So just how bad is the trade finance gap? According to a study by the African Development Bank (AfDB), Africa’s trade finance volumes totalled US$350bn in 2014, leaving a gap of US$110bn.
This means that around one quarter of all trade deals are unable to secure financing, severely constraining Africa’s ability to grow (Chart 1).
Chart 1 - Africa's trade finance gap, 2014
The situation is even worse for intra-regional trade, which received just US$60bn of finance in 2014, forcing African traders to seek alternative sources of finance for an estimated 57% of trade deals (Chart 2).
Chart 2 - Funding for Africa's intra-regional trade, 2014
Given that the estimate of official intra-regional flows, at around 15% of total volumes, hugely underestimates the true size of flows (because it does not capture informal trade), it is likely that trade finance is available for less than a quarter of all intra-regional flows.
The size of the trade finance gap is puzzling as trade finance is remarkably low risk. According to research by the ICC, out of 2.4mn transactions worth US$2.4 trillion in 2014, short-term trade finance customer default rates ranged from a low of 0.033% to a high of 0.241% (Chart 3).
This compares with a 1.38% default rate reported by Moody’s for all corporate products. Some experts have questioned this estimate, arguing that it includes only LCs, and not corporate defaults, and that it does not factor in the refinancing of many failed trade deals (often by using overdrafts).
Nonetheless, an estimate by Afreximbank puts the level of African trade finance defaults at between 0.4% and 0.5% (Chart 4). Clearly trade gets paid, as the saying goes.
Chart 4 - Africa's trade finance
default rate (Afreximbank)
African markets are risky, it’s true. But the perception of that risk is skewed. There are at least a dozen African markets with a better track record on governance, macroeconomic stability and trade openness than any of the BRICS, or even Southern Europe.
The asset creditworthiness of borrowers is another constraint. Without a track record, collateral or transparent financials, many traders cannot be financed by banks, as the performance and credit risks are too high. And for those traders that do secure finance, the SOL and balance sheet limitations of confirming banks restrict the volumes available, preventing traders from scaling up their operations. Liquidity constraints also scupper many deals, as the most reliable deals (such as Cocobod and Sonangol) suck up available financing and crowd out new entrants. A final factor to consider is the wave of de-risking that is occurring in African markets. Multinationals are exiting relationships with correspondent banks out of fear of sanction under Draconian AML and KYC regulation, or simply because the cost carrying out DD is too high. This could kill off correspondent banking in Africa, removing another source of finance for local traders.
The end result of these factors is that the bulk of trade finance is available at the end of the value chain, close to the final market. This financing often takes the form of multi-billion dollar PXFs and RCFs for multinational trading houses and offtakers, which feed the financing down the chain to the processers and local traders. The concentration of financing at the end of the chain reflects the declining level of risk as commodities pass through it. Let’s take a typical African value chain, producing maize flour for export to the sub-region (Chart 5). Dozens of risks impact the flow of the commodity through the chain, from the risk the crop won’t be produced (country, crop & producer risk), the risk that it will be lost or damaged as it moves down the chain (quality, logistics & warehousing risk), to the risk that the bank will not be repaid (credit risk).
The level of risk determines the level of financing. If an African trader has a shipload of bagged & graded rice en route to its final destination, a bank might finance up to 100% of its value, secure in the knowledge that the trader can make the margin he needs for a profit. But the proportion of financing tapers as we move up the chain, so that as the level of risk increases, conversely the availability of financing decreases. As a result, there is more financing available for commodities stored in a bonded warehouse at an international port, than for a warehouse up-country. In a bonded warehouse, the bank can re-export the goods if there is a default; in an up-country warehouse, the bank must factor in transport, quality & country risk. When pre-financing the crop itself, banks typically finance just 25% of the total value of the crop. And some banks refuse to pre-finance at all, only joining the value chain once the commodity has been produced.
As a result, the big international banks tend to be involved at the far end of the value chain, while local banks, such as Ecobank, tend to finance the middle of the chain – the local buyers and processers. But this financing is not strictly speaking trade finance. Rather, it is working capital or overdrafts, secured against the balance sheet. Under this model, the bank extends a facility at the start of the season to a producer or processer, who uses the funds to purchase inputs, pay for transport and buy feedstock, and repays the bank once the goods have been sold. But the level of financing available is limited by the bank’s SOL and the client’s balance sheet, as most small-scale traders have no real assets. This prevents small traders from scaling up their operations, which is essential if they want to compete with the established players. Instead, they are forced to focus on niche commodities, or to become an extension of the trading houses’ own value chains.
The solution to breaking this log-jam is well known – indeed, there is nothing new in the world of trade finance. Structured lending, using a collateral controller to ensure the security and quality of the commodities, can enable traders to scale up the volume of goods to many times the value of their balance sheet, while giving banks the comfort that, in the event of a default, they have security over the goods and can liquidate the position. However, these structures are expensive and time-consuming to construct, and require reliable partners to ensure the quality and free movement of goods through the chain to their final destination. For most banks it can prove too complicated to put together financing for small producers near the start of the value chain. Indeed, many will not consider deals worth less than US$10m. This is because, for small ticket deals, banks cannot justify the time and expense to comply with KYC and AML regulation, especially in unfamiliar markets.
Trading houses have stepped into the breach, filling the financing gap with a variety of models. The most popular at the moment is pre-payment and invoice discounting, although trading houses can offer direct financing for their most reliable suppliers. They are even developing financial services of their own, becoming more like trade finance banks; for example, Cargill offers its clients a package of futures & options, price risk management and input finance. This has cemented the trading houses’ grip on the sector, and is choking off the emergence of new players. By recycling the money given to them by banks, and using it to finance their suppliers, trading houses have been called ‘shadow banks’. But this is not entirely accurate: trading houses do not operate under the same regulations or scrutiny as banks. Perhaps a better description would be ‘shadow financiers’, providing the liquidity to ensure the flow of commodities through the chain. The key losers in this process are those at the start of the chain – the farmers and local producers – who are starved of the finance they need to invest in inputs and machinery. Government subsidy schemes and micro-finance have provided some assistance, but the financing gap remains vast.
The solution to this problem is to finance the entire chain as one vertically integrated and harmonious flow of commodities, money & services. This chain runs from the farmers at the start, through the traders and processers in the middle, to the offtakers and consumers at the end. Value chain financing is not a replacement for conventional finance. But it is ideal for linking together commodity flows that are financed separately, in this way reducing the concentration of risk at any one point in the chain. When all of these flows operate as one chain, it is easier to mitigate the risks. And if you know all the players, you can be flexible with repayments (many traders slip a few days over their 90-day financing limit).
But the task of knitting together the value chain is formidable, especially in Africa where economic activity is fragmented and most agricultural production is by smallholders. The multinational trading houses and offtakers have had some success in creating value chains in Africa, producing minerals from ‘pit to port’, and food and cash crops from ‘farm to fork’, or ‘seed to shelf’ (to use Olam’s phrase). The integrity of these value chains makes them attractive for finance, and syndications for the largest traders continue to be oversubscribed by banks. But in Africa these value chains are the exception, rather than the rule, and Africa will only be able to break the trade finance log-jam when such value chains become commonplace. This will require regulatory support from governments, as well as cooperation between local and international banks, the former leveraging on its local knowledge and relationships with key stakeholders, the latter on its structuring expertise and large balance sheets. Ultimately, this process will be driven by the next generation of African champions, who will aim to emulate the success of former African start-ups such as Dangote, Olam and ETG.
The end result of these factors is that the bulk of trade finance is available at the end of the value chain, close to the final market. This financing often takes the form of multi-billion dollar PXFs and RCFs for multinational trading houses and offtakers, which feed the financing down the chain to the processers and local traders. The concentration of financing at the end of the chain reflects the declining level of risk as commodities pass through it. Let’s take a typical African value chain, producing maize flour for export to the sub-region (Chart 5). Dozens of risks impact the flow of the commodity through the chain, from the risk the crop won’t be produced (country, crop & producer risk), the risk that it will be lost or damaged as it moves down the chain (quality, logistics & warehousing risk), to the risk that the bank will not be repaid (credit risk).
Chart 5 - Risk versus finance: pulling in opposite directions
As a result, the big international banks tend to be involved at the far end of the value chain, while local banks, such as Ecobank, tend to finance the middle of the chain – the local buyers and processers. But this financing is not strictly speaking trade finance. Rather, it is working capital or overdrafts, secured against the balance sheet. Under this model, the bank extends a facility at the start of the season to a producer or processer, who uses the funds to purchase inputs, pay for transport and buy feedstock, and repays the bank once the goods have been sold. But the level of financing available is limited by the bank’s SOL and the client’s balance sheet, as most small-scale traders have no real assets. This prevents small traders from scaling up their operations, which is essential if they want to compete with the established players. Instead, they are forced to focus on niche commodities, or to become an extension of the trading houses’ own value chains.
The solution to breaking this log-jam is well known – indeed, there is nothing new in the world of trade finance. Structured lending, using a collateral controller to ensure the security and quality of the commodities, can enable traders to scale up the volume of goods to many times the value of their balance sheet, while giving banks the comfort that, in the event of a default, they have security over the goods and can liquidate the position. However, these structures are expensive and time-consuming to construct, and require reliable partners to ensure the quality and free movement of goods through the chain to their final destination. For most banks it can prove too complicated to put together financing for small producers near the start of the value chain. Indeed, many will not consider deals worth less than US$10m. This is because, for small ticket deals, banks cannot justify the time and expense to comply with KYC and AML regulation, especially in unfamiliar markets.
Trading houses have stepped into the breach, filling the financing gap with a variety of models. The most popular at the moment is pre-payment and invoice discounting, although trading houses can offer direct financing for their most reliable suppliers. They are even developing financial services of their own, becoming more like trade finance banks; for example, Cargill offers its clients a package of futures & options, price risk management and input finance. This has cemented the trading houses’ grip on the sector, and is choking off the emergence of new players. By recycling the money given to them by banks, and using it to finance their suppliers, trading houses have been called ‘shadow banks’. But this is not entirely accurate: trading houses do not operate under the same regulations or scrutiny as banks. Perhaps a better description would be ‘shadow financiers’, providing the liquidity to ensure the flow of commodities through the chain. The key losers in this process are those at the start of the chain – the farmers and local producers – who are starved of the finance they need to invest in inputs and machinery. Government subsidy schemes and micro-finance have provided some assistance, but the financing gap remains vast.
The solution to this problem is to finance the entire chain as one vertically integrated and harmonious flow of commodities, money & services. This chain runs from the farmers at the start, through the traders and processers in the middle, to the offtakers and consumers at the end. Value chain financing is not a replacement for conventional finance. But it is ideal for linking together commodity flows that are financed separately, in this way reducing the concentration of risk at any one point in the chain. When all of these flows operate as one chain, it is easier to mitigate the risks. And if you know all the players, you can be flexible with repayments (many traders slip a few days over their 90-day financing limit).
But the task of knitting together the value chain is formidable, especially in Africa where economic activity is fragmented and most agricultural production is by smallholders. The multinational trading houses and offtakers have had some success in creating value chains in Africa, producing minerals from ‘pit to port’, and food and cash crops from ‘farm to fork’, or ‘seed to shelf’ (to use Olam’s phrase). The integrity of these value chains makes them attractive for finance, and syndications for the largest traders continue to be oversubscribed by banks. But in Africa these value chains are the exception, rather than the rule, and Africa will only be able to break the trade finance log-jam when such value chains become commonplace. This will require regulatory support from governments, as well as cooperation between local and international banks, the former leveraging on its local knowledge and relationships with key stakeholders, the latter on its structuring expertise and large balance sheets. Ultimately, this process will be driven by the next generation of African champions, who will aim to emulate the success of former African start-ups such as Dangote, Olam and ETG.
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