Volatile commodities give Asia's trade banks a headache

The sharp swings in commodity prices are proving to be a challenge for Asia’s trade finance banks, as they face a trade-off between declining oil prices, which help to lower shipping costs, and surging credit rates.

Several months ago, the cost of freighting cargo was almost higher than the cost of the underlying product being shipped. But banks flush with liquidity were still willing to lend with fine margins and in some cases, little structure.

This is in sharp contrast to the present situation: the high-yield bond market is now closed and liquidity is scarce. In the debt capital markets, triple A-rated companies are now paying high premiums to obtain financing. Add to this the current volatility in commodity prices and the result is that banks are increasingly reluctant to issue new letters of credit (LCs), which are used to guarantee shippers’ payment for their cargo.

“Fast declining commodity prices for oil, iron ore and agricultural products, are causing some Asian banks to reject documents under import letters of credit as their buyer would prefer not to pay the higher price contracted earlier,” says Amita Jhangiani, managing director and Asia-Pacific regional trade head at Citi in Hong Kong.

“Trade banks therefore need to check their export LCs very carefully, ensure that they work with clients with whom they have long-term relationships and who can sustain the volatility, and also work with issuing banks who have a good reputation in dealing with trade documents.”

Experts point to a noticeable slowdown in trade volumes within certain sectors, particularly steel. There have been heightened concerns about falling demand for commodities on news that some of China’s steelmakers were cancelling iron ore contracts from India. The issue, however, is not restricted to China; market commentators also note a slowdown in volumes of steel being shipped to other booming economies.

"Dubai, for example, has been a big consumer of steel and concrete given its explosive growth,” says Chris Lewis, head of trade and supply chain for Greater China at HSBC. “But given falling commodity prices, buyers are gambling on further price reductions and holding off on entering into any new purchase contracts. As a result, local steel inventories are starting to increase. Also, wide swings in prices, as in the current market, can cause a disturbance in the trade finance industry since the number of documentary credit discrepancies and delayed payments increases. This puts working capital pressure on everyone."

Recent declines in oil prices have helped to reduce the cost of shipping. On the other hand, banks are finding it difficult to fund LCs on the usual terms, which adversely affects bulk shipping of goods such as iron-ore, coal and wheat.

“Commodity prices have been influenced both from the physical and financial perspective. The growth in China and India has been pushing up the physical price of commodities,” explains Tan Kah Chye, global head of trade finance at Standard Chartered Bank.

“We should also not underestimate how the financial market has been very active in the paper trades of commodities. Proprietary traders of commodities will now be a lot more measured in the level of their activities. Their capacity to engage is also currently restricted. Therefore the softening of prices is possibly coming from both the physical side of the commodity trade and the trading or proprietary side. It is hard to say how much of each is influencing the price trend, but both are having an impact,” he adds.

Experts also note that when commodity prices are volatile, the risk of price repudiation on a shipment or a contract increases, particularly in the case of relatively new and unproven trading relationships. As a result, banks nowadays tend to be more willing to fund deals where there is an existing proven trade relationship between a buyer and a seller. Banks claim this helps to reduce risk levels and potentially lowers capital requirements through structuring.

There are concerns that the intra-Asia trade flows, particularly those involving commodities, are not capable of outweighing the worldwide economic downturn. Trade between China and Latin America for example, has slowed in the past few months, especially for commodities such as cotton, which is exported to China for use in the garments industry.

Orders from the US and Europe in the retail business have also declined and this is expected to impact freight in terms of outbound trade from Asia into the OECD markets. The concern is that if orders don't pick up, freight charges will subsequently be impacted.

“Historically, companies have shifted their manufacturing bases to Asia in order to capitalise on lower costs of production, but if freight charges remain volatile, this puts pressure on production costs,” concludes Tan Kah Chye at Standard Chartered Bank. “Hence putting all production facilities in China and India may not be the right thing to do. It might be better for companies to onshore some activities in order to gain better diversification and remain competitive."