The role of Development Financial Institutions (DFIs) is to invest commercial, yet catalytic capital to help create jobs, boost growth, and fight poverty and climate change amongst other mission aligned objective – with a focus on frontier and emerging markets. Since 2000, DFIs have grown from almost US$12 billion in annual investments to US$87 billion in 2017—an increase of six times. This developmental capital has played a significant role in helping many countries and companies advance their socio-economic development. In recent years, DFI’s has also played a prominent role in providing direct capital to financial institutions especially where there has been a strategic alignment in developmental goals. However, there is still much do to, with greater collaboration required with private market participants, particularly where current approaches have greater room for improvement, namely with respect to Trade Finance.
The Asian Development Bank (ADB) estimates a global trade finance gap of US$1.5tn with 40% of this deficit coming from the Asia-Pacific region and 74% of the gap made up by SMEs and mid-cap companies. Specifically, for Africa, the African Development Bank estimated that the market for bank-intermediated trade finance was between US$330-350bn in 2014 with unmet demand for trade finance in Africa higher than US$120bn.
Amid the fallout from Covid-19 this figure has skyrocketed. New research from the International Chamber of Commerce (ICC) estimates a capacity of US$1.9 to US$5tn in the trade credit market is necessary simply to return to 2019 levels. Factoring in this estimation along with the existing 2019 trade finance gap (US$1.5tn) means that, we now need between US$3.4tn and US$6.5tn to be able to meet the SDGs.
The impact of this global trade finance gap is serious. It is a major impediment toward reducing poverty and minimising inequality – two areas that the UN’s Sustainable Development Goals (SDGs) set out to eradicate back in 2015.
Against this backdrop, Development Finance Institutions (DFIs) are playing an increasing role in addressing the trade finance gap in Emerging and Frontier Markets (EFM), mostly through supporting commercial banks’ trade finance activities on a funded and unfunded basis as well as direct lending to larger companies (primarily in the energy and resources sector). To complement these efforts, we believe that there is potential to further penetrate the EFM trade finance market by increased collaboration between DFIs and Non-Bank Financial Institutions (NBFIs). DFIs approach of supporting commercial banks to mobilise trade finance in EFM has its flaws. Commercial banks are under increasing pressure to comply with one-size-fit-all global banking regulations relating to capital, liquidity and various other compliance laws and regulations. The developmental capital allocation to SMEs through commercial banks has been seriously impeded due to ever increasing pressure on the Banks to comply with a stringent global regulatory environment, especially trade finance which is cross border in its very nature.
DFI Activity in Trade Finance
DFIs that are quite active in EFM trade finance include the likes of the International Finance Corporation (IFC), the European Bank for Reconstruction and Development (EBRD), the Islamic Development Bank (IDB) through International Islamic Trade Finance Corporation (ITFC), CDC Group UK (CDC), the African Development Bank (AfDB), Afreximbank, The Eastern And Southern African Trade and Development Bank (TDB), Asian Development Bank, and the Inter-American Development Bank (IDB) amongst others. DFIs support EFM trade finance through various means such as export credit agencies, issuing credit instruments to banks in addition to guarantees, risk-sharing facilities and trade facilitation programs. Most of these activities rely on Commercial Banks with selective direct support to large international players active in EFM.
Despite their growing participation in the segment, DFI trade finance activity is often limited to their respective member countries with only a handful of DFIs involved in direct trade finance lending. Whilst this approach has many merits - catalysing significant impact and flow of funds, it leaves a considerably large missing middle. SMEs who form most companies in EMF and continued to be underserved by commercial banks as demonstrated by the increasing trade finance gap, something which will likely unfortunately only grow further as COVID-19 forces banks to re-look at their strategies and core customer base. Since the global financial crisis of 2008/2009, many international banks that have traditionally supported EFM’s trade link to the developed consuming countries has left this space which have been a significant contributor to the trade finance gap.
Limitations of Relying Solely on Commercial Banks:
Capital and Risk Regulations: Increasingly stringent capital and risk requirements mean that banks (especially regional ones) have lesser capital available to lend. In addition, capital is risk based and SMEs and EMFs are rated high risk on most traditional risk models, and therefore require higher amount of capital making cost of finance very expensive or are simply ignored by commercial banks. For DFIs, this translates to reduced exposure to local trade finance markets. In detailed study by WTO in 2017, the main constraints to additional supply of trade finance highlighted by bank respondents clearly shows that risk and regulatory requirements that Banks have to comply with were the greatest barrier to increase trade finance lending to SMEs.
Shortage of Supply: Demand for trade finance far surpasses supply - DFIs that are active in this space are only accessing a portion of the market and hence a portion of total available returns. For example, in 2014 Afreximbank was only able to process US$2.68bn out of US$23.8bn in requested trade finance products despite its great efforts to help narrow the gap. The unmet trade finance demand (the trade finance gap) in Africa is conservatively estimated at US$91bn in 2014. Although this represents a 26% decline compared to 2011, the gap is still significant and ranges between US$90bn and US$120bn.
Client concentration: Trade finance access remains disproportionately skewed to large corporates while new entrants and SMEs are clearly at a disadvantage when it comes to accessing trade finance.
Globally, in 2014, 47% of trade finance requests were submitted by SMEs versus 14% which are submitted by large corporates. However, SMEs’ were rejected 52% of the time while the approval rate among large corporates was around 87%.
In Africa, the ten biggest customers of commercial banks have accounted for as much as 58% of the banks’ books in the past while new clients and SMEs accounted for only 15% and 28% respectively.
In Asia-Pacific, according to banks surveyed by the ADB, SMEs account for 51% of trade finance demand. The rejection rate of SME requests was 45% compared to mid-sized-larger sized firms (39%) and multinational corporations (17%).
Why do SMEs Face Challenges Accessing Finance?
While the barriers to accessing trade finance impacts all countries, it is SMEs in EFM that are impacted the most. Factors include but are not limited to:
The relatively small deal sizes (e.g. sub US$5m) presented by SMEs makes returns less attractive for banks especially when compared to larger corporates. Considering the associated transaction and due diligence costs, this results in bankers typically choosing to focus efforts on upper middle market and large corporates. The irony is, in EFM, SMEs are the largest employers and economic contributors. According to the World Economic Forum a lack of access to trade finance is a top-three export barrier for half of the world’s countries – particularly the poorest ones.
For international banks, currency risk, local bank credit risk and sovereign risk can be deterrents against lending to EFM SMEs, even if the SME itself has a solid business model and a strong growth trajectory.
Trade Finance is a specialist operation where highly experienced origination; risk & operations personnel are required, particularly those who can understand the nuances of SMEs, many commercial banks take a product led approach, hence if a financing requirement does not fit a box, the transaction is declined…. This impacts SMEs given that a volume driven commercial bank will focus such efforts on larger clients vs. smaller.
There have been many DFI backed schemes to facilitate trade finance with large multinational banks, however there is limited public data available on their success in terms of how many transactions that would have genuinely been declined were approved as a result of the scheme. Anecdotal evidence gathered from SMEs points towards there being very limited benefit.
Faced with some of these challenges, SMEs are increasingly turning to alternative sources of trade finance such as trade finance funds to support their needs.
Impact of COVID-19 on Trade Finance
COVID-19 has impacted the global supply chains as never seen before. Access to trade finance was already an issue and COVID-19 has exacerbated this further with EFM been hardest hit. For EFM, reduced trade activity coupled with increased perceived risk has resulted in increased cost and shortage of trade financing. International trade is a major source of hard currencies for EFM and COVID-19 is putting pressure on the balance of payments which is resulting in shortage of liquidity and therefore rapid decrease in foreign reserves. International trade and trade finance are a pivotal component in economic recovery and COVID-19 response.
DFI’s have responded to the challenge and 16 OECD countries grouped under ‘DFI Alliance’ has announced to work together to respond to the COVID-19 pandemic in EFM. The measures are wide ranging and as per official statement, includes targeting liquidity issues in financial sectors, supporting the viability of existing private sector companies, and promote new investment in goods and services necessary to global health, safety, and economic sustainability. The DFI Alliance is developing mechanisms designed to sustain companies, return them to full production, and restore employment opportunities essential to the societies in which they operate.
The exact support mechanism targeting international trade and trade finance is unclear at this stage. Any COVID-19 response of such nature should specifically focus on ensuring that the flow of goods and capital through international trade and trade finance is prioritised and ensuring that SMEs are not left out from such measures.
A Case for Blended Finance
Trade Finance Funds are widely accepted as complementary to banks, especially since funds offer access to the EFM SME trade finance segment that banks struggle to service. Additionally, as international banks de-risk, more and more alternative trade finance providers are filling in the gap that has been left behind. This begs the question, how can DFIs work more closely with trade finance funds?
DFIs have been working with funds in different segments of the capital structure for many years, e.g., supporting a significant number of VC & PE funds and microfinance funds, hence a segment of the capital structure that is the lifeblood for economic development and growth should surely align to their stated goals.
Trade Finance has many characteristics that are attractive to traditional investors, however, to crowd this capital in, DFIs must play a key role by being the first or an early mover, in line with their stated objectives of supporting sustainable development. Using a blended finance approach can go a long way, be it through direct equity participation, direct funding/seeding of funds, traditional guarantees or through risk participation, DFIs can play a significant role in furthering access to trade finance for SMEs.
In recent years, niche Trade Finance funds have shown mixed track records with a few firms failing owing to various reasons. There have been many lessons learnt, one of the most important being the role of governance. In addition to capital, DFI’s can play a pivotal role in development of this asset class by influencing governance, underwriting discipline, reporting and genuine ESG integration into the firms and strategies.
“If SMEs in emerging markets do not have access to financing--trade and other types of financial support--they will not survive the pandemic. Given the overwhelming importance of SMEs, this is a critical gap that must be filled by banks and other financial institutions. Business as usual will not work. Financial institutions have to get creative about how to get money into the hands of the smaller firms that need it most.” – Deborah Elms, Executive Director, Asian Trade Centre.
Whilst the importance financing of international trade was explicitly recognized in the 2015 Addis Ababa Action Agenda as an important means of implementation of the SDGs, significant opportunities remain for existing and new market participants to support trade and development.
Through further support from commercial banks, DFIs and greater proactive collaboration with specialist private investment firms, we strongly believe that additional and greater impact can be achieved, particularly benefiting those at the bottom of the pyramid.
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