the most creditworthy economic agents, but unable to access credit in a scenario with heightened overall risk perceptions that lead to more stringent requirements by the banks, or simply because funds are not available any longer.”[i] The negative impact that Basel II may have on trade flows, inter alia, through increased procyclicality of trade finance, has also triggered complaints.[ii] Balance-sheet exposure to least-developing countries costs banks apparently three times as much as exposure to developed countries, creating a large asymmetry in access to this type of lending.[iii] The urgency of the situation prompted the WTO Director General to take the unusual step of hosting a meeting of main trade-finance providers, which was held November 12 in Geneva.
In a recent paper, World Bank staff points out that trade credit was traditionally thought to be only relevant from a microeconomic point of view, but he argues this should no longer be the case. [iv] The author explores the role of trade credit as a mechanism for the amplification of shocks at the macro level and finds strong evidence for the hypothesis that an increase in the use of trade-credit along the input-output chain linking two industries results in an increase in their correlation.[v] This is certainly not good news to the many countries that have moved, in the last two decades, to find their niche as providers in a number of global production chains. The problems for both providers who need cash but also buyers, who face the threat that their cash-strapped providers may disappear because of the inability of holding up without such credit, are becoming more evident.
The International Finance Corporation had recently announced an increase of their Global Trade Finance Program (from US$ 1 billion to US$ 1.5 billion) and it is now considering doubling the new amount. Still, this and other pledges of trade-finance available would fall far short of what is needed. According to an estimate presented at the November 12 WTO meeting, the liquidity gap in trade finance amounts to US$ 25 billion. Analysts at that meeting predicted that the situation will get still worse.[vi] The concerted government efforts in a number of industrialized countries to recapitalize their banking systems may, for this purpose, not be of much help. A reporter said that, as the government takes a stake in banks, their priorities may be to get taxpayers’ money back and, politically, stimulate lending to domestic business rather than devote taxpayers’ equity to far-off trade finance.[vii]
Moreover, the scarcity of trade credit is bringing the spotlight to another, little heard of, sector that is vital to the continued operations of supply chains: trade insurance. While large companies tend to take the risk that trade credits will not be honored, small providers could be so largely affected by the failure of a big buyer that they usually take insurance. Recently, however, because of the drying up of credit, trade insurers have seen a rise in their losses. Atradius, the UK’s biggest credit insurer, saw its losses increase to account for more than 70 per cent of revenues, up from a norm of 50-60 per cent.[viii] In what some reports say is a panic reaction, they are quickly blacklisting as non-insurable many companies, some of them large buyers such as General Motors, Woolworths and Ford. Moreover, trade credit insurers are likely to base their assessment of the creditworthiness of a foreign company partly on the economic stability of its home country. A commentator speaks of the formation of a vicious circle: “insurers are cutting trade credit insurance because they believe that the scarcity of bank loans has increased the chances of businesses failing. Companies who use the cover are then more exposed to collapse themselves, because some lenders will not advance new funds unless credit insurance is in place.”[ix]
The seriousness of the problem is in evidence in the swift action taken by countries like Brazil and India, where governments have rapidly made available credit support for exporters. But it is unlikely that smaller countries will be able to have that support forthcoming.
Overall, the full model on which world trade has thrived in the last several decades, is in question. The model has fostered the power of companies with transnational scope to locate pieces of the production chain at the lowest cost locations. To the extent that what is in question is the capacity of large conglomerates to increase profit margins at the expense of small and medium producers, this might not be bad news. But the other side of the story is the havoc in full economies which have been restructured to participate in the global economy through global production chains, and whose productive base will be wrecked by the credit failure.
The role of commodity prices
Another significant impact that developing countries will bear is that derived from commodity prices. Between 2002 and 2007 the prices of all commodities, in dollar terms, increased 113 per cent.[x] This average masks large differences between the minerals group (around 260 per cent) and food and tropical beverages (a 60 per cent). But it is clear that the increases were all significant, nonetheless, especially after decades of declining prices. The fact that some factors behind the increase (e.g., growing demand from high-growth economies such as India and China) were out of the epicenter of the financial crisis led some to hope that the fall in prices would not be that significant. However, as growth projections for China and India were revised downwards such hopes faded.
With a scenario of lower demand everywhere, commodity prices are on their way down at, in some cases, shocking speed (e.g., oil which went to a 50 % of price in two months). There is a bright side to the slump in commodity prices. Developing countries that until the middle of this year were trying to cope with rising bills for their food and fuel imports will definitely benefit.
But the prevailing side of the picture are the significant negative effects that lower prices will have on export revenues. The fact that the exceptional growth period experienced by developing country economies in the last five years coincides with the surge of commodity prices is more than a mere coincidence. For all but two Latin American countries, commodities represent more than 50 % of their exports. More than three quarters of the growth in export revenue in 2007 were due purely to price increases of those commodities.[xi] A similar trend is notable in Africa which is, in fact, more dependent on commodities than Latin America. Primary commodities, including fuels, account for near 70 percent of the average exports in the period 1995-2006.[xii]
What these numbers are saying is that what has been characterized as a boom actually hides meager progress –or even retrogression — in the export structures of developing countries. Very few countries had been able to use the increased revenue from the boom in commodities to get higher up in the ladder of diversification and value-added. In some cases the hindrance was that the rents of the boom were not captured at the country level, while in other cases captured rents were not devoted to invest in infrastructure and productive capacity but in either immediate consumption or long postponed social needs. A few countries were merely able to take advantage of the access to the natural resources to expand into natural resource-based manufactures. As a result, trade profiles have not changed much, leaving no room for cushioning the impacts of the decrease in prices. The effectively utilization of increased commodity revenue would have required a capacity that, after years of downsizing and withdrawal from economic planning, states were barely starting to re-build.
To the extent that some countries were able to develop some manufacturing capacity, there are signs that this may also fall prey to the scenario of lower demand in client countries. Lower demand would force an adjustment that, given the small margins available to adjust in price, will have to be done via downsizing. The scarcity in trade credit mentioned in the previous section is a compounding factor, as integration in global production chains is the common expression of the export-led model in manufactures by developing countries.
Not having made use of the surpluses of good times to diversify, developing countries will be faced with the challenge of diversifying in bad times, and with less income. But at least it is clear that the incipient capacity for planning that, in a learning-by-doing fashion, they were starting to develop, is at least as important an asset as any potential new access to markets, and should be carefully nurtured.
The role of trade in infrastructure and the sustainability of debt
The impact of lower export revenues will be also felt in a number of indirect ways. It is very common that, in times of boom, countries tend to be overoptimistic about future trends. The risks of infrastructure projects going wrong are generously evaluated against the backdrop of the growing income prospects. Costs and terms of borrowing that are very high compared with the historical, but not with the most recent, reality tend to be considered viable. This boom has been no exception.
One particular trend in public funding for infrastructure projects has been the increased role of private sector participation, through contracts that provide public funding guarantees, often encouraged by multilateral financial institutions. For example, it is common practice in public-private partnership contracts to attach provisions that guarantee a certain level of demand and, therefore, revenue to the provider. If the economic activity then does not sustain such demand, the government becomes liable for the difference. The exchange rate risk is sometimes built into demand guarantees. That is, in spite of devaluations that may be necessary for monetary and economic policy reasons, devaluations whose impacts domestic investors and citizens bear in terms of decreased import purchasing capacity, would not affect the private investor. [xiii]
So, whereas ideally private sector participation should mean less of the risks of a downturn will be borne by the countries, and more by the private sector, the reality of public-private partnerships has been generally the opposite. Compounding the generous concessions built into private sector contracts, guarantees do not represent an immediate expense, so they escape the degree of scrutiny that actual budget expenditures would receive.[xiv] This opacity also fosters what the IMF has called “a guarantee culture” on the part of the private sector, so guarantees, instead of a subsidiary mechanism, are provided for risks that the private sector would be best positioned to manage on its own. Since the guarantees are more likely to be called at a time of generalized economic distress (e.g., a financial crisis) their fiscal consequences are aggravated by their pro-cyclicality and potentially multiplying effects.[xv]
As put by the World Bank, the financial crisis will cause some existing projects to experience financial distress, and will cause significant dislocations in countries’ agendas to address infrastructure deficits. [xvi] The links to trade are even clearer for many of the projects which were ostensible undertaken to improve trade competitiveness, considered a complement to increased liberalization of trade. There are usually no clauses safeguarding the country’s position in the contract in case the expected returns from exports do not materialize. Neither are there provisions to ensure the country would capture a greater share of the revenue in case the projects yield higher-than-expected returns.
The World Bank announced that it is going to be further increasing its provision of funding for infrastructure. It has been announced that over three years IFC is to invest a minimum of US$300 million and mobilize between US$1.5 billion and US$10 billion from other sources. But the provision of more lending may be a factor that improves or worsens the situation. The final effect will depend on what is the appropriate sharing of risks and returns between private and public actors and particularly between IFC and its borrowers, and whether a realistic and sound methodology is used for the evaluation of trade-related returns.
For low income countries, and in spite of the debt relief committed in the Heavily Indebted Poor Countries Initiative and is most recent expansion, the Multilateral Debt Relief Initiative—launched by the Group of 8 meeting in Gleneagles 3 years ago – debt situations will deteriorate. Trade is a key factor in that equation. The least risky group is, according to the most recent reports, the 18 low income countries that received all debt relief commitments already. Out of the countries in this group, less than half of them have a low risk of falling back into debt distress.[xvii] Moreover, those with low and moderate risks are highly vulnerable to export shocks.[xviii] Of the countries that were not eligible for HIPC/MDRI, one third are also either in or at risk of debt distress.
But it is important to keep in mind that the assessment of risks and “sustainability” is according to the rather tolerant parameters of the Debt Sustainability Framework adopted in 2005. Such reform resulted in a ramping up of the thresholds at which borrowers are considered to be in trouble. Some substantial criticisms had been made of the methodology for measuring debt sustainability in the past, which relied on overoptimistic projections of export and GDP growth.[xix] In spite of its attempt to address the problem with stress-testing methodologies, the boom of the last years continued to boost the optimism of projections. The IMF/ Bank staff assert, referring to the situation of countries not in the HIPC/MDRI program, that the situation is not worse because these countries were having an export growth rate of 11 percent average in a 10-year average. Export projections based on such trends will be rendered useless by the impact of the crisis and so will the projections of debt ratios for many countries. The very notion of “low” or “moderate” risk will certainly come under challenge.
But increasing debt problems are not confined to the LICs group. Commodity prices have been a major factor in the worsening export outlooks of several middle-income countries, such as Argentina, Mexico, Brazil, South Africa and Kazakhstan. As the current accounts of some countries show signs of worsening, making more borrowing necessary, rating agencies such as Fitch have proceeded to downgrade them.[xx] The downgrades will only increase the costs for these countries to repay their existing obligations or refinance them, feeding a well-known vicious circle.
Reciprocally, the need to direct more income to paying debt service can only contribute to accentuate the problems both low and middle income countries have in making investment necessary to expand their production capacity or place them in tighter competition with pressing immediate social needs.
Trade as a driver of foreign investment
There was another factor boosting the “boom” in developing countries and it was record increases in foreign direct investment. Most of the investment was tied, in more or less direct ways, to the high rates of export growth. ECLAC reports that unprecedented volumes of FDI in Latin America and the Caribbean were largely attributable to the persistent worldwide demand for the natural resources in abundant supply in the region. Natural resource-seeking investment was a high share.[xxi] But there was also so –called market-seeking investment, that actually tries to profit from the greater purchasing capacity developed in some countries.[xxii] This purchasing capacity that increased consumption markets was also largely dependent on the boom of natural resource exports, and will be gone with it. Commodity trends are associated even to some FDI flows in manufacturing, as reported by UNCTAD in regards to resource-based manufacturing products in Latin America.[xxiii] FDI in natural resource-based sectors was also a significant factor in FDI growing inflows into Africa and Central Asia.
This is no more than a confirmation of what civil society organizations had repeatedly said about the need to carefully scrutinize foreign investment for its contributions to development, and avoid “predatory” investments. The attraction of foreign investment to export-oriented sectors failed to ensure that part of the revenues from increased prices will contribute to a domestic capital base. As for market-seeking investment, they are fast to withdraw from countries no longer considered “good businesses” after competing medium and small sized companies have been wiped out.
But the trend also shows the limitations of FDI as a stable source of finance. Exactly when capital flows will be needed by countries running into balance of payment problems, FDI will be headed towards the exit.
Trade and exchange rate movements
The financial crisis has also underscored the difficulties faced by developing countries trying to benefit from trade in the absence of a system to provide some measure of stability to exchange rates. The projections of market access and competitive advantages are made more difficult. Domestic investment oriented to exports, especially in a long term, is hampered. Costs of finance are rendered more volatile, too.
In already two studies,[xxiv] the IMF has argued that fluctuations of exchange rates do not have such a strong impact in trade performance and has advocated in favor of market-based hedging instruments as the way forward for developing countries that are affected. Critics contend that this is only available to large companies, with the means and sophistication to pursue such hedging. But difficulties being faced by companies in emerging markets should call into question whether even for large companies in developing countries this practice is a reliable safeguard or the most efficient use for the resources of both the private sector and the government. In countries such as Brazil, Mexico and South Korea, companies have reportedly lost huge amounts by taking the wrong side on derivatives to hedge against dollar movements.[xxv] In Brazil, the government had to intervene to protect the companies affected by lending to them at below-market interest rates, in another sign of the costs that the problem may have for developing countries public treasuries.[xxvi]
In addition to these effects that the financial crisis will have on the export chances of developing countries, the trade profile of the countries exposed to the currency movements has important implications for the scope of the impacts. The currencies of commodity-dependent economies are especially affected, as their currencies tend to lose value in the face of declining commodity price trends that make their growth and export prospects more dubious and may prompt investors to withdraw capital. Some experts use the term “commodity currencies” to refer to the strong correlation between the prices of commodity exports and the currencies in countries such as Chile (copper) or Australia and New Zealand (agricultural products).[xxvii] Even if the direction of causality might remain open to question, the phenomenon means, by definition, that the export profile of the country has a strong impact on how its currency will fare. Though the research cited here focuses on commodity-producing countries, there are indicia that it could more broadly relate to undiversified export structures.[xxviii]
Trade in financial services
The impact of the crisis will also be determined by the degree of openness to trade in services, particularly financial services, of developing countries. The flexibility of many of these countries to introduce the capital management techniques required by the crisis has been compromised already by trade and investment agreements.
In a recent speech, the WTO Director General Mr. Lamy’s stated belief that financial services trade openings can also be useful, by “bringing fresh capital inflows.” However, the experiences with foreign banks operating in developing countries has oftentimes not meant they bring “fresh capital.” Quite to the contrary, their business model is often based on use of existing domestic capital that, given a larger pool of resources and access to intra-company credit or international capital markets, can be better leveraged.
The latest IMF’s World Economic Outlook reports that it is the developing countries that more opened themselves to foreign banks –economies in Eastern Europe– that are faring worst comparing to the ones that had a relatively more closed financial sector, such as those in Asia. Indeed, as the crisis erupted, it became clear that, far from representing relief, foreign banks operating in developing countries brought added woes. The crisis started with a number of banks based in developed countries that had either invested in subprime market securities or provided backup credit lines for special purpose vehicles and had to recapitalize them.[xxix] For supervisory purposes, the originating banks were not even subject to the jurisdiction of developing countries that are now bearing the impacts. Yet, developing countries are now suffering lack of access to credit. Even the remedial measures taken in developed countries to deal with distressed banks represent a problem as they can hardly match such back-up government support.
But liberalization of financial services do not only bring dangers to the banking sector. In a powerful piece, Vander Stichele argues that the government obligation not to stop a foreign service provider from entering the country and offering financial services that have been committed may mean in practice that it could be difficult for the authorities to prohibit derivative trading, a measure many governments are finding necessary to implement.[xxx]
As Joy Kategekwa says, referring to similar rules in the Economic Partnership Agreements, “The role of regulation has never been more vindicated than at this time of financial turmoil,”[xxxi] so extreme caution in adopting any new rules, and even a roll-back of existing ones, is in order.
Trade as a development finance tool
As the financial crisis unfolds, it is increasingly clear that developing countries stand to suffer the most, and that the impacts will be most strongly felt through trade. Years of trade reforms in these countries have emphasized an export-led, pro-liberalization model. Reforms, on the other hand, sidelined the reality that no country can succeed in using trade to develop and reduce poverty without supportive internal and external financial structures. This is the time to pursue a rebalancing act. Trade can be a development finance tool and one that helps countries weather, rather than place them at the mercy of, financial cycles. But, in order for that to happen, trade concerns should be at the center and guiding the reform of international finance.
[i] Working Group on Trade, Debt and Finance. Communication from Brazil. WT/WGTDF/W/39. 6 October 2008. WTO.
[iii] Working Group on Trade, Debt and Finance. Expert Meeting on Trade-Finance. Note by the Secretariat. WT/WGTDF/W/38. 14 July 2008.
[iv] Raddatz, Claudio 2008. Credit Chains and Sectoral Comovements: Does the Use of Trade Credit Amplify Sectoral Shocks? Policy Research Working Paper 4525. The World Bank. Development Research Group.
[vi] WTO 2008. Lamy Warns Trade Finance situation “deteriorating.” News Release. November 12.
[vii] Financial Times 2008. The view isn’t pretty as the banking crisis dust settles. October 19.
[viii] Financial Times 2008. Credit insurers are well-placed… and unpopular. November 17.
[ix] Financial Times 2008. Companies feel chill as credit cover dries up. November 15.
[x] UNCTAD 2008. Trade and Development Report. Table 2.1.
[xi] ECLAC 2008. Economic Survey of Latin America and the Caribbean: Macroeconomic Policy and Volatility.
[xii] UNCTAD 2008. Economic Report on Africa.
[xiii] Kessler, Tim 2005. Assessing the Risks in the Private Provision of Essential Services. In Buira (ed.) The IMF and the World Bank at 60. Anthem Press: London.
[xiv] IMF 2005. Government Guarantees and Fiscal Risks. Prepared by Fiscal Affairs Department (in consultation with other departments). April 1.
[xv] Ib., p. 10
[xvi] 2008. Global Financial Crises: Responding Today, Securing Tomorrow.
[xvii] In the World Bank’s classification, countries may have a low, moderate or high risk of debt distress. IMF/ World Bank 2008. Debt Sustainability in Low Income Countries – Recent Experience and Challenges Ahead.
[xviii] Ib., 13.
[xix] For a survey of criticisms see Caliari, Aldo 2006. The debt –trade connection in debt management initiatives. The need for a change in paradigm. Paper prepared for UNCTAD Workshop “Debt Sustainability and Development Strategies.” Geneva.
[xx] Financial Times 2008. Downgrades emphasise emerging economy risks. November 10.
[xxi] 2008. Foreign Direct Investment in Latin America and the Caribbean 2007.
[xxiii] UNCTAD 2008. World Investment Report.
[xxiv] IMF, 1984, The Exchange Rate System: Lessons of the Past and Options for the Future, IMF
Occasional Paper No. 30 (Washington: IMF) and IMF 2004. Exchange Rate Volatility and Trade Flows – Some New Evidence. Prepared by Peter Clark, Natalia Tamirisa, and Shang-Jin Wei, with Azim Sadikov, and Li Zeng. Approved by Raghuram Rajan. May 2004.
[xxv] Financial Times 2008. Mexico attacks ‘unethical’ derivatives selling. October 23; Financial Times 2008. Brazil assesses Impacts of Currency Crisis. October 28.
[xxvii] Wall Street Journal 2008. Bad Crop: Commodity Currencies. November 11.
[xxviii] As put by John Plender in “Insight: Reality for Emerging Markets”, Financial Times 2008. November 11. (“Growth rates can be very high – in China’s recent case, as high as 12 per cent or so in real terms – but cycles are more extreme than in the developed world. This is not just true of energy and commodity-related economies. It also applies to Asian countries that rely more on manufacturing. They lack the protective cushion of a large service sector when the manufacturing cycle turns down.”)
[xxix] Borio, Claudio 2008. The financial turmoil of 2008-?: a preliminary assessment and some policy considerations. Bank for International Settlements. Working Paper No. 251. Monetary and Economic Department. March.
[xxx] Vander Stichele, Myriam 2008. How trade, the WTO and the financial crisis reinforce each other. For more information on how GATS will impact financial services in the US context, see Public Citizen 2008. The WTO’s General Agreement on Trade in Services (GATS): Implications for Regulation of Financial Services in the U.S.
[xxxi] Kategekwa, Joy 2008. The Financial Crisis: Lessons for EPA negotiations. In South Bulletin (bulletin of the South Centre), 16 October 2008, Issue 25.