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06 Jul 20

Trade Finance, Supply Chains, and Blended Finance in the Age of COVID-19

Trade Finance, Supply Chains, and Blended Finance in the Age of COVID-19

COVID-19’s potential impact on the Sustainable Development Goals is becoming clear, and global trade, a US$ 17 trillion industry which helps direct funds to businesses worldwide, supporting economic growth, industrialization and infrastructure development, is where great disruptions are already being felt. The COVID-19 pandemic has challenged global trade and supply chains in four different ways:

1. Supply chain and logistics disruptions

Consumers worldwide have dealt with delays or shortages in the supply of goods, with companies enduring the same challenges, particularly those sourcing goods from multiple suppliers across multiple countries. Disruptions in global trade and supply chains directly impact economic competitiveness and job creation, with developing market companies facing greater difficulties in exporting their goods overseas, leading to cutbacks in export-oriented jobs in the developing world, impacting SMEs and the livelihoods of poor people in particular. These broad trends contributed to the IMF’s latest projection of a contraction of 4.9% in global GDP in 2020. Lives are directly affected when critical medical goods such as breathing machines are delayed, or critical components are unavailable. However, such disruptions will likely soon be overcome through various types of workarounds, where necessary.

2. Re-thinking supply chain strategies and industrial policies

Companies worldwide are reviewing their supply chain strategies, very few of which were designed to cope with a global pandemic. Diversification and redundancy will be the trends to watch in this space. For example, to reduce future risks of supply chain disruption post-pandemic, Japan launched a US$ 2.4 billion fund to help finance local businesses bringing manufacturing back to Japan from China, or moving it to other countries in Southeast Asia. Ultimately, cost increases may arise, which manufacturers will try to pass on to customers. This will happen across different industries, particularly where cross-border supply chains exist. Governments are also starting to ask whether certain critically important products, such as testing kits and face masks, could be produced domestically to avoid international competition for limited manufacturing capacity in future crises. Just as companies will invest to modify their supply chains, governments may rethink their industrial policies in the realm of critical goods, however defined.

3. Digitization for resiliency

The pandemic has revealed the urgent need to digitize global trade and supply chains to keep goods and services moving and operable. This trend will undoubtedly lead to an evolution in the global system of trade finance, which is largely paper based. More speed is needed to create a globally harmonized and interoperable digitized infrastructure with standard identifiers (e.g. the Legal Entry Identifier developed by the International Organization for Standardization) and with laws and technical protocols (as recommended by the International Chamber of Commerce and the UN Commission on International Trade Law). This requires investment, international dialogue, and process re-engineering across trade finance departments at banks, and in exporters, importers, customs, port operations, shipping companies and freight forwarders. The Trade and Development Bank’s partnership with dltledgers, a platform using blockchain technology to enable trading companies to connect their supply chain network to their financing banks, thereby digitizing trade finance processes, is a good example of how vital trades can continue to be effectively financed despite the pandemic.

4. Pressures in banking systems and trade finance

Banks’ credit appetites tend to change with a lag, but when they change, they do so abruptly. COVID-19’s demand shock threatens to create a global wave of bankruptcies and non-performing loans, pressuring banking systems worldwide. For example, in the wake of the Global Economic Crisis (“GEC”), developed country banks quickly reduced their risk limits and all but stopped confirming letters of credit from developing country issuing banks. As trade finance halted, it threatened essential trade flows and job creation, and several DFIs stepped in to provide guarantees of issuing banks at market-conform rates. DFIs like IFC, EBRD, and ADB continue to operate these programs with significant financial success and development impact. Indeed, in response to the pandemic, the AfDB is allocating up to US$ 270 million to help its private sector clients access trade finance and guarantees, while IFC’s existing Global Trade Finance Program is providing US$ 2 billion to cover financial institutions’ payment risks, thereby facilitating their trade financing operations. With COVID-19, global trade finance so far does not seem to have suffered any material credit risk or operational risk issues, but the GEC scenario may repeat itself. Let’s hope for the best but prepare for the worst.

How can blended finance support economic recovery and resiliency in global trade?

While blended finance will have a minimal role in the initial response to COVID-19, including disruptions to supply chains and logistics, it can contribute materially in the following three areas for medium-term recovery and long-term economic reconstruction:

1. Reduce prices of vital goods: Governments rethinking their industrial policies to improve pandemic resilience and achieve self-sufficiency for certain critical goods are likely to pursue Public-Private Partnerships (PPPs) to alleviate pressure on the public purse. Here, government agencies tender out concessions for the manufacturing and distribution of key products to the private sector, and back these concessions with partial offtake contracts. Blended finance can help lower the prices of critical goods, like medicine or medical diagnostic equipment to improve the accessibility of essential commodities, especially for low-income consumers; by “buying down” the cost of manufacturing through philanthropic grants, viability gap funding and technical assistance from DFIs, international health or development agencies, and concessional financing through private foundations and/or local state-owned banks.

2. Catalyze private sector capital: Post COVID-19, DFIs and development agencies may be more interested in funding the digitization of global trade finance in countries deemed to be key nodes of global trade. Again, this may take the form of PPPs, where blended finance can be used to catalyze private sector capital, offering an appropriate financial return for the risk taken in making impactful digital investments. Savings from efficiency gains and incremental revenues created by more business activity, more customs duties collected, and less leakage should make these digital infrastructure investments financially attractive propositions. Importantly, the Principles for Digital Development – guidelines integrating best practices into technology-enabled development programs - should be adhered to.

3. Boost transaction volume: DFI trade finance programs extend guarantees to cover relatively short-dated trade finance transactions. Depending on the issuing banks selected to be eligible for the guarantees and their customer base, the impact of these programs can be felt in a large number of SMEs, supporting job creation, economic growth, and gender equality. These guarantee portfolios yield low single-digit market-based returns, with typically zero losses and very low delinquencies over extended periods of time, due to the criticality of the goods purchased. This fixed income-like risk-return profile, akin to longer-dated commercial paper or shorter-dated notes, has proven to be attractive to insurance companies, who are happy to take some of the guarantee exposure off the books of the DFIs running the trade program. This use of DFI guarantees, enhanced by risk transfer mechanisms to the private sector to free up DFIs’ balance sheets to boost transaction volume, is a powerful example of blended finance leveraging public sector risk guarantees into private sector capital deployment. This co-financing can be taken to the next level through a more developed syndication effort by DFIs and their trade finance programs, marketing this investment opportunity to a broader spectrum of institutional investors, for whom it can serve as an appropriate liquidity management strategy.

This blog post, contributed by Robert van Zwieten, is part of a series on how blended finance can help mitigate the impact of COVID-19 on the sustainable development goals. Did you read our first article on COVID-19, the Sustainable Development Goals, and Blended Finance?

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