http://www.independent.co.uk/news/business/analysis-and-features/shipping-holed-beneath-the-waterline-995066.html
Leading Economist Warns of Food Riots
Letters of Credit and The Disruption of International Trade: Systemic
Risk, Contagion and Trade Finance
By The London Banker and RGE Monitor
November 15, 2008 — “Global Research” — November 15, 2008 — Back in the
old days (pre-1980s), the term systemic risk did not refer to contagion of
illiquidity within the financial sector alone. Back then, when the real
economy was much more important than low margin, unglamorous banking, it
was understood that the really scary systemic risk was the risk of
contagion of illiquidity from the financial sector to the real economy of
trade in real goods and real services.
If you think of it, every single non-cash commercial transaction requires
the intermediation of banks on behalf of – at the very least – the buyer
and the seller. If you lengthen the supply chain to producers, exporters
and importers and allow for agents along the way, the chain of banks
involved becomes quite long and complex.
When central bankers back in the old days argued that banks were “special”
– and therefore demanded higher capital, strict limits on leverage, tight
constraints on business activity, and superior integrity of management –
it was because they appreciated the harm that a bank failure would have in
undermining the supply chain for business in the real economy for real
people causing real joblessness and real hunger if any bank along the
chain should be unable to perform.
As the “specialness” of banks eroded with the decline of the real economy
(and the migration globally of many of those real jobs making real goods
and providing real added-value services to real people), the nature of
systemic risk was adjusted to become self-referencing to the financial
elite. Central bankers of the current generation only understand systemic
risk as referring to contagion of illiquidity among financial
institutions.
They and we all are about to learn the lessons of the past anew.
We are now starting to see the contagion effects of the current liquidity
crisis feed through to the real economy. We are about to go back to the
bad old days. Whether the zombie banks are kept on life support by the
central banks and taxpayers of the world is highly relevant to whether the
zombie bank executives pay themselves outsize bonuses and their zombie
shareholders outsize dividends with taxpayer money. It appears sadly
irrelevant to whether the banks perform their function of intermediating
credit and commercial transactions in the real economy along the supply
chain. The bailout cash and executive and shareholder priorities do not
seem to reach so far.
The recent 93 percent collapse of the obscure Baltic Dry Index – an index
of the cost of chartering bulk cargo vessels for goods like ore, cotton,
grain or similar dry tonnage – has caused a bit of a stir among the
financial cognoscenti. What is less discussed amidst the alarm is the
reason for the collapse of the index – the collapse of trade credit based
on the venerable letter of credit.
Letters of credit have financed trade for over 400 years. They are
considered one of the more stable and secure means of finance as the cargo
is secures the credit extended to import it. The letter of credit
irrevocably advises an exporter and his bank that payment will be made by
the importer’s issuing bank if the proper documentation confirming a
shipment is presented. This was seen as low risk as the issuing bank could
seize and sell the cargo if its client defaulted after payment was made.
Like so much else in this topsy turvy financial crisis, however, the
verities of the ages have been discarded in favour of new and unpleasant
realities.
The combination of the global interbank lending freeze with the collapse
of the speculative, leveraged commodity price bubble have undermined both
the confidence of banks in the ability of a far-flung peer bank to pay an
obligation when due and confidence in the value of the dry cargo as
security for the credit if liquidated on default. The result is that those
with goods to export and those with goods to import, no matter how worthy
and well capitalised, are left standing quayside without bank finance for
trade.
Adding to the difficulties, letters of credit are so short term that they
become an easy target for scaling back credit as liquidity tightens around
bank operations globally. Longer term “assets” – like mortgage-back
securities, CDOs and CDSs – can’t be easily renegotiated, and banks are
loathe to default to one another on them because of cross-default
provisions. Short term credit like trade finance can be cut with the flick
of an executive wrist.
Further adding to the difficulties, many bulk cargoes are financed in
dollars. Non-US banks have been progressively starved of dollar credit
because US banks hoarded it as the funding crisis intensified. Recent
currency swaps between central banks should be seen in this light, noting
the allocation of Federal Reserve dollar liquidity to key trading partners
Brazil, Mexico, South Korea and Singapore in particular.
Fixing this problem shouldn’t be left to the Fed. They aren’t going to
make it a priority. Indeed, their determination to accelerate the payment
of interest on reserves and then to raise that rate to match the Fed Funds
target rate indicates that the Fed are more likely to constrain trade
finance liquidity rather than improve it. Furthermore, the Fed may be
highly selective in its allocation of dollar liquidity abroad, prejudicing
the economic prospects of a large part of the world that is either
indifferent or hostile to the continuation of American dollar hegemony.
. If cargo trade stops, a whole lot of supply chain disruption starts. If
the ore doesn’t go to the refinery, there is no plate steel. If the plate
steel doesn’t get shipped, there is nothing to fabricate into components.
If there are no components, there is nothing to assemble in the factory.
If the factory closes the assembly line, there are no finished goods. If
there are no finished goods, there is nothing to restock the shelves of
the shops. If there is nothing in the shops, the consumers don’t buy. If
the consumers don’t buy, there is no Christmas.
Everyone along the supply chain should worry about their jobs. Many will
lose their jobs sooner rather than later.
If cargo trade stops, the wheat doesn’t get exported. If the wheat doesn’t
get exported, the mill has nothing to grind into flour. If there is no
flour, the bakeries and food processors can’t produce bread and pasta and
other foods. If there are no foods shipped from the bakeries and
factories, there are no foods in the shops. If there are no foods in the
shops, people go hungry. If people go hungry their children go hungry.
When children go hungry, people riot and governments fall.
Everyone along the supply chain should worry about their children going
hungry.
When that happens, everyone in governments should worry about the riots.
Controlling access to trade finance determines who loses their jobs, whose
children go hungry, who riots, which governments fall. Without dedicated
focus on the issue of trade finance and liquidity from those in the
emerging world most interested in sustaining the growth of recent years,
little progress can be expected. Trade finance is rapidly communicating
the stress on bank liquidity to the real economy. It presents a systemic
risk much more frightening than the collapsing value of bits of paper
traded electronically in London and New York. It could collapse the
employment, the well being and the political stability of most of the
world’s population.
The World Trade Organisation hosted a meeting on trade credit in
Washington Wednesday to highlight the rapid and accelerating deterioration
in trade finance as an urgent priority for public policy.
I look at the precipitous collapse of the Baltic Dry Index and I wish them
Godspeed.
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