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Introduction

Trade finance is critical for the facilitation of international trade by overcoming the challenges of information asymmetry, contract enforcement, and liquidity issues inherent in cross-border transactions. A key instrument used by banks in trade finance is the letter of credit. In a typical cross-border trade operation involving bank intermediation, an importer (buyer) would request a bank to issue a letter of credit which would represent its obligation to pay the exporter (seller) provided the terms of the contract are fulfilled. Hence, the letter of credit provides a guarantee to the exporter (seller) that the payment for the goods or services he provided will be made since an established financial institution is not expected to default on a payment.

This brief summarizes the main findings of the AfDB’s report on trade finance based on a survey covering 277 banks in 45 African countries in 2011 and 2012. Specifically, it gives a description of the extent of use of letters of credit by African banks to facilitate cross-border trade. It also examines pricing and constraints that prevent banks from meeting the existing demand for this instrument.

Letters of Credit: A Backbone of Trade Finance

According to the Bank for International Settlements (BIS) in 2014, letters of credit accounted for 50% of the value of global trade finance. In Africa, virtually all banks engaged in trade finance issue letters of credit. Specifically, the survey conducted by the African Development Bank (AfDB) in 2014 shows that the proportion of respondent banks that issued letters of credit was 94% in 2011 and increased to 96% in 2012.

These rates are similar across banks with different ownership structures, as well as across sub-regions. African banks recognize the importance of letters of credit in facilitating international trade, and it reflects their active participation in this key aspect of the financial system.

The Quantity and Value of Letters of Credit Issued

The average annual number of letters of credit issued by African banks in 2011 and 2012 was 380 and 400, respectively. These letters had an average value ranging from USD 1.65 million to USD 2.34 million, although significant variations exist across sub-regions. For instance, the average value stood at USD 0.6 million in Eastern Africa and about USD 7 million in Southern Africa. The Central Africa sub-region shows the second-highest average value for letters of credit issued (USD 6 million), which is surprising given the average size of its economies. Similarly, there is significant variation across bank types. For instance, the median value of letters of credit for majority government-owned banks (USD 5 million) is significantly higher than other types of banks, which all have average values less than USD 2 million.

Pricing of Letters of Credit: A Crucial Factor

The pricing of letters of credit provides interesting insights about the ease of access to trade finance for African firms. The modal quarterly fee rate for issuing a letter of credit ranges between 0.6% and 1%. For about two-thirds of the responding banks, quarterly fee rates for letters of credit do not exceed 1%.

The distribution of fee rates for African banks did not change significantly between 2011 and 2012. Unfortunately, it is difficult to determine from the survey how the distribution of these rates compares to those charged at the height of the 2008 global financial crisis, but some inferences could be drawn from other surveys. The 2013 ICC’s survey of banks showed that the majority of banks reported no increase in fees between 2011 and 2012 compared to the preceding two years. This suggests that pricing for letters of credit has stabilized somewhat following the increase triggered by the 2008 global financial crisis. However, current rates are likely to be still higher than the pre-crisis level.

Across countries, there is a negative correlation between the level of fees for opening letters of credit and the level of financial system development in the issuing bank country. Specifically, North and Southern Africa have the lowest average fee rates for issuing letters of credit. The correlation is not perfect though as Eastern Africa shows a slightly higher average fee rate than the Central African sub-region even though the former has relatively more advanced economies.

Unmet Demand: Rejection Rates for Letters of Credit

For instance, firms that are likely to apply for letters of credit are usually existing clients of the banks. Therefore, the number of applicants is likely to underestimate the actual need for trade finance. Even with this restricted sample, it still indicates a substantial degree of constraints for firms that ultimately need the financing.

The reasons disclosed by responding banks for the rejections of letters of credit are quite varied. The most frequently cited reason is the creditworthiness of clients. This underscores the high level of information asymmetry prevailing on African credit markets given the lack of credit reporting systems as well as poor capacity of African firms. It is unlikely that all the firms or individuals that are rejected for this reason are not creditworthy. More likely is the situation where banks are not always able to appraise the creditworthiness due to lack of information on the credit histories of the individual or firms. In other developed markets, this problem is mitigated by the presence of credit bureaus that provide credible information on the credit histories of borrowers.

Client creditworthiness, while a persistent problem, can also be exacerbated during or after a financial crisis. This is because counterparts in other regions of the world can push African banks to be more risk-averse even though trade finance is not as risky as other bank activities.

Another major reason for banks rejecting requests for opening a letter of credit is foreign exchange liquidity (especially US dollar). This constraint is a universal problem in this sector, including other regions of the world. The main reason for this challenge is that the US dollar is the main currency for trade finance with about 80% of letters of credit being denominated in the US dollar. The other potential competitors for the US dollar are far behind. For instance, only about 7% of global trade was denominated in the Euro in 2012. For Africa, the Euro accounted for 4% of the LCs issued. While it is expected that the Euro, and especially the Chinese Renminbi, will increasingly play larger roles in this market, the US dollar is expected to remain dominant in the foreseeable future. Given this constraint for African banks, the AfDB’s trade finance program where it provides lines of credit denominated in US dollars or other foreign currencies fills a major gap since commercial sources of foreign currency can be scarce.

Another significant reason for banks denying requests for issuing letters of credit is the lack of sufficient limit that African banks have with their confirming banks. For obvious prudential reasons, confirming banks have limits for each issuing bank. The latter serves as an upper bound for the value of trade that is confirmed through a given issuing bank. Confirming banks have also country limits that restrict the amount of business they could do with all issuing banks operating in a single country. Some of the limits faced by African banks are binding for reasons such as country size, balance sheet limit, and other relevant risk issues. In other words, the size of the limit for each African bank is usually positively correlated with country size and economic stability but negatively with the country’s fragility. In fact, many foreign-based confirming banks require cash collateral from African banks to confirm letters of credit when the limits are reached, even though trade finance transactions are low-risk and self-liquidating.

Trade finance programs implemented by development finance institutions such as the AfDB offer, among others, risk participation agreements (RPAs) that are particularly suited to addressing these types of constraints. In a typical RPA, the AfDB shares with a confirming bank up to 50% of the credit risk on a portfolio of trade finance operations issued by African banks and backing a trade transaction with at least one leg in Africa. This allows confirming banks to increase their risk headroom and therefore confirm a greater number of letters of credit issued by African banks.

Challenges of Single Obligor Limits

Single obligor limit is another reason cited by responding banks to reject requests to issue letters of credit. Many banks offer trade finance services to existing clients. This means that requests for trade finance are likely to come on top of existing lending to that client. Therefore, it is not surprising that single obligor limits can become binding for banks. Another explanation for this result is the relatively small size of the balance sheet of African banks, which restricts the amount of business that any particular issuing bank can do with a client.

There is also a correlation between rejection rates and US dollar liquidity. Specifically, banks with rejection rates over 30% are disproportionately likely to declare US dollar liquidity as a major constraint. Similarly, when insufficient limit with confirming banks is a binding constraint, banks are likely to have a high rejection rate for letters of credit.

Conclusion

Letters of credit are critical instruments in trade finance and facilitate international trade transactions. They account for about half of the value of international trade. The AfDB trade finance report summarized in this brief highlights the importance of this instrument for Africa. Despite this importance, many constraints faced by commercial banks in issuing letters of credits to support the international trade transactions performed by African firms.

Consequently, there is an opportunity for Development Finance Institutions (DFIs) such as the AfDB to put in place programs and operations aimed at relaxing those constraints. Specifically, the Bank’s recent Trade Finance Program addressed some of the key constraints revealed by the survey, namely USD liquidity and limit constraints.

In conclusion, the continued promotion and enhancement of trade finance instruments like letters of credit in Africa are vital to boosting the continent's economic growth and global trade integration. By addressing the challenges and constraints faced by African banks, especially those related to creditworthiness assessment and foreign exchange liquidity, we can ensure that the potential of trade finance is fully harnessed to support businesses and drive economic development across the continent.

Reference:

Chief Economist Complex | AEB Volume 6, Issue 1, 2015

African Development Bank (AfDB). 2014. “Trade Finance in Africa”, Abidjan, Ivory Coast.

Bank of International Settlement (BIS). 2014. Trade Finance: Development and Issues.

Beck, T. S.M. Maimbo, I. Faye, and T. Triki. 2011. Financing African through the Crisis and Beyond.

International Chamber of Commerce (ICC). 2012. “Rethinking Trade & Finance”, Paris, France.

International Chamber of Commerce (ICC). 2013. “Rethinking Trade & Finance”, Paris, France.

International Monetary Fund (IMF), the Bankers Association for Trade & Finance (BAFT), and the International Financial Services Association (IFSA). 2011. “Trade Finance Study”, Washington, DC.

Malouche, M. 2009. “Trade and Trade Finance Developments in 14 Developing Countries”, Washington, DC

Mann, R.J. 2000. “The Role of Letters of Credit in Payment Transactions”, Michigan Law Review, 98(8): 2494-2536.