Financial Crisis, SMEs, and the Economy

2.1 Channels of Transmission From Finance to the Real Economy

The economic literature has identified various channels through which financial crises spread to the real economy². There is a monetary channel, as well as channels for credit, bank capital, wealth effects, exchange rate, uncertainty and cost of capital that provides various explanations as to how, starting from a financial crisis, real economic output gets depressed. Often, these channels may be active at the same time; for example, as a currency crisis ensues from the financial crisis—causing a rise in interest rates and bankruptcies as well as significant drops in domestic output and employment—significant asset price reductions can take place at the same time, leading to a decline in private consumption (wealth effect) and, thus, to further drops in output. For the current global financial crisis, the bank capital channel and credit channel may be the most relevant transmission mechanisms to understand. The ‘bank capital channel' holds that financial crises can erode bank capital, making banks extremely averse to lend, thus leading to a deeper economic downturn (Bernanke, Lown, and Friedman 1991). The ‘credit channel' argues that during financial crisis, banks tighten their lending standards and reduce credit availability. These credit constraints lower consumption and investment, thus worsening the economic downturn. Moreover, the credit channel holds that, on the demand side, the crisis reduces the value of collateral and thereby the ability of firms and households to borrow, leading once again to a deeper domestic output cut. Either of these transmission channels is likely to be the main reason for the current global slump.

Whether the increased risk aversion exhibited by banks is due to weak capitalization or merely motivated by extreme cautiousness, the effect is a cutback in available funds for trade finance which, in turn, impinge on the volume of trade. Trade finance is considered a relatively low-risk, routine activity, but where bank margins are also low. The low risk stems from the fact that the usual collateral for trade finance is clear and tangible— the value of the cargo it finances.³ But the low margin income for banks means that, because lenders tend to concentrate most funding on the most profitable segments of financial markets, in times of a tight liquidity squeeze, low value-added products such as short-term trade finance can be easily abandoned or reduced. Besides its low margins, trade finance's preferential treatment had changed since the 1980s sovereign debt crisis, leading banks to consider trade finance as a less preferred source of profit. Previously, trade finance had preferential treatment in London Club debt restructurings; today, they are no longer distinguished from other loans by creditors, and are hence subject to the same restrictions in the case of risks.

In the current global crisis, while only anecdotal evidence exists that point to difficulties in accessing finance, and, so far, there is no evidence that traders are unable to ship because of lack of trade financing, the cost of trade finance instruments has, nevertheless, tripled since last year. The increase in cost points to the same root causes as the lack of access.

2.2 Banks' Role in Trade Finance

But what, exactly, are banks' role in trade finance?⁴ First, banks provide working capital to exporters, through short-term loans, credit lines or an overdraft facility, or advance payment of exporters' bonds, or discounting of receivables. This pre- or post-shipment financing enables exporters to produce and ship products during the entire cash cycle. Banks in the exporting country can also extend buyer's credit to a foreign buyer to finance the purchase of exports. Often, the availability of financing such as this can affect the relative competitiveness of the exporters and enable them to attract more contracts.

Second, banks render services that facilitate the receipt or transfer of payment in a less costly and risky way (from simple intra-bank money transfers to relatively complex instruments such as leasing, letters of credit [L/Cs], and foreign exchange-related services). They can accept and confirm L/Cs as a counterparty of the importers' bank, or be the issuing bank in the case of importers' L/Cs. Third, banks can provide insurance against trade-related risks, through freight and export credit insurance or forward contracts.

Of course, there are also forms of trade financing that do not require the intermediary role of banks. The transaction can be done purely between the importer and exporter on a “cash-in-advance” basis or on an “open account” basis (when shipment occurs before payment is due). The former is akin to a supplier credit while the latter is like a consumer credit. Companies can also directly issue Bills of Exchange or Promissory Notes⁵. Some countries also make use of counter-trade or barter system by which they exchange goods at an agreed value without cash or credit terms. All these different forms of exchange have varying levels of risks and would not apply to all types of enterprise. For example, only financially stable exporters and those linked with vertical production networks and have long history of buyer-seller relationship can afford to export on an open account basis, while almost 90% of trade transactions are done via documentary credits.

2.3 Finance and SMEs

Banks, in both normal and crisis period, usually give priority to low-risk borrowers like large enterprises with profitable investments and sound collateral. SMEs are usually at the bottom of banks' preferred customers, except when the government requires banks to provide loans to this group. Why are SMEs, generally, unable to obtain financing? For banks, SMEs, especially in developing economies, are always considered higher risk because of their opacity, and lack of collateral and audited financial statements. Sometimes, they have no good, profitable projects, no clear titles to real estate and other collateral, no clear managerial targets and succession plans, and no available credit history. SMEs hesitate to approach banks because of a cultural barrier, i.e., they do not want the strict monitoring by banks. At times, too, they may not have adequate information of all that banks can offer. This is particularly true of trade finance instruments.

In the succeeding sections, this general interlinkage of bank liquidity problems, collateral issues, SME weaknesses, and trade financing will come into play as the effect of the crisis on SMEs is discussed.

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