The remainder of this paper will proceed as follows. Based on the most recent literature, Section 2 introduces the economics of trade finance, outlines what may be unique about it, and discusses its economic implications. Section 3 reviews briefly the nature of the current global crisis and its practical impacts on the trade finance market. Section 4 discusses the potential scale of the trade finance gap. Section 5 presents the possible rationales for intervention to support trade finance. To conclude, Section 6 reviews the policies and tools that have been used to support trade finance in the past and discusses which policies and tools are likely to be the most effective in addressing the specific problems of trade finance experienced in the current crisis.

# 2. <u>The economics of trade finance</u>

By providing critical fluidity and security to enable the movement of goods and services, trade finance lies at the heart of the global trading system (Auboin & Meier-Ewert, 2008). Some 80 to 90 percent of all trade transactions are said to be financed.<sup>5</sup> Trade finance mechanisms exist to support two fundamental aspects of the trading process _: risk mitigation_ and _liquidity_ .

- _Risk mitigation_ : Any economic exchange involves an element of risk, principally that the seller will fail to deliver the goods or services as agreed or that the buyer will fail to pay or to accept the goods or services. In an international trading environment these risks are heightened by such factors as macroeconomic volatility, political risk, information asymmetry, and moral hazard. As a result, traders require facilities which mitigate and/or compensate for these risks.

- _Liquidity_ : Suppliers normally face a gap in time between when they incur production costs and when they receive payment from the buyer. This creates a liquidity gap, which is often made greater by payment terms that grant buyers a period of days or weeks in which to make payment. In an international trading environment, this time period tends to be extended still further due to the relatively longer time required for products to reach their markets. Firms typically require access to credit to offset this liquidity gap.

The vast majority of trade finance involves credit extended bilaterally between firms in a supply chain or between different units of individual firms.<sup>6</sup> Banks also play a central role in facilitating trade, both through the provision of finance and bonding facilities and through the establishment and management of payment mechanisms such as telegraphic transfers and documentary letters of credit (L/Cs). Complementing the activities of the banks are the following entities:

- _Export Credit Agencies (ECAs)_ : ECAs are quasi-governmental agencies that generally provide cover – including partial or comprehensive insurance and guarantees – to offset counterparty risk. In most cases, ECAs do not provide direct funding to traders but rather complement the role of banks by guaranteeing the trade financing they provide to exporters.

> 5 Although this range of 80-90 percent is widely reported, the source and evidence for the claim is unclear. 6 According to messaging data from SWIFT, approximately 90 percent of trade finance occurs through interfirm, ‘open-account’ exchange. Estimates from FImetrix (2009) suggest that 10-20 percent of trade finance is composed of cash-in-advance payments (these mainly involve SME buyers, and inordinately in developing countries); 45-80 percent is on open account (of which 30-40 percent is intra-firm), and 10-35 percent is bank intermediated.

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