metadata: authors: 0: author: Ellingsen,Tore
1: author: Vlachos,Jonas Dimitrios
count: World
docna: 0: docna: Trade finance in a liquidity crisis
docty: Policy Research Working Paper
subtopic: Financial Regulation & Supervision,Trade Policy,Trade Finance and Investment,International Trade and Trade Rules,Trade and Services
teratopic: Law and Development,Private Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
abstracts: cdata!: The paper discusses the reasons for
            supporting international trade finance during a liquidity
            crisis. Targeted interventions are justified when prices are
            rigid and sellers insist on immediate payment due to fears
            of strategic default. In this case, buyers who reject the
            seller's offer fail to internalize the seller's
            benefit from additional liquidity. A general infusion of
            credit will not facilitate the beneficial transaction, but
            an infusion targeted at the buyer's bank's trade
            finance supply will do so. Since there is a need for
            interventions in one country to benefit actors in another,
            international coordination is called for.
repnme: repnme: Trade finance in a liquidity crisis
display_title: Trade finance in a liquidity crisis
listing_relative_url: /research/2009/11/11373976/trade-finance-liquidity-crisis
topicv3: Trade Finance m1326673 370,Trade m1326924 698,Trade in Services m1326928 780,Trade and FDI m1504264 2556,Trade Guarantees m1505111 3906
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Law and Development,Private Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
no_of_pages: 24
author_keys: 0: author_key: 1104852
1: author_key: 1040434
model_extractions: WPS5136 Policy Research Working Paper 5136 Trade Finance in a Liquidity Crisis _Tore Ellingsen JonasVlachos_ The World Bank Poverty Reduction and Economic Management Network International Trade Department November 2009
Policy Research Working Paper 5136

# **Abstract**

The paper discusses the reasons for supporting international trade finance during a liquidity crisis. Targeted interventions are justified when prices are rigid and sellers insist on immediate payment due to fears of strategic default. In this case, buyers who reject the seller’s offer fail to internalize the seller’s benefit from additional liquidity. A general infusion of credit will not facilitate the beneficial transaction, but an infusion targeted at the buyer's bank’s trade finance supply will do so. Since there is a need for interventions in one country to benefit actors in another, international coordination is called for.

This paper—a product supported by the International Trade Department, Poverty Reduction and Economic Management Network—is part of a larger effort in the department to better understand the role of trade finance in the current global economic crisis in the context of the G20 initiative. Policy Research Working Papers are also posted on the Web at http:// econ.worldbank.org. The authors may be contacted at Tore.Ellingsen@hhs.se and jonas.vlachos@ne.su.se.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
*

finance), finance finance finance financial finance Any resources spent on trade finance provision could trade finance is warranted.

finance

*

Chauffour,
<!-- Start of picture text --> Our main argument in favor of trade finance targeting in times of a financial crisis<br>is that firms are then likely to have an incentive to hoard cash.<br>funding for inter-firm transactions has greater social value than other funding, because<br>trade finance cannot be hoarded by borrowers.<br>finance<br><!-- End of picture text --> <!-- Start of picture text --> finance,<br>first<br>effects<br>financial inter-firm<br>find financial<br>financial effective specific finance<br>definitions finance,<br>whereas Section 3 gives a brief overview of the role of financial frictions in international<br>finance<br>fine<br>definition finance financial<br>firm definition,<br><!-- End of picture text -->
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|not clear that the trade credit multiplier effect justifies specific trade credit subsidies.<br>finance|
|---|

financial definition finance
<!-- Start of picture text --> significant<br><!-- End of picture text --> <!-- Start of picture text --> more willing to provide specific loans for input purchases than to provide general cash<br>finance<br>firms<br>Numerous studies document that international contract enforment is a serious concern for firms<br>(Antras<br><!-- End of picture text -->

|(Antras<br>Marcouillier(2002)whofindthatpoorcontractenforcementisamajorimpedimenttointernational|
|---|
financial fixed firms profitable finding financial financing.

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<!-- Start of picture text --> firms<br>rather than suppliers benefiting from the financial<br>financial<br>finance difficult,<br>the one hand, the above evidence tell us that trade finance cannot remove all financial<br>financial<br>financial<br>finance<br>firms<br>finance financial<br>finance financial<br>finance<br>finance financial<br>financial firms.<br>affecting financial<br><!-- End of picture text -->

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<!-- Start of picture text --> finance<br>specifically finance.<br><!-- End of picture text --> <!-- Start of picture text --> finance<br><!-- End of picture text -->

# financial

## first

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# justified

financial finance program is the insight that it is more difficult to make credible pledges across

# financial

beneficial effects. first effect financially firms

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effect firms’

# firm.

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## profit

<!-- Start of picture text --> deal with the current crisis ought to focus on the indirect effect rather than the direct<br>effect. effects<br><!-- End of picture text -->
|first|
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firms advice, and we believe that many do, the outcome is that firms collectively suffer from

|offset|
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|figures<br>final|
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|Jaffee<br>non-financialfirms,|
|---|
<!-- Start of picture text --> benefit<br>finance<br><!-- End of picture text --> <!-- Start of picture text --> finance<br><!-- End of picture text -->

|offering.|
|---|

|thebooksofthebuyer’sbank—withtheseller’sbankbeingpaidoffatthetransaction|
|---|

|firms.|
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10 TRADE FINANCE IN A LIQUIDITY CRISIS To the extent that sellers and buyers are located in the same country, there is reason to expect domestic support for trade credit funding. However, when they are located in separate countries, the most appropriate intervention is to provide selective funds to the buyer's bank, whereas the bene�ts to a large extent �ow to the seller's country. This, then, is an argument for international policy coordination.

An empirical implication of our argument is that imports in countries where there is less trust in the buyer's bank will be hit relatively hard by the �nancial crisis. According to IMF (2009), imports to LDCs are expected to decline more than exports from these countries, while the reverse is expected among advanced economies. Assuming that there is less trust in the LDCs banks (partly due to less credible government guarantees), this is in line with our model's predictions. Needless to say, this is not a formal test of the model and the pattern could be due to other factors, but at least the pattern is broadly consistent with our story.

The next section articulates our argument formally. Thereafter we discuss two other models that capture dimensions that the �rst model neglects.

# 5. Price rigidity and trade finance

Here is a simple model that clari�es the logic of our main argument. A seller has a resource that a buyer may purchase and re�ne. Re�ning takes two periods. For simplicity, we assume that the process is costless. It increases the value of the resource from c to v. Traditionally, the seller and the buyer have been trading at a price ~~p~~ = (c + v)=2 that splits the gains from trade equally. For reasons alluded to above (and further expanded upon in the next section), we suppose that this price is rigid in the short run.

However, due to an imminent liquidity shock, both the seller and the buyer faces a one-period return to holding cash of r. That is, from the date 0 perspective, the two parties know that they can trade to generate a surplus at date 2 of v � c, but also that any cash held at the beginning of period 0 earns an expected return r if
reflect 2 <

>

~~_~~ words, if the liquidity shock is sufficiently large relative to the return to trading, then profitably <u>~</u> Extending specific finance benefits benefits
difference off at firms, insufficient offered offered financial

# financial

deflation?

there a straightforward channel from financial frictions to temporary downward price costs are zero and that the good is infinitely lived.

financial 6 different
—o financial differently.

6 6 different off buyer.

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deflation, financial inefficient financial let us consider a modification of the above model.

p Pp ~~SO~~ Pp ~~STpP —~~ <u>$s—</u> p> DP, ~~ P> DP, If the uncertainty is sufficiently small,
sufficiently profit T — — inefficient ~~—~~ digit market interest rates, this is a reasonable number for a firm that cannot borrow ~ = financial

*

finance
17 TRADE FINANCE IN A LIQUIDITY CRISIS correspondingly. The reason is that the seller has to give some surplus (information rents) to the buyer when there is uncertainty concerning the buyer's interest rate.

But before endorsing trade �nance subsidies on the basis of asymmetric information, it is necessary to ask why the seller would be unwilling to provide funding.<sup>7</sup> Suppose for concreteness that the seller can borrow a fraction ' of the value of the receivables at interest rate r1, and that the remainder would have to be funded internally, at the opportunity cost r2.<sup>8</sup> One possibility is that r2 is just too large for the seller to want to extend trade credit. If so, the current model (like the model in the previous section) suggests that the problem is alleviated by relaxing the seller's �nancial constraint. Alleviating it through trade �nance subsidies is then only justi�ed if the government believes that provision of general loans is likely to attract borrowers whose projects are less socially desirable than those borrowers who need to fund trade credit extension.

Another possibility is that ' has dropped, in which case the optimal intervention depends on the causes of the drop. If it is due to the general credit crunch, the answer is to recapitalize intermediaries, not to target trade credit.

# 8. Spillovers from trade and FDI

Altogether, we think that the incomplete information model helps to explain why uncertainty about trading partners' �nancial conditions can create ine�ciencies in the non-�nancial sector, and not only in the �nancial sector. Our point here echoes Blanchard and Kremer (1997). In the context of the reorganization of production in transition countries, they note that transition creates asymmetric information about valuations. Blanchard and Kremer also observe that such uncertainty about trading

> 7We shall not here discuss in detail the features of an optimal trade credit contract in case the seller can raise the necessary funds; for a seminal analysis of this issue see Brennan, Maksimovic and Zechner (1988).

> 8It is well known that ' tends to be well below 1 even in normal times. A likely explanation is that intermediaries fear that �rms try to borrow against fake invoices.
<!-- Start of picture text --> magnifies inefficiencies<br>effects,<br>financial<br>qualified,<br>firms<br>benefit<br>firms<br>The value of such spillovers cannot be captured by firms extending trade credit<br>finance<br>financial effect.<br>firms<br>finance<br>firms<br>finance firms<br><!-- End of picture text -->
finance problems are particularly severe in international transactions as it is more difficult to <!-- Start of picture text --> finance<br>specifically,<br>finance<br>benefiting<br>suffer<br>finance insufficient<br>non-financial firms,<br>finance<br>financial<br>Antras,<br><!-- End of picture text -->
Rhodes, Daniel Stelter, Shub Saumya, André Kronimus), www.bcg.com/impactexpertise/publications/files/Collateral-Damag ~~e —__ _~~
21 TRADE FINANCE IN A LIQUIDITY CRISIS

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- [17] IMF (2009): World Economic Outlook Database, April 2009.

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22

# TRADE FINANCE IN A LIQUIDITY CRISIS

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