Exports and financial shocks: New evidence from Japan

Mary Amiti, David E. Weinstein , 23 December 2009

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One of the most striking features of the current crisis is the collapse in international trade – a fact highlighted by the recent Vox ebook.

Figure 1 plots the ratio of real world exports to real gross domestic product for a sample of the largest economies in the world. As this plot shows, the decline in world exports was much greater than the decline in world GDP. Between the first quarter of 2008 and the first quarter of 2009, the real value of GDP fell 4.6% while exports plunged 17% – a decline of $761 billion in nominal terms. Moreover, this decline in exports was much larger than standard gravity and macro models of trade would have predicted given the changes in supply, demand, and relative prices (see Chinn 2009, Campbell et al 2009, Levchenko, Lewis, and Tesar 2009a, and OECD 2009).

Figure 1. Quarterly movements in the ratio of world exports to GDP, 1995–2009

Source: This figure was constructed using national sources: Australia, Australian Bureau of Statistics; Belgium, the Banque Nationale de Belgique; Canada, Statistics Canada; France, National Institute of Statistics and Economic Studies; Germany, Deutsche Bundesbank; Hong Kong, Hong Kong Census and Statistics Department; Italy, Istituto Nazionale di Statistica; Japan,Cabinet Office; Netherlands, Centraal Bureau voor de Statistiek; Norway, Statistik Sentralbyra;South Korea, Bank of Korea; Spain, Instituto Nacional de Estadistica; Sweden, Statistiska Centralbyran; Switzerland, State Secretariat for Economic Affairs; Taiwan, Directorate General of Budget, Accounting and Statistics; United Kingdom, Office of National Statistics; and United States, Bureau of Economic Analysis. The set of countries accounted for 66% of world GDP and 68% of world exports in 2008.

Why the collapse in trade?

Several authors have argued that trade finance may have been partially responsible for the remarkable fall in trade (Auboin 2009 and OECD 2009), but most empirical work on trade finance has been hampered by not having any information on the institutions providing the finance and what was happening to domestic sales at the same time (e.g. Bricogne et al (2009), Levchenko, Lewis, and Tesar 2009b, Mora and Powers 2009 and Chor and Manova 2009). Hence, the mixed findings of these studies are hard to interpret because one cannot identify a clear link between changes in financial conditions and changes in exports and the inability to address the question of whether financial shocks affect exports more than domestic sales as is suggested in Figure 1.

The role of trade finance has come as a surprise to most academic economists, as trade finance is almost completely ignored by the academic literature. Most international models assume international payment settlement markets function perfectly. In a new paper, (Amiti and Weinstein 2009), we argue that a potentially important reason why most macro and trade models have failed to predict the dramatic collapse in world exports is due to their simplistic modelling of the financial sector’s role in international trade. We suggest that in order to understand how trade responds to financial crises, it is necessary incorporate “financial accelerators” as used by Bernanke, Gertler, and Gilchrist (1999) that specify why export flows are likely to be hard hit by financial shocks.

International trade differs from domestic trade

To understand the central role played by finance in international trade, we need to begin with what textbooks on international financial management refer to as “the fundamental problem with international trade”. How do firms guarantee payments across international borders? (See for example Bekaert and Hodrik 2007.)

International trade differs from domestic trade in two fundamental ways.

  • First, international trade is typically riskier than domestic trade. While firms often know how to work domestic legal systems for dealing with payment defaults and delays, it is often much more difficult for them to collect payments in foreign countries even if foreign legal systems are fully functional.
  • Second, the added shipping times associated with international trade often mean that international transactions take two months longer than domestic transactions. This imposes additional working capital requirements on exporters.

As a result of these added risk and working capital needs, exporters typically turn to banks and other financial firms to handle the payments. The exporters benefit from these arrangements because these financial firms typically assume all of the importer’s default risk and also provide working capital loans.

The importer also benefits because this eliminates the need for cash-in-advance payment terms, and the importer can avoid payment issues associated with the non-shipment, late shipment, or damaged shipments since banks will not pay the exporter in any of these situations.

The link between trade finance and exports

Around 40% of all trade finance contracts use ‘letters of credit’. This requires the importer to ask its issuing bank for a letter of credit guaranteeing payment for the imports. Using the letter of credit as collateral, the exporter will often obtain a working capital loan from its negotiating bank to cover the production costs of the goods. Assuming all of the documents are in order, the issuing bank will issue a banker’s acceptance to the negotiating bank guaranteeing payment at a future point.

Although the working capital loan is paid back by the exporter, the negotiating bank needs to raise money to cover the cost of payment to the exporter in addition to the funds it needed to raise for the initial working capital loan. This is often achieved by selling the issuing bank’s bankers acceptance to other investors.

Over the last several decades “open account” transactions have become increasingly common. In these transactions, importers do not use banks to guarantee payments to exporters. In order to handle these high risk transactions, exporters often turn to non-bank financials like the CIT Group, which provide working capital loans, export insurance, and export factoring (buying trade credits from the exporter at a discount). For example, a 2007 survey of suppliers using open account transactions (Scotiabank, 2007) found that 38 percent of respondents used financial institutions for post-shipment financing, 30 percent used them for pre-shipment financing, 49 percent used them for buyer default insurance, 24 percent used for political risk insurance, and 22 percent used them as export factors. The fact that all documentary credit transactions and at least half of all open account transactions require financial institutions to provide capital or insurance suggests a strong potential for a financial accelerator in trade.

A financial crisis can create a number of problems in this payment process. If an exporter’s negotiating bank cannot easily raise capital, the bank may not be able to make working capital loans or discount the exporter’s trade credits. This may leave the exporter starved of credit and unable to ship on time. Similarly the bankruptcy or financial difficulties of major non-bank financial institutions like CIT and AIG meant that many exporters using open account transactions were left scrambling for financing and insurance support.

Similarly, if an importer’s issuing bank runs into trouble, foreign negotiating banks may not accept their letters of credit thereby undermining both the negotiating bank’s willingness to provide working capital and payment guarantees to the exporter.

While all the parties in these transactions can find new guarantors, this is likely to take time. Finding new banks to take on credit risk is likely to be particularly difficult in a financial crisis when there is enormous uncertainty about the exposure of many, if not all, financial institutions to toxic assets.

All of this suggests that the defaults in the interbank lending markets that occurred in the wake of the 2008 Lehman Brothers bankruptcy may have made banks exceedingly risk averse about lending to each other – and this break down in the interbank lending is likely to have had a significant impact on exporters.

But what about the reality? Evidence from Japan

We examine the impact of the Japanese financial crisis of the 1990s on exports. The Japanese case is an ideal laboratory for understanding these forces for a number of reasons.

  • First, as in the financial crisis of 2008, the crisis in Japan was also caused by twin real estate and stock bubbles that metastasised into interbank loan market defaults.
  • Second, because Japanese data enables us to match exporters with their negotiating banks, we can assess directly how much a decline in the health of an exporter’s bank affects the exports of a firm relative to its domestic sales.

Our results suggest that exports are much more sensitive to the health of negotiating banks than domestic sales. The relationship between bank health and the change in exports is not only statistically significant but also quantitatively important. Of the 10.5% decline in Japanese exports that occurred following the 1997 banking crisis, we find that the direct effect of declining negotiating bank health on exports caused about a third of the decline. This is likely to be an underestimate because declining bank health may have negatively affected Japanese exporters through many other channels in addition to trade finance.

Conclusion

Our study has a number of important implications for the current crisis. Although Japan’s recession and banking crisis was severe, it was largely localised. This time the financial crisis was global, featuring banks in many countries. In the US, the unwillingness of markets to lend short-term to banks was clear from the rising interbank loan spreads from a typical 50 basis points over treasury rates to 450 basis points following the Lehman bankruptcy. All of these indicators point to a seizing up of short-term credit markets, and it would be hard to see how this could not have had a profound impact on the ability of firms to export.

There is good reason to believe that the current crisis is likely to have had a much more severe impact on exporters than the Japanese crisis. The global nature of the recent crisis is likely to have meant that both the exporter’s and the importer’s banks are likely to have suffered capital losses, making it even harder for exporters to finance their transactions..

All of this suggests that the impact of the current financial crisis on international trade is likely to have been even larger than during the Japanese financial crises of the 1990s.

References

Amiti, Mary and David E. Weinstein (2009), “Exports and Financial Shocks.” CEPR DP 7590.

Auboin, Marc (2009), “Restoring Trade Finance: What the G20 Can Do.” In The Collapse of Global Trade, Murky Protectionism, and the Crisis: Recommendations for the G20, ed. Richard Baldwin and Simon Evenett, London: Centre for Economic Policy Research.

Baldwin, Richard (2009), (ed). The Great Trade Collapse: Causes, Consequences and Prospects, VoxEU.org ebook, 27 November.

Bekaert, Geert and Robert Hodrick (2008), International Financial Management Ch 18. New Jersey: Prentice Hall.

Bernanke, Benjamin S, Mark Gertler, and Simon Gilchrist (1999), “The Financial Accelerator in a Quantitative Business Cycle Framework”, in J.B. Taylor and M. Woodford (ed.), Handbook of Macroeconomics, edition 1, vol. 1, Chapter 21: 1341-93, Amsterdam; New York and Oxford: Elsevier Science, North-Holland.

Bricongne, Jean-Charles, Lionel Fontagné, Guillaume Gaulier, Daria Taglioni, and Vincent Vicard (2009) “Firms and the global crisis: French exports in the turmoil,” Bank of France.

Campbell, Douglas L, David Jacks, Christopher M. Meissner, and Dennis Novy (2009), “Explaining Two Trade Busts: Output vs. Trade Costs in the Great Depression and Today”, VoxEU.org, 19 September

Chinn, Menzie (2009), “What Does the Collapse of US Imports and Exports Signify?”, econbrowser.com

Chor, Davin and Kalina Manova (2009) “On the Cliff and Back? Credit Conditions and International Trade during the Global Financial Crisis,” Stanford University.

Levchenko, Andrei A, Logan Lewis, and Linda L. Tesar (2009a). “The Collapse of International Trade during the 2008–2009 Crisis: In Search of the Smoking Gun.” University of Michigan, mimeo.

Levchenko, Andrei A, Logan Lewis, and Linda L. Tesar (2009b). “The collapse of US trade: in search of the smoking gun,” VoxEU.org, 27 November.

Mora, Jesse and William Powers (2009). “Did trade credit problems deepen the great trade collapse?” VoxEU.org, 27 November.

Organization of Economic Cooperation and Development (2009), OECD Economic Outlook 1 (85).

Scotiabank (2007). “2007 AFP Trade Finance Survey: Report of Survey Results”, Association for Financial Professionals, October.

Topics: Global crisis, International trade
Tags: financial crises, trade collapse, Trade finance

Assistant Vice President, Federal Reserve Bank of New York

Carl S. Shoup Professor of the Japanese Economy and Associate Director of Research at the Center for Japanese Economy and Business