Confirmation of the Role of Financing Difficulties in Collapsing Trade Volumes

One of our pet themes in recent weeks is that the fall in trade traffic, indicated and possibly overstated by a dramatic fall in the Baltic Dry Index, is due at least in part to difficulties in arranging and getting other banks to accept buyers’ letters of credit.

For those new to this topic, international trade depends to a large degree on letters of credit. While they can help finance shipments, an even more fundamental role is that they assure the shipper that he will be paid for the cargo sent. Without banks using letters of credit as the means to send payment to exporters, parties that are new to each other or conduct business with each other infrequently could never trade with each other (one type, a documentary letter of credit, requires that forms, often a very long and elaborate set of them, verifying that the goods have been inspected and certified, that customs, have been cleared and all relevant charges and duties paid, be presented and vetted before payment is released).

Some readers scoffed at the idea that a fundamental element of trade could be breaking down and yet attract more notice; a few argued that the L/Cs were being used as an excuse for buyers to break commodities deals struck when prices were higher.

However, as has been discussed in gruesome detail, banks are reluctant to take credit exposures to other banks on the most plain vanilla. short term exposures, namely interbank lending. It has been a struggle for central banks to get banks to lend to each other for longer than overnight. Trade financing is a backwater, operationally intensive, low profit area that simply does not register on senior managements’ or regulators’ radars. And problems in this area would have virtually no impact on banks, so even acute problems here would simply not register, particularly in comparison to all the other fires that central banks are struggling to smother.

Further confirmation of our theories came from a UBS Equity Derivatives Macro Sales note from last week (hat tip reader Scott). The article indicates that one reason the scarcity of finance has not yet led to manufacturing shutdowns is that users are running down inventories.

Key sections (boldface theirs):

The four indicators that have tracked as a guide to the resource sector have been the Baltic Dry Goods Index (BDIY), the Index of iron and steel stocks listed on Topix (TPIRON), three month copper and spot gold. Of the four, copper has the best track record but each has at one time or another been the “best” leading indicator. The trick is know – at the time – which is fulfilling that role at the moment. There is no doubt that the indicator that the market believes is showing the way at the moment is the BDIY but I would caution you to be careful how you interpret its message.

Now that’s a brutal chart.

A couple of points here – firstly, the BDIY does not always reflect the state of global demand for traded bulk products. Note that after the Index peaked at the end of 2004, the BDIY fell sharply while global bulk demand and prices did not. The cause then was a surplus of new capacity that came on line. Over this period the correlation between mining equities and the BDIY fell from over 0.9 to below 0.1. The BDIY rising or falling does necessarily imply that the cause is a change in demand for bulk commodities.

Secondly, the unprecedented collapse in the BDIY shows that conditions in the shipping market are terrible. This is NOT due to a new supply of ships. As Tim Marshall from UBS notes, “The last time that we saw the BDIY fall below 1,000 points and continue in a southerly direction and reach its lowest level of 554 points was in July 1986. At that time it was the mountain of new supply of ships entering the freight markets that had led the BDIY to reach its lowest levels ever. This time around the avalanche of new ships has not yet arrived, and may be permanently delayed due to the critical lack of funding due to the worst-ever financial crisis being faced by all banks all around the world, and yet the BDIY is sinking towards these historically low landmarks.”

So far so good – as you know I have been banging the drum about slowing demand in emerging Asia being the principal cause of almost all the macro economic dislocations we are seeing at the moment – but even I must admit that I have been surprised at the scale and the pace of this apparent fall in demand. And that’s because I think I was missing something. In two of my more recent notes, I have pointed out some of the oddities of the commodity markets such as the essential futility of the cost of production argument to support prices and the systematic way we seem to have over-estimated demand during the up run in the cycle. I would now suggest that the BDIY is now sending us a similarly muddled signal, namely that while apparent demand has collapsed, real demand has been much less impacted and that what we are actually seeing is a huge run down in stocks.

The cause is the break down of the world commodity trading system. For the past few weeks Andy and I have been reporting in our respective dailies on the difficulties being faced by importers and exporters of basic materials in getting access to bank finance to fund trades. For example, Andy wrote about South Korea’s request for immediate aid support from the US to fund food and fuel imports, I discussed how the lack of trade finance was reducing the volume of coal shipments into Rotterdam and was affecting the volume of US grain exports. When you come to think about it, if banks are reluctant to lend to each other because of perceived counter-party risk, why are they going to lend to a small trader from Asia, Africa or even Europe. We know of banks that have rejected letters of credit from other banks – and we are aware of banks that have simply refused to pay out on letters of credit because they claimed they did not have access to the funds. Without a working trade finance system the global market is going to break down……….eventually.

And that’s where we are at the moment. The reason that spot iron ore prices in India have collapsed – more than halving in three months, is because Chinese demand has vanished but it has vanished because of a combination of real demand destruction and apparent demand destruction caused by the inability to finance cargoes. Its the same for other bulk commodities, industrial metals, coal, oil and even food. The slump in global demand for basic materials is real but it is not as bad as the BDIY would make you believe.

For now the gap between the real and apparent demand destruction is being filled by running down stocks. Now this can last for a while both because stocks were, I believe, generally larger than the market perceived and because investment stocks of commodities are being returned to the market and because lower real demand means lower consumption. But in the end, stocks will become exhausted and then we face a binary option. If the trade finance markets remain closed than manufacturing around the world will start to shut down and the world will fall into a depression. But if trade finance resumes then commodity prices should stage a spectacular dead cat bounce as stocks get rebuilt.

The former case is too dreadful to hope for so I must assume that in some way finance resumes and the markets bounce.

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  1. Richard Smith

    So the stock is piling up in all the wrong places. Who’s suddenly found themselves funding that stock? Are there any clues? You’d think they’d be more vocal. Unless it’s some more banks not wanting to attract attention, I suppose.

    If what you’re describing is real (horribly plausible but me, I still want more data), I can’t see how this ends in anything but sudden stops as the various pipelines of stuff in transit finally empty; and then long waits for the pipelines to fill up again. Makes me wonder exactly what we’ll be short of, and for how long. You’ll be looking out, but are there any clear indications of what that might be, when, and what order?

  2. FairEconomist

    Unfortunately the most critical industrial stocks are now in the Land of Opacity, China. If the outcome is the industrial system partly shutting down we may not even know until the Chinese banks start acting strangely because of depression in China.

  3. vlade

    Aaah.. The wunderbar world of just-in-time. Works like magic when it works, crashes the system when it doesn’t. Another tick on the list of how we optimized away the fat (=ability to cope with shock), coz booms and bust were banned, right?

  4. mathias

    Some of the extreme decline might be due to the fact that it takes some time for shipping companies to change the routes that ships take and the frequencies of routes? So currently they might fill up ships at extremely low prices until they find the right “supply”. Still distressing when the amount of goods transported changes by so much …

  5. Curmudgeon

    If oil tankers stop moving and the pipelines run dry, then several billion people are going to die in fairly short order from exposure, civil unrest, and starvation.

    Why aren’t governments taking a harder line on this?

  6. john bougearel


    Very entertaining!

    Yes, booms and busts were banned and ain’t they a bitch when the economic dyke damming the shaky system bursts .

    nice connection with just-in-time deliveries lessening the ability to cope with shock. Maybe I ought to keep that ten pounds of fat on me on second thought!

  7. baychev

    so a contraction in the availability of the medium of exchange (USD) leads to both price deflation and volume contraction.
    this side effect of having single global reserve currency should be scary enough to promote some change this Nov 15.

  8. russell1200

    I am curious as to what this lack of liquidity is going to the current insurance model of having very high levels of coverage boosted up by the purchasing of reinsurance – or cat bonds, or insurance index derivatives, etc.

    Seems like another odd thread to unravel.

  9. fresnodan

    I am jsut too stupid to understand these “letters of credit.” I would think that banks issue these to shippers (exporters or importers)that they have some long term relationship with. If these letters are necessary for shipping, wouldn’t this just be the most routine of transactions? How much capital is at risk for a shipment, and how often do these “shipments’ default? Are new shippers popping up daily? Wouldn’t shippers use the same bankers they always use? Do the new shippers make up that large a percentage of the market?

  10. Anonymous

    Is it possible that more data could be gleened from ship and cargo insurers like Lloyds and others? Maybe insurers do not make this information public?

    The poster above that stated, ‘if oil shipments are delayed the results will be evident quickly’, is correct.

    Perhaps there is more to ‘Iran trades oil for rice’ than simply avoiding use of the dollar? It could be that banks are so short dollars that they are unwilling to use them to honor letters of credit. Just thinking out loud…

  11. Yves Smith


    Do you know anything about large scale commercial real estate construction? If you are the developer, unless you watch the contractor (and this includes big famous names), as in having your people on site, you will easily pay for materials three times over (I have been told this by one of the very biggest developers in NYC who has for at least a decade also done large joint projects outside the metro area, Forbes 400 level. Being big and rich does not protect you from being ripped off. And it was a common occurrence as he rose through the developer food chain).

    Now these are people who deal with each other regularly. And it is both the construction company (albeit more around the margin, they do not want to kill the geese that lay the golden eggs) and the guys on the site. Stuff walks off on a regular basis. Construction sites are a beehive of activity and it is impossible to watch everything all the time.

    Now when you are talking international shipping, even if the end buyer and end seller are BigCos used to dealing with each other, there are many middlemen (if nothing else, ports are in the hands of the local stevedores) and plenty of opportunities for theft, adulteration, and partial substitution along the way.

  12. Curmudgeon

    What kind of effect will this be having on commodity prices?

    If firms are drawing down internally-owned stockpiles then open market demand will be artificially suppressed.

    Bring the trade network back to normal and commodity prices ought to go up.

  13. Allan Baraza

    Can someone explain to me why the interbank market is that much more important than direct borrowing from central banks? While I understand the interbank market is supposed to more accurately price rates, central banks have target rates on which all other rates more or less depend on…some light would be appreciated.

  14. Anonymous

    A fairly large percentage of petroleum moving around in tankers is ‘finished product’, not crude.

    If a country has an excess of gasoline it may be shipped to another end user. This is common practice now in the US and elsewhere because diesel is in great demand for trucking, trains, farm machinery, etc. After crude oil is cracked the yield of diesel is less than that of gasoline.

    Trade in petroleum is complex. It is possible for a country to be both an importer and exporter of gasoline, for instance.

    I believe the trade of cereal grains is more straight forward.

    Yves…I think one of the reasons for large containers and container ships was to discourage theft of product. It is tougher to steal a container than a case of scotch whiskey. :) …but all things are possible.

  15. Anonymous

    Letters of credit involve a transaction between two banks. Now consider how risk averse banks are today and how little they trust each other when seemingly any hiccup can bring a bank to its knees… you see the problem?

    Now a question of my own. Can higher rates for letters of credits have an inflationary impact? Particularly in a JIT environment where shortages must be overcome at any cost?

  16. MarcoPolo

    Yves, I’m happy you are keeping your eye on this. Anybody else would have blown it off – including myself.

    Still there are some inconsistencies in your post.

    You ask, if banks are reluctant to lend to each other why would they lend to a small trader in Asia? Foreign banks don’t. Never did. An Asian bank makes the loan to the Asian importer. We suppose that this Asian bank knows his customer’s credit risk. (And is compensated for it.) That’s the finance part. The Asian bank then draws up the L/C and “advises” the exporters bank that the financing is in place and that the Asian bank guarantees payment. That’s the L/C (guarantee) part. In an era of tighter credit it’s not such a surprise that the financing part is more difficult. And that some will not be forthcoming. I understood you to mean that it was the L/C part that had broken down. That the exporter’s banks were refusing to accept the guarantees of the importer’s banks. “…getting other banks to accept buyers’ letters of credit.” If that were the case, or to the extent that it is the case…. Not a happy thought.

  17. MarcoPolo

    Yves said: “Now when you are talking international shipping, even if the end buyer and end seller are BigCos used to dealing with each other, there are many middlemen (if nothing else, ports are in the hands of the local stevedores) and plenty of opportunities for theft, adulteration, and partial substitution along the way.”

    I shipped containers. We sealed the containers and they weren’t opened until they were inspected by customs on the other side. Where I think they were resealed. We never had any problem with that.

  18. fajensen

    Works like magic when it works, crashes the system when it doesn’t.

    This is all expressed in classic queue theory from way back – 1909!!

    However it is futile to explain the necessity of excess capacity to MBA’s and Finance people.

  19. Kees van der Hof - Netherlands

    Being a Dutch ex-linershipping broker please note the Baltic dry index is a spot-market which trades futures for bulkcarriers. A recent article of John Kemp in the Hellenic Shipping News explains a lot. "clearing queues at the massive commodity export harbours in Brazil and Australia have returned millions of tonnes of bulk carrying-capacity to the market. Clearing queues rather than a sudden downturn in trade volumes provides the best explanation for plummeting rates." The full article is available at

  20. Anonymous


    The letters of credit may or may not actually involve credit or a loan per se.

    Letters of credit are a way of a seller knowing in advance of shipment that the funds are available on the other end of the transaction. The letter of credit is the bank verifying that funds are available. This could be cash on hand by the depositor not a loan. What people are afraid of is the buyers bank going under between the time the container leaves port and when it arrives for the buyer to take possession of the goods. Typically the letter of credit funds are not distributed until it is verified that the goods were received in the condition agreed upon. If the bank is out of business though, there is no guarantee you will get paid even though you shipped the goods.

  21. MarcoPolo

    anonymous 7:32

    exactly. I find it difficult to make these points in the comments section of a blog. The guarantee part of a L/C is separate from any financing agreement between an importer and his bank. If the guarantee part is breaking down – importer’s bank doesn’t trust exporter’s bank – it represents a determination concerning the counterparty risk incumbent in the transaction not the credit risk. It’s one thing to know credit is less available to importers. It’s another to know that banking relationships are so tenuous that L/C’s once in place can’t be honored.

  22. RDO

    Exactly Anon of 7.32 and Marco Polo.

    For an importer, an L/C shifts the credit risk from the exporter to the bank of the exporter.

    As such an L/C is only as good as the credit standing of the exporting bank.

    There is however an option for the importer to ask their bank to “confirm” the letter of credit, shifting the credit risk from the exporters bank to the importers bank. I’m sure however that that option has become very expensive.

    If you cannot trust the creditworthiness of exporters banks anymore, L/Cs are dead letters and trade will suffer bigtime.

    This is a huge issue.

  23. Anonymous

    I confess I did not think banks were being so stupid, but this is the second time I have seen this mentioned in a couple of days. FTAlphaville in their live blog yesterday mentioned a bank who sent a team out to china to investigate economic conditions their and discovered the problem.
    I also found an article on bloomberg by chan sue ling enttitled Shipping Lines Say Tight Credit Cutting World Trade.

    Details came from Khalid Hashim the managing director of Precious shipping out of Thailand who had this to say.

    Letters of credit and the credit lines for trade currently are frozen,Nothing is moving because the trader doesn't want to take the risk of putting cargo on the boat and finding that nobody can pay.

    According to Klaus Nyborg, Deputy Chief Executive Officer at Pacific Basin. Tighter credit has contributed to this year's 80 percent drop in the Baltic Dry Index.

    It is interesting that all these claims seem to be specific to Asia and if you look at somewhere like the tankerworld site there is no mention of it. I am wondering if this is limited to smaller shipping agents and is fairly localized.

    The implications for commodity prices and as a side result US treasuries could be extremely significant.

  24. Anonymous

    Some readers scoffed … breaking down and yet attract more notice


    do you mean ‘…and yet not attract more notice …

  25. Hank Roberts

    What is the actual shipping time between ports for grain shipments, especially across the Pacific?

    I’ve found mentions of “two to three weeks” or “a month” in tourist-on-freighter discussions, but those may not be the major shipping routes and would not include handling time.

    A lot of corn, wheat, and soy must be ‘in the pipeline’ en route or at the ports right now.

    I’m sure people who speculate on short term shortages or surpluses in local markets track this volume and time of shipments carefully.

    But where to look?

  26. Bendal

    Wasn’t there an article describing bulk shipments being idled on the docks a few weeks ago on this very website, and mentioning the same reason why?

    If wheat, iron ore, etc are not being shipped, are there shortages being reported already somewhere? ISTM that would be a more immediate indicator than looking at the BDIY numbers.

  27. dlr

    The article Mr. van der Hof linked to (above) is excellent. Extremely informative on every aspect of the whole issue. Very interesting to read. Thanks very much

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