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.