In the financial world, when hard times strike, investors and financiers tend to grab their assets and head for the high ground. Essentially this means they purchase safer – or better quality – investments so as to reduce their exposure in any given market. A common example of such a move is when speculators switch to a commodity such as gold or another precious metal.
These are considered to be safer ‘havens’ for capital especially when crises occur. The practice has been dubbed ‘flight-to-quality’ and has reappeared somewhat in light of the global pandemic. This phenomenon has appeared across various spaces in the financial world, not least of all in trade finance…
The most succinct definition of flight-to-quality (FtQ)is that of fear. And when it comes to trade finance, the commodities space, in particular, is experiencing a rise in the phenomenon. FtQ effectively describes a market whereby a crisis has occurred and investors attempt to offload assets that pose a risk to them and replace them with ones that are safer.
Basic supply and demand principles then tell us that the riskier assets lose value, both because they are risky but also because their demand becomes more dilute. A downwardly cascading market pressure can result. Volatility in the marketplace increases along with faster capital outflow.
As the problem broadens out, in can start to touch other industries and wide economic problems can occur (as outlined by Khanthavit in the ABAC Journal of Assumption University).
The rise of Covid-19 has essentially created a market environment in crisis. As the pandemic spread governments were forced to respond in the only way they knew how: to try to restrict humans from coming into close enough contact with one another to further the virus’ spread. As lockdown measures came into effect, commerce, trade, and wider
the business drew to a halt and economic activity precipitously slowed.
As the pandemic continued to infect and mutate, widening concerns caused greater uncertainty still, and money began moving to safer and more traditional investments. Consumption, investment, trade, and financing, became subject to a flight-to-quality. Figure 1 shows the four general elements of trade financing as discussed by the Asian Development Banks’ Brief of December 2019.
As can be seen, Risk Mitigation is a large part of the accepted process. It is no wonder then that a response such as FtQ exists. Should a market become volatile, alleviating a business’ exposure to possible economic hardship makes good sense even if in the longer term it can cause broader financial problems.
The Little Guy
Particularly in regard to trade finance, SMEs tend to be the first victims in the movement of investment to perceived places of increased safety. Toward the middle of 2021, the Global Trade Review discussed how the trade finance sector (and more narrowly the commodities arena) was divided: although banks had started restricting financing to smaller trading arms, the larger end of the market was thriving. Sentiments of bustling and happy business operations were expressed at an industry event by Christophe Salmon of Trafigura in 2020.
He mentioned how despite the limiting and de-risking measures being taken by business entities, financing options had remained widely available to larger players. Large traders – especially in commodities – have since declared a string of oversubscribed revolving credit facilities amongst other instruments. Smaller to medium-sized traders appeared to be being left out.
Traders in SMEs can be reluctant to speak of any difficulties they may be having establishing finance since it can damage their image in the eyes of potential financiers. In Asia, and especially in Hong Kong, bank anxiety has increased after frauds and defaults have occurred in Singapore through 2020 and into 2021.
The result has been the tightening of credit facilities making it tougher for trading entities with less of a brand or reputation to garner fiscal support. This, in conjunction with the specter of the global pandemic, continues to haunt the financial well-being of SMEs. The FtQ in trade finance tends to mean a movement away from businesses that are smaller and have less of a public profile, to ones that are more established, have a broader financial footprint, and can be more easily assessed.
From the perspective of a financier, this is all too understandable. But from the point of view of a small trader, this can mean that not only is support harder to acquire, but that also a smaller business that is more sensitive to market forces is seeing those market forces turned against them. When this happens broader impacts can occur over time as output slackens off and then unemployment rates start to increase.
When a market becomes more unstable and a flight-to-quality kicks in, it is normally accompanied by a flight-to-liquidity (FtL). FtL is defined as a movement of bigger flows of capital into or toward more liquid assets. Much like its brother, FtL occurs when a market has become volatile as a result of a crisis. When a market becomes more precarious, an investor will look for assets that are easier to offload with speed as opposed to illiquid assets that are less dynamic.
As pointed out by Standard Chartered, in response to the pandemic, treasurers looked to draw down on credit instruments in order to protect their businesses from a pending liquidity crunch. Trade diminished quickly as demand tailed off and, as widely reported, supply chains were deeply affected. In response, organizations made approaches to their suppliers in order to extend payment terms.
This might have been seen as beneficial to larger buyers but in fact, the problem was pushed further up the supply chain. ‘Liquidity’ stress landed on the shoulders of suppliers who typically would have less access to finance, which then escalated market volatility. As a possible solution, some financiers in the sector sought to expand support more widely: to tier two and three suppliers in the hope of adding resilience to supply chains.
In reality, this has proven problematic. In reality, organizations have lacked the ability to apply inputs across the entirety of the ecosystem of their supply chain making it difficult in targeting appropriate suppliers. What ultimately took place was a drive to create new programs to take onboard suppliers where new credit terms and instruments were brought into play. The drawback here is that such initiatives take time, something that COVID-19 has had little patience for. Hopefully, the current pandemic has set in motion a chain of events that will make trade, and its financing, less sensitive to any new and inevitable future crises.