Confidence Trick Trashes Trade

The Age

Tuesday November 18, 2008

David Hirst. David Hirst is a journalist, documentary maker, financial consultant and investor. Planet Wall Street is syndicated by News Bites, a Melbourne-based sharemarket and business news publisher.

Trade is in a dive, and therein lies the risk of very serious supply chain disruption, writes David Hirst.

LAST week I drove 1300 kilometres through Australia, some of the richest country on earth. From the Queensland border to the ACT, along the Great Western Highway and the Oxley, I passed fat cows and sheep and wheat as high as an elephant's eye. Hay was stacked and rolled along the way. The creeks, rivers and dams were brimming and birdlife abundant.

The towns were bustling and prosperous - a happy land, back from the near-death of drought, the wealth of generations mingling in pubs and internet cafes, and therein was some good, sound provocative thinking.

Indeed the internet is abuzz about a "not for the faint-hearted" blog from the popular (at least until his most recent column was published) "London Banker" who, unhappy, as many are with New York University's Professor Nouriel Roubini's view of "systemic risk", decided to write about risks to the system.

The matter involves something growing dear to the heart of Planet Wall Street, the Baltic Dry Index (BDI), the most useful measure of what is happening out there in the trading world. Two sites have posted this analysis with a warning to keep the blood pressure tablets close by. Before dismissing it as idle internet chatter, note that it's a major cause for alarm at the World Trade Organisation.

London Banker's problem with the popular systemic risk scenario is that it is all about people passing pieces of paper around and it has nothing much to do with people passing the bread across the table. The BDI, on the other hand, concerns itself with the more mundane bread-and-butter matter of human survival.

At the heart of the matter are letters of credit and the fact that, due to the complexities of modern banking, a single bank going belly-up can unhinge the credit system upon which trade has been based, according to London Banker, for 400 years.

In fact, he could probably go back 4000 years, for trade involving acceptance of similar credit arrangements pre-dates the birth of Christ.

Before 1980, London Banker observes, the term "systemic risk" was a lot scarier than that postulated by Professor Roubini. In those days, he writes, the term "did not refer to contagion of illiquidity within the financial sector alone. Back then, when the real economy was much more important than low margin, unglamorous banking, it was understood that the really scary systemic risk was the risk of contagion of illiquidity from the financial sector to the real economy of trade in real goods and real services."

Every single non-cash commercial transaction (virtually all trade) requires trust among a network of banks, and the "supply chain" - the number of banks involved - has become long and complex.

In days past, banks required strict constraints. Central banks appreciated just how special banks were and "demanded higher capital, strict limits on leverage, tight constraints on business activity, and superior integrity of management".

We have loosened banking considerably since those days and London Banker argues that the perception of systemic risk changed to the point where "central bankers of the current generation only understand systemic risk as referring to contagion of illiquidity among financial institutions".

"One thing we should concede to the English is that they know something of banking and of trade. As recently as 40 years ago, Australian schoolkids sang "rule Britannia, Britannia rules the waves" and London is still a great trading centre, which is why London Banker's theory has the internet and the WTO agog and why I bring it before a public that might have missed this fascinating scenario.

London Banker writes: "The recent 93% collapse of the obscure Baltic Dry Index - an index of the cost of chartering bulk cargo vessels for goods like ore, cotton, grain or similar dry tonnage - has caused a bit of a stir among the financial cognoscenti. What is less discussed amid the alarm is the reason for the collapse of the index - the collapse of trade credit based on the venerable letter of credit.

"The combination of the global interbank lending freeze with the collapse of the speculative, leveraged commodity price bubble have undermined both the confidence of banks in the ability of a far-flung peer bank to pay an obligation when due and confidence in the value of the dry cargo as security for the credit if liquidated on default.

"The result is that those with goods to export and those with goods to import, no matter how worthy and well capitalised, are left standing quayside without bank finance for trade."

There are other clouds, including scaling back letters of credit, as liquidity tightens and short-term credit, like trade finance, can be "cut with the flick of an executive risk" as London Banker puts it.

Also, the bulk of cargoes are financed in US dollars which US banks have hoarded as the liquidity crisis intensifies. "Recent currency swaps," London Banker writes, "between central banks should be seen in this light, noting the allocation of Federal Reserve dollar liquidity to key trading partners Brazil, Mexico, South Korea and Singapore in particular... Furthermore, the (US) Fed may be highly selective in its allocation of dollar liquidity abroad, prejudicing the economic prospects of a large part of the world that is either indifferent or hostile to the continuation of American dollar hegemony."

The WTO hosted a meeting on trade credit in Washington last Wednesday to highlight the rapid and accelerating deterioration in trade finance as an urgent priority for public policy. The urgency is growing and may soon be manifest in most unpleasant ways.

"If cargo trade stops," London Banker argues, "a whole lot of supply chain disruption starts. If the ore doesn't go to the refinery, there is no plate steel. If the plate steel doesn't get shipped, there is nothing to fabricate into components. If there are no components, there is nothing to assemble in the factory. If the factory closes the assembly line, there are no finished goods. If there are no finished goods, there is nothing to restock the shelves of the shops. If there is nothing in the shops, the consumers don't buy. If the consumers don't buy, there is no Christmas."

Or, even more urgently, "if cargo trade stops, the wheat doesn't get exported. If the wheat doesn't get exported, the mill has nothing to grind into flour. If there is no flour, the bakeries and food processors can't produce bread and pasta and other foods. If there are no foods shipped from the bakeries and factories, there are no foods in the shops. If there are no foods in the shops, people go hungry. If people go hungry their children go hungry. When children go hungry, people riot and governments fall.

"Controlling access to trade finance determines who loses their jobs, whose children go hungry, who riots, which governments fall. Without dedicated focus on the issue of trade finance and liquidity from those in the emerging world most interested in sustaining the growth of recent years, little progress can be expected. Trade finance is rapidly communicating the stress on bank liquidity to the real economy. It presents a systemic risk much more frightening than the collapsing value of bits of paper traded electronically in London and New York. It could collapse the employment, the well-being and the political stability of most of the world's population."

Australia once again may be sheltered by its internal abundance and its favourable trading position with our partners. But we should be getting our house in order. The gabfest in Washington at the weekend revealed the appalling emptiness of the words "coherent", "co-ordinated" and "urgent" when it comes to international action. It was a major lurch into the 1930s and as nation after nation slides into deep recession, trade-dependent nations need be even more wary of the dark skies ahead.

© 2008 The Age

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