Can impact investors step up to the trade finance gap?
By: Mike Guerin
Tags: Trade, Finance, Supply Chain, Impact Investing, International

In the 1990s, I had a front row seat to the wave of investment that was then flowing into emerging markets, first as a government trade specialist and later as an equity analyst in Russia. This was the beginning of a 20 year run for emerging markets, when structural reforms, global economic integration and commodity supercycles translated into equity outperformance against the S&P. I’ve since made the shift to working in trade credit technology, but knowing the role that development finance played in the EM story, I think there’s an unmistakable place for impact investors in this one today.

Simply put, the inflow of foreign portfolio investment into the emerging world didn’t happen out of nowhere. For much of the 1980s, the World Bank’s IFC, among others, systematically gathered data, deployed capital, and worked with private sector institutions to support local capital markets and build the case for EM equity investment. Boosted by some good PR (“Third World Equity Fund” was not a winner), this work led to the creation of almost 150 emerging markets funds by the early 1990s. The IFC effort was a critical catalyst to the sustained investment and growth that followed.

This experience taught me three lessons. First, it’s worth paying attention when the IFC puts resources behind an opportunity. Second, the cold start problem is an area where investors with a development agenda can play a foundational role. And finally, when market forces and development agendas are working in tandem, substantial capital can be deployed at speed, with far reaching benefits.

What has my attention today is that since the 2008–9 recession, there’s been a concerted effort across a range of NGOs and multilateral institutions, the IFC included, to shine a light on what has been described as the global trade finance gap. The issue that they’re highlighting is the shortage of institutions and capital to intermediate risk and provide funding for firms trading cross border, with a particular focus on SMEs.

Trade finance is sizable opportunity. Setting aside for a moment corporate programs, where most capital and trade finance technology is focused, this cross border need stands in sharp contrast to the remarkable and growing access that SMEs have to export opportunities today.

Despite a financing challenge that SMEs rank as one of their top concerns, SMEs are now responsible for as much as a third of the $24.5T in goods and services sold cross border every year. Technology and the growing policy consensus for free trade are essential drivers, having steadily chipped away at the cost and complexity of cross-border trade for even small players.

The underlying cause of the financing shortfall is, in part, bank deleveraging, which took place in response to newly introduced post-crisis capital and lending rules. These requirements have pushed out some of the main trade finance banks, and have led many of those who remain to focus on their investment-grade clients. Given that SMEs are north of 95% of all firms in most countries and can employ as much as two-thirds of a nation’s workforce, there is a strong policy impetus to ensure they’re not excluded from supply chains that are increasingly global in nature.

Another constraint is local financing practices prevalent where many suppliers are based. In Asia, for example, local lenders in even the more sophisticated markets often require property as collateral. This is an inefficient use of capital that can place institutional loans out of reach of many smaller firms, and it’s compounded by local regulations in some markets which have slowed the development of suitable trade finance products.

As if today’s trillions of dollars of trade aren’t enough to bring this into focus, the Asian Development Bank and others have argued that SME exports could be lifted by as much as another $1.5T annually, if unfunded SMEs gain access to trade finance.

There are other reasons why trade finance is worth a closer look. Trade credit durations are short, with limited correlation to equities. Yields for sub investment-grade facilities — which can be for sizable firms — are attractive. Because they are short duration, lenders should be able to quickly adjust exposures and rates. This affords them a degree of protection against market disruption.

For a decade, the International Chamber of Commerce has recorded annual trade finance default rates across a range of banks, and they are considerably lower than other, comparable loan products made in the same markets. Although the data set needs to be extended, this exercise is similar to the IFC’s work in the 1980s, when the IFC began recording surprisingly attractive investment returns data for a group of emerging stock markets.

Based on these metrics alone, it’s not surprising that there are investors who want to put money to work in this area today. What’s needed is supporting data and new technologies if they’re to do this at scale. The impact investment community can speed their development, and help ensure success with some strategic capital.

Part of the hesitation, I suspect, lies in siloed portfolio allocation strategies in an increasingly interconnected world. Products, including financial services, can originate in one country with far reaching effects on others. Can more be done by moving from a distinction between investing domestically and abroad, to a strategy that explicitly supports these growing cross border relationships?

Similarly, supply chain finance programs exist that can put significant amounts of capital to work, with clear benefits for export-led economies, and with relatively little risk. Performance data from these programs, particularly ones targeting SMEs, will help create transparency and draw more investors, much as the IFC’s data did for emerging markets. With $500B now allocated to impact mandates, and with as much as $23T deployed in socially responsible strategies, scale is an asset that can create precedent and leverage.

These aren’t the only opportunities in global trade, and there are some investors, impact included, who are pursuing them. Nonetheless, technology-led disruption is underway, with implications for growth, financial inclusion, and the environment. New institutions will be created, and outdated processes will be replaced. With financing needs outpacing what’s being delivered today, well timed impact investment can play a critical role.