Published: January 01, 2000
Latin America’s economic fortunes have been transformed in recent decades, as greater political stability and increasingly open economies have spurred stronger growth. Critical to this renaissance is trade, both within the region and internationally (globally, cross-border trade has more than tripled in the last 30 years). Most importantly, over the past two decades Latin America has experienced huge growth in trade flows with other emerging market regions, which helped to buoy its economy.
The acceleration of so-called South-South trade between emerging market regions – with China a crucial trade partner given its appetite for Latin America’s natural resources – has given Latin America’s trade greater balance. In the past, the region suffered when its major trade partner, the US, slowed. Today, China represents around 30% of Brazil’s global trade, with the US and Europe accounting for around 25% each. Germany, Japan and various countries within Latin America are represented in the top 10 of both importing and exporting partners. Latin America’s broad trade base is expected to support continued expansion, with global trade predicted to grow at an average rate of 7% to 2020.1
The growth in trade in Latin America has put the unique financial characteristics of the region under the spotlight, such as its highly regulated markets and non-convertible currencies. With numerous different currencies, and widely varying regulatory regimes, managing trade and foreign exchange effectively can be challenging. Historically, trade finance and FX have been considered separate disciplines, both by companies and within banks. However, increasingly, the huge benefits in terms of risk management and cost efficiency of the convergence of trade finance and FX are being recognised.
The size of the company will generally dictate how it manages its trade risk. Likewise, companies with trading relationships at different levels of maturity will typically make use of contrasting trade finance tools or forms of payment.
For example, smaller companies, or those trading with each other for the first time, may use traditional trade finance products such as letters of credit (LCs) or other documentary collections to manage the associated trade risks. Globally, volumes of such products have remained relatively flat over the last decade (with a brief spike in use during the financial crisis when risks were elevated). Nevertheless, traditional trade finance products remain an important tool in Latin America. Alternatively, larger companies, or those with long-established trading relationships, may trade on open account basis, making payments using regular cash management tools such as direct wire transfers. More than 80% of trade transactions globally are now on open account.
Latin America companies that trade with China use both traditional trade products and open account. This is due to the wide variety of trading relationship many companies have and their different trading practices. It increases the complexity for businesses that must manage processes associated with both traditional trade finance instruments and open account trading.
Currency risk, which arises from the fluctuation of one currency against another, is the most significant cause of complexity for trade transactions involving highly-regulated markets, such as Brazil and Argentina. Currency risk is a permanent risk inherent in all import and export transactions: it requires a strategy for dealing with moving exchange rates. Currency volatility can be particularly high for some Latin America currencies, with swings of as much as 12% per annum possible, compared to a global average of around 2% to 4%. Such volatility can have a great impact on cash forecasting and a company’s bottom line.
While companies may seek to eliminate FX risk by conducting international trade only in their home currency, the risk of volatility between two currencies is always present. By transacting in their home currency, companies pass the FX risk on to their suppliers or customers – who may either fail to manage the risk appropriately, or charge a premium for taking it on. Exporters may find that pricing goods in the local currency of their trading partner makes it easier for those partners to understand the actual cost of goods, while ensuring a level playing field with competitors who also are pricing in local currency. Additionally, exporters pricing goods in their home currency may experience the unwelcome result of sales volumes being determined to some extent by the prevailing exchange rate. A Brazilian company selling goods in the US may find that if the US dollar appreciates by 10% against the real, sales will increase – but if the dollar depreciates, sales will fall as the price of the goods becomes less competitive. By pricing in the local currency, companies can ensure that sales volumes are determined by the merits of the product itself, rather than by currency movements.[[[PAGE]]]
Importers purchasing goods from international suppliers in their home currencies may find they are paying more than cost plus profit mark-up for those goods. Suppliers in Latin America may accommodate fluctuations in local currencies in the pricing of their products. Purchasing goods in local currency can allow companies to negotiate more competitive local pricing and avoid overpaying for their imports.
A small or mid-sized Latin American import company using a LC to extend its terms requires a FX transaction when the payment is closed, and is therefore exposed to changes in the value of its local currency in the period before payment is due. Similarly, a larger corporation trading on open account, and making wire payments, will likely automatically transact FX when payment is due, inevitably at a different rate than that which prevailed when the sale was made. In order to manage such currency risks, both large and small companies need effective support from their bank.
Historically, many companies have considered trade finance instruments and foreign exchange as separate functions. Similarly, most local banks have taken a silo approach to trade finance and FX. However, the growth of trade in Latin America – combined with the region’s strong dependence on trade finance tools and large number of currencies – means that convergence of trade finance and FX is desirable for companies. Ideally, companies should seek to work with a bank that offers integrated support from its FX and trade experts, and a single platform for trade finance and FX trading, in order to improve risk management and lower processing costs (especially for those transacting large volumes).
By considering trade finance and FX together, companies can adopt a more flexible approach to business, selecting the currency for transactions according to the circumstances, and then choosing to hedge if necessary. Banks that recognise the benefits of a converged approach to trade finance and FX are better placed to play a consultative role for companies. For example, small companies may have limited experience of FX risk and need guidance from their bank on hedging strategies for their long-dated trade contracts. Larger corporates, which are more likely to manage FX risk internally, may require support to achieve close integration between their ERP system and their bank’s systems. A bank provider with an integrated trade finance and FX model is able to offer a single point of contact, streamlining communication, support and technology (such as the exchange of files).
Moreover, by working with a bank that integrates trade finance and FX (and potentially cash management), greater efficiency – through automation, for example – is possible. A standardised workflow using a single portal (either from a bank or third party) for trade finance, FX and cash management helps to lower costs, reduce errors and improve risk management. Greater integration also facilitates improved connectedness within a company, making it easier to reconcile invoices, for example. To illustrate, a company using a bank’s online portal can see all outstanding trade instruments on a single screen and then (depending on the functionality of the portal) book a forward, or non-deliverable forward, against their future exposure, locking in price certainty. On maturity of the forward, the proceeds are delivered to the trade bank, which will credit funds to the exporter, assuming trade terms are met.
Automation of regulatory requirements is especially important in Latin America, which has a complex and demanding FX and regulatory environment. Without automation of regulatory requirements, documentation associated with trade finance and FX can be costly and time-consuming to manage in many countries in Latin America. For example, in Brazil, all FX transactions are registered at the central bank and must be supported by paperwork. Taxation is also a key challenge, as it may vary according to the nature of the transaction. All transactions are confirmed through a FX confirmation/contract using a template defined by the Central Bank of Brazil, which must be signed by both parties.
For companies importing and exporting throughout Latin America, FX rate volatility can have a significant impact on the ultimate cost of goods, for the importer, the exporter or both parties. It is strongly advised that each party to a trade transaction be aware of how FX will be treated and the agreed currency for the invoice and payment. There should also be clarity as to who will bear the volatility risk. The party bearing the volatility risk should work with FX specialists to determine the benefits of a hedging strategy to protect against surprises or unexpected losses (or gains) due to FX changes.
Note
Source: ICC (International Chamber of Commerce)
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