Trade Finance Gap: Impact on Inclusive Trade

Covid-19’s Impact on the World Economy

The IMF estimates that the global economy shrunk by 4.4% in 2020, the worst decline since the Great depression of the1930s, as a result of the Covid-19 crisis. Real GDP Growth for most countries has ranged between 0% to -15% in 2020 and global foreign direct investment has fallen from $1.5 trillion in 2019 to $859 million in 2021. World trade too has declined by 5.3% in 2020 because of declining demand. Although a short-term positive recovery is underway, the World Trade Organization (WTO) estimates that we will continue to feel the effects of the pandemic and the pace of expansion will lag pre-pandemic levels in the near future. Accompanied by the disruption to the global supply chain, these events have serious long-term implications for the financial health of firms that drive a nation’s economy.

Trade as a Means of Recover

In response to the crisis, governments across the world have introduced stimulus programs for economic recovery. Given its ability to generate employment, and aid poverty reduction, boosting trade is another significant way in which the world can aid recovery. According to UNCTAD, “While the pandemic may be far from over, it had become clear that transforming global approaches to trade and development cannot be avoided when charting a sustainable course to recovery from the pandemic…it is our belief that recovery from the pandemic can help reshape global production networks and reset multilateral cooperation for the better, accelerating achievement of the Sustainable Development Goals.

The Trade Finance Gap

However, there are significant barriers to trade that have been exacerbated by recent global events. One such key impediment is access to trade finance – recent estimates indicate that the trade finance gap has gone up from $1.5 trillion to $3.4 trillion. While access to trade finance affects all firms, it affects SMEs in emerging markets the most, despite their significance in generating employment and boosting economic growth. According to Deborah Elms, Executive Director, Asian Trade Centre, “If SMEs in emerging markets do not have access to financing – trade and other types of financial support – they will not survive the pandemic. Given the overwhelming importance of SMEs, this is a critical gap that must be filled by banks and other fintechs.”

Trade finance is important since it allows SMEs to manage risk and liquidity challenges. Both importers and exporters face counterparty and currency risks while engaging in trade. This is even more pronounced for SMEs with limited resources. Further, there are long payment cycles especially for cross-border transactions, which can strain working capital reserves. While trade finance instruments address these challenges, a significantly large number of SMEs face obstacles in accessing them.

Why is Trade Finance Inaccessible to SMEs?

According to the Asian Development Bank’s (ADB) survey of 469 firms, over 40% of SME applications for trade finance are rejected, compared to 19% for large multinationals. Reasons for rejection include the unsuitability of application for support (19%), lack of collateral (15%), lack of profitability (10%), KYC concerns (10%) and lack of information and poor presentation of application (8%), among others. The likelihood of trade finance applications being rejected has also increased significantly given macroeconomic uncertainties as well as weakened balance sheets because of reduced demand. Responses from banks surveyed by the ADB, corroborate these findings– 72.4% banks felt that Anti money laundering and KYC requirements were the largest barrier to trade finance, followed by Basel regulatory requirements(62.1%), general economic uncertainty due to the Covid-19 pandemic (60.9%),high transaction costs (50%), concerns about companies’ ability to perform during COVID-19 (49.3%), low credit ratings (44.9%) and client’s lack of familiarity with products (37.4%), among others. Moreover, when an SME’s application for finance is rejected, they resort to inefficient second-best options such as informal financing (which it typically more expensive) or self-financing (which ties up valuable capital).

A large segment of SMEs lack the awareness, skills and expertise regarding trade finance products. Further, trade finance instruments are characterized by high costs and complexity; they are also resource intensive, making them inaccessible to SMEs. For instance, letters of credit are relatively higher cost trade finance instruments that rely on specialist, accurate documentation from SMEs. Further, there is a mismatch between an SME’s ability to demonstrate fit and suitability against traditional measures of credit worthiness. Typical SMEs operate with limited resources and do not have the capacity to collate the data required for applications. Moreover, many SMEs have not yet digitized operations completely; hence, manual records need to be referenced for applications, which can make the process even more tedious for SMEs. Smaller firms also tend to be wary of digitization, since they believe that rather than create transparency, this will bring their operations under more intense scrutiny for compliance with corporate governance requirements. Robust compliance with such norms is again resource intensive and many SMEs do not have the expertise or human resources required. Given they are resource and capital constrained, most SMEs also lack collateral which affects their ability to secure trade finance.

A Change in Approach

There is a need for fintechs to look beyond traditional measures such as cash flow, profitability, and ability to furnish collateral when considering SMEs for trade finance. There is no denying that lending to SMEs involves a certain degree of risks; however, fintechs can consider characteristics such as a firm’s expertise in their domain, their future plans, their relationships with suppliers and buyers, to measure a firm’s potential and ability to pay. Moreover, there is a need to offer innovative financial solutions that can reduce the risk for the capital provider while lowering the information burden on SMEs. There is also an equal need for SMEs to focus on their long-term goals and investing in digitizing processes as well as maintaining records that improve their eligibility to receive trade finance.

Innovative Solutions

To overcome obstacles in accessing trade finance, there has been a move towards supply chain finance instruments such as receivables discounting and inventory financing. In addition, several financial institutions have adopted innovative solutions to assess an SMEs ‘worthiness’ for capital. For instance, some firms use a combination of elements such as past repayment records, business model assessment, as well as existing public domain data to gauge an SME’s suitability to receive trade finance. Some institutions are also looking at GST data to assess a firm’s credibility and have created products for GST backed lending. At an international level, the ADB, the European Bank for Reconstruction and Development as well as the International Finance Capital have pledged funds for trade finance. The International Trade Center and partners in November 2020 launched the SME trade Finance Guide to help SMEs learn about access to finance. The International Chamber of commerce has launched ICC Trade Now to connect small businesses with financial service providers across its global network of 45 million businesses. The B20 and Business at OECD under the Saudi Arabian Presidency have proposed an innovative solution - the ‘GVC passport’ to provide an authoritative, authenticated, verifiable financial status of an entity that can be leveraged across the GVC without a firm being required to furnish the same information /documentation again.

The Path Forward

Despite these measures, there is a need for further concerted action by the ecosystem, especially fintechs to adopt measures to reduce the trade finance gap. Approaching trade finance from the perspective of truly understanding an SME’s abilities, challenges, and potential rather than defaulting to traditional financing requirements has the potential to bridge the trade finance gap, aid SME productivity and growth, and thereby improve their ability to contribute to economic growth and propel the sustainable development agenda. Summarizing this potential, By deploying technology and process improvements in tandem, an opportunity exists for fintechs to help bridge the growing trade finance gap. This will enable SMEs to fulfil their role as the much-needed engines of economic growth. Most importantly, by doing so, the world will be one step closer toward alleviating poverty and inequality.