The current political and economic climate in the Middle East has strengthened the need for letters of credit. LIZ SALECKA reports that they now look set to continue playing a crucial role in domestic, regional and international transactions – despite the global movement towards open account trading.
Although about 80 per cent of global trade is now open account-based, approximately 70-80 per cent of all Middle Eastern trade volumes still rely on LCs, according to statistics published in 2010 by the World Trade Organisation. as a result, LCs have remained a core trade service for local banks and a very lucrative fee-earning business.
However, despite this, there is strong belief that local banks should not shy away from the provision of modern-day structured trade fi nance solutions, such as supply chain finance, which could help local companies reduce trade transaction costs and tap into more cost-eff ective financing.
According to Suresh Vaidhyanathan, group CFO, Platinum Corporation FZE, certain Middle Eastern corporates have shown a growing interest in switching to open account trade. he, nevertheless, points out that in the current environment LCs are likely to prevail as a primary risk mitigation tool for both importers and exporters.
“Disclosure and governance standards in the Middle east are still evolving albeit with an increased focus in recent years, but they are still in their infancy compared to other developed markets. This adversely impacts on the rapid growth of open account trade,” he explains.
“The recent turmoil in some of the countries in the region may also be a setback in eff orts by corporates to move to open account trading.”
However, Vaidhyanathan also points out: “There has, for sure, been a signifi cant push by corporates to eliminate the need for banking intervention through LCs – and the resultant costs. This is more noticeable in the case of long-standing principal-agent relationships that are widely prevalent in the region.”
Similarly, John Wartig, group director-finance, Al-Futtaim Group, points out that, in today’s economic climate, LCs are still commonly relied on by Middle Eastern corporates when arranging import and export finance and also serve as financial guarantees for local payments.
“In the post-financial crisis period, the world became more aware of counterparty credit risk – particularly given a contraction in the availability of credit insurance two years ago – and financial guarantees have been commonly relied upon to improve credit risk,” he says, pointing out that more robust documentation is now required for all transactions.
“Middle eastern importers have been exerting pressure on suppliers for extended credit terms, and this is oft en backed by documentary credits of some sort. Over the past few years, overseas suppliers have been keen to retain letters of credit as a standard requirement as this has allowed them greater access to receivables fi nancing.”
He adds that a number of Al-Futtaim Group’s own principal overseas suppliers, such as Toyota and Chrysler, rely on his group’s LCs for their own receivables financing programmes.
As a major Middle eastern importer, the Al-Futtaim Group itself has implemented a range of LC-backed financing structures to boost its own import fi nance lines. While local banks arrange the LCs, international banks step in to provide the funding. “These are typically multibank structures, combining a local financial guarantor and an overseas liquidity provider,” explains Wartig.
“The usefulness of these structures includes the ‘dollarisation’ of working capital lines, lower costs, as well as the fact that these are typically term loans and, therefore, good from a liquidity management point of view.” however, he points out that, while local banks have accommodated such structures, they have not yet taken steps forward to provide such import fi nance facilities themselves – either on their own or in conjunction with overseas banking partners.
“We have mainly brought import financing structures to them, rather than having been presented with such structures by them as a ‘package deal’ using their overseas correspondent banks or trade finance partners,” he says.
Wartig, nevertheless, believes that local banks should seek to capitalise on the provision of structured trade finance solutions, despite global banks’ stronger international networks.
“Trade finance should present local banks with a meaningful opportunity to grow a relatively profi table business area under Basel II given the more favourable capital treatment for trade fi nance,” he says.
“Global banks have a distinct advantage both in terms of being able to provide multi-currency trade finance, as well as end-to-end supply chain finance across borders.
However, local banks are generally better-placed to provide end-to-end cash management solutions, which, for us, includes elements of trade finance.”
He adds that whereas some local banks have found it difficult to off er structured fi nance solutions, having been held back by liquidity constraints, there is a movement in this direction at present.
“Some of them are now coming up with alternative structures such as the provision of working capital lines, which are not LC-based. They are coming up with new products, which were not there a year ago, to provide alternative types of funding to corporates,” he says.
Vaidhyanathan also believes that local banks should take steps to off er structured trade fi nance solutions, which can add value to corporates’ trade transactions whilst also reducing their costs.
“Local banks need to adopt better methods of capturing the cream of trade finance business, particularly cross-border business that is today being dominated by international banks,” he says, pointing out that otherwise global banks will lead in the provision of structured trade financing and benefi t from growth in cross-border trade.
However, he, too, admits: “Global banks are in a strategically strong position to facilitate international trade between importers and exporters through their widely entrenched presence and localised knowledge of complex terrains.”
First Gulf Bank is one local bank that is currently actively designing a range of structured trade finance products and solutions for launch in the near future.
George abraham, executive vice president, group head of corporate banking at First Gulf Bank, acknowledges that LCs still represent a vital, core trade business.
“Letters of credits form an integral part of the fee-based revenue generated by local banks,” he says. “Volumes on open account trade have marginally progressed in the Middle East, but are still a far call in comparison with other international markets. This clearly signifies that LCs are a preferred mode and will continue to exist in the coming future.”
However, he recognises that local banks, such as First Gulf Bank, need to become more dynamic and adapt to the everchanging needs of the global and local economy.
“While the risk-averse companies would still prefer the secured letter of credit mode, other cost-sensitive organisations may switch to other alternate modes,” he says.
He also believes that many local banks will follow First Gulf Bank’s example, and that their local knowledge and relationships could put them at an advantage to global banks when offering structured trade finance solutions.
“Banks in the Middle east are gearing up to facilitate structured trade and supply chain solutions. These solutions will eventually need to be customised to cater to the specific needs of this region.
“Global banks have the geographic strength of network, which might aid them in business acquisition. however local banks such as First Gulf Bank have their own distinct advantages and can be more flexible so as to be in line with local cultural and economic dimensions within the governing framework.”