Despite the commitment globally to enhancing and investing in African trade finance for sustainable economic development on the continent, the practicalities of global banking regulation and reforms developed and imposed by western policymakers, not to mention their strange form of behavioural economics, really undermine any real progress for Africa, write George Wilson, head of institutional trade finance, and Derryn Faure, institutional trade finance, at Investec Bank Limited.


Everyone has heard of the trade finance gap, and we have written numerous articles on its root causes, but the harsh reality is that extraneous Basel capital and liquidity regulations continue to make financing African trade finance deeply unprofitable.

Economists have long understood the macro mechanisms of ‘terms of trade’ (ToT), which is defined as the ratio of a country’s import and export prices, and ‘balance of payments’ (BoP), which is a statement of all transactions between all of a country’s entities and the rest of the world. But there is perhaps a misunderstanding regarding the nuts and bolts of how trade finance works in Africa, where there are deficiencies that widen the trade finance gap and how western policymakers need to embrace and promote solutions like structured letters of credit (SLCs) and trade refinance loans to African banks, if they are really intent on improving things.


Terms of trade and balance of payments in African countries

Essentially, all African economies’ ToTs and BoPs have been, are and will continue to go the wrong way as they simply don’t export enough in dollars to meet their dollar import bills. Their central banks jealously guard their FX reserves and ration their dollars to promote good policy in the form of paying for essential imports and to eschew speculation. This has a direct influence on the exchange rate as the parties sell local currency to buy the dollars through the central banks – too much selling pressure and their currency devalues.

An African importer must open a dollar LC facility with its local bank, which registers the LC with their central bank (for example, Form M in Nigeria) along with the total amount and maturity date, and then, at maturity, it pays as many of the dollars as it has bought with local currency from the central bank window. Any dollar shortfall must somehow come out of the local issuing banks’ treasuries.

This worsened recently, a sign of unprecedented times: all of Africa’s developing economies have borrowed enormous quantities internationally through a period of unrealistically low Federal Reserve rates. Now, African states are having to manage skyrocketing inflation for their dollar imports and completely impossible debt servicing costs, as previous governments’ dollar debts swell with US and global interest rates, domestic debt and inflation unsustainability. Their ToTs and BoPs have deteriorated as inflation has worsened their import bill and debt service costs and devaluation have made their debt unsustainable.


African trade finance dependence on short-term US dollar liquidity

For all intents and purposes, ALL African SME trade is financed through local African banks – there are microfinance, factoring houses and funds, but it is overwhelmingly commercial, private banks that ultimately shoulder SME domestic trade, corporate payments from exports and the dollar liquidity and credit needed for critical imports like grain, fuel, etc.

The treasuries of these banks, being the engine rooms for the availability of trade finance, must ensure there is enough local currency and dollar liquidity available to meet their trade payment obligations at maturity, as well as maintain their mandatory regulatory ratios. Failure is not an option as missed payments fatally undermine the ‘trust’ all trade is founded on. To miss a dollar LC trade payment due to an international bank is a default that could activate every cross-default clause in every single contract, collapse the bank and disastrously undermine confidence in the market.

African banks receive support for these critical imports from their central banks and governments from the FX ‘windows’ that provide liquidity to pay these import bills from its foreign currency reserves, which are calibrated in months of ‘import cover’, for this reason.

Unfortunately, even before the debt crisis that emerged in 2023, central banks seldom provided the full FX value of the LC at maturity. In 2022, it was estimated that only 30% of qualifying Nigerian LCs’ FX was actually collected by the time the LC was payable. As such, it is left to the treasuries of African commercial banks to manage this incredibly difficult balancing act, ensuring they have their own critical pool of short-term dollar liquidity and associated trade credit from international banks and multilaterals to fund any shortfall from the central bank. There is NO other safety net.


Global banking regulations and trade credit

In the wake of the global financial crisis in 2008 and the Basel regulatory progressions, there came a wave of African bank ‘de-risking’. The unintended consequences of global banking regulation and the capital treatment of trade make financing African trade finance deeply unprofitable. African banks need short-term, self-liquidating dollar trade refinancing facilities from international banks to sustain their trade finance FX requirements. However, due to this ‘de-risking’, the availability of dollar liquidity has diminished.

DFIs and multilaterals, with their trade programmes, partially redress the international banks’ profitability problem by guaranteeing away the regulatory capital and liquidity costs and/or injecting dollars, but they are not doing enough. It needs to be understood that there is no other magic trade mechanism for delivering trade finance for these critical transactions outside the commercial banks in these developing countries. Even emergency international aid ‘after the horse has bolted’ would need to be piped through these same banks and that’s the complete opposite of ‘sustainable’.

It is imperative that we acknowledge that developed markets’ global policies and regulations cannot simply be ‘handed down’ to developing economies. Unfortunately, well-meaning western bureaucrats, labouring under psychological biases, have created the commercial ingredients for widening the African trade gap. But solutions are out there, in the form of trade refinance loans and structured (synthetic) LCs.


Trade refinance loans

Trade refinance loans are credit facilities made to African banks by international banks, which take dollar risk on the African banks, referencing identifiable LC or trade receivables. An international bank may make a ‘post’-finance loan of a sight LC which it has confirmed to create 90 days of credit for the buyer before they have to pay for their consignment. Or a third-party international bank might ‘re’-finance an LC to an issuing African bank that has been confirmed by another international bank. When the African bank must pay the confirming bank at maturity, they can use the dollars lent in the refinance facility to pay the entire obligation, whether or not they’ve received all the requisite dollars from the central bank in time.

Unfortunately, trade refinance loans necessarily exclude the vast and most deserving majority of African banks’ trade portfolios – SME and smaller, non-documentary trade – due to the huge evidentiary burden on African banks to prove that these dollars are being used for trade. This is not a matter of regulation, it’s a matter of trust…

Regulation is however still a problem, as one of the main reasons why this is viable for the international banks is because they tend to be on ‘Basel 2 Advanced’ which effectively means that these banks can, at their discretion, reduce the capital costs of this lending because they have labelled it “trade finance”. They share some of this benefit with the borrowing African bank in the form of pricing, which makes it cheaper than other wholesale funding of the same tenor and therefore profitable for everyone in the chain. Unfortunately, Basel 3.1, due for implementation in 2025, will rid the world of this ‘uneven playing field’ and at a stroke destroy the African trade refi market…


Structured LCs

Structured (or synthetic) LCs (SLCs) also have huge potential to solve the liquidity problem for African banks, but won’t fulfil their potential due to their underserved reputation and thus consequent difficulty in selling into the secondary market, stunting their beneficial scale. SLCs are the only ‘home-grown’, trade-tenor, hard currency injection that can fund African banks’ un-refinanceable SME trade portfolios, as they require no detailed underlying substantiation. There is an excellent ITFA white paper on SLCs that elucidates their history, parties, motivations and risks. They are a truly developmental and an additional and entirely sustainable source of self-sustaining dollar liquidity for African banks’ treasuries.


Irrationally unsustainable

This is where the irrational behavioural economics really comes into play. Western ignorance and psychological misconceptions are foisting inappropriate regulations and policy onto the continent. Africans are best placed to trade themselves out of the gap; they just need the credit and liquidity, and trade refi and SLCs are the best tools to enable African banks to sustainably raise this for themselves.