THE ROLE OF STRUCTURED COMMODITY FINANCE IN ECONOMIC DEVELOPMENT

Many developing nations are rich in natural resources that are often under-utilised. The author outlines how traditional financing methods are unsuitable for many ventures in developing countries, and how greater use of structured commodity finance could help to make better progress, boosting economic activity and generating new wealth in the developing world.

resource-rich country needs to make the best use of its combined factors of production. Challenges, powever, abound. Governments, seeking to maximise the well-being of their citizens, need to work with businesses and entrepreneurs who are seeking to maximise profits. What’s more, many nations appear to lack the human capital needed to turn raw materials, machinery, labour and capital goods into sustainable streams of income. Lack of credit to finance business ventures is also a major problem. For financiers and investors, traditional lending methods are seen as prohibitively risky, because they focus on the economic history of the borrower. One of the first things banks typically request when financing an operation (whether it is balance-sheet-backed or working-capital based) is the track record of the entity being financed. In developing nations, these track records are usually non-existent, limited, or highly volatile and, as a consequence, access to finance is often denied.

Overcoming the obstacles

In a structured finance transaction, these obstacles are overcome. 

Structured commodity finance, which emerged in the late 1980s, is an alternative and cost-effective financing tool for commodity producers and trading companies operating in developing nations. How does it work? Put simply, it transfers the risks in a trade-financing deal to those who are better equipped to bear them. Rather than focus on a company’s credit rating, structured commodity finance works in its simplest form by securing loans against the commodities a company produces. Lenders therefore become more interested in a company’s ability to deliver its goods than in the strength of its balance sheet or its cash-flow track record. If a transaction proceeds normally, the financier is automatically reimbursed and the loan is self-liquidated. If anything goes wrong, the financier has recourse to some assets as collateral. In some instances, the loan is secured against a commercially stronger counterparty rather than the commodities themselves but, regardless, the effect is the same: the credit risk is moved away from the party that is being financed and onto a risk or series of risks that are lower than that of the ultimate borrower, the commodity supplier.

The Angolan experience

One prominent illustration of how these techniques can be used comes from the 1989 crude oil pre-finance structures in Angola. At the time, the country´s high risk rating prohibited access to conventional methods of financing. However, by using structured commodity finance, the Angolan state oil company was able to benefit from early disbursements of its future supplies. In this case, the company gained access to the funds it needed by issuing letters of credit backed by the receipt of shipping documents of crude oil supplies. Although the physical delivery of the commodity took 40days, the Angolan state oil company received payment for its supplies much earlier, with lower costs and risk. As this case illustrates, the use of such techniques allows companies and governments in the developing world to transform raw materials into ready capital and revenue. Aside from pre-finance, structured commodity finance may also incorporate toll finance, warehousereceipt finance, counter-trade finance and even asset-backed securities. Nevertheless, in all its forms, the basic principle is the same: turning factors of production into readilyaccessible money.

Why isn’t structured commodity finance used more widely?

Unfortunately, both local and foreign banks in emerging markets are not making the most of the opportunities presented by structured commodity finance. In Angola, for example, there have been no signs of domestic banks capitalising on their natural advantages. Banks are present on the ground, even outside of the capital. They know the local players, including the service providers, such as warehousemen and inspection companies, and are therefore well positioned to spot problems early on and to resolve them, either informally or through the legal system.

Yet, despite these strengths, very few banks are currently using structured finance techniques. As a consequence, valuable opportunities for profit are lost, and, more broadly, the country’s commodity suppliers, traders and currency remain poorly linked with regional and international markets, despite increased public investment in transport infrastructure. Why aren’t banks doing more? One reason may be lack of human capital and enterprise. The local banks in developing nations that do have a portfolio of commodity-sector loans generally lack in-house expertise in commodity-based finance. At the same time, the foreign banks that have such expertise generally look at ‘big-ticket’ transactions which can be handled directly with international commodity firms. Developing the necessary expertise can also be difficult. It is hard to build fixed models for structuring commodity purchases around warehouse receipts, or other small commodity-sector loans, because the data is restricted and because one transaction often varies greatly from the next. For example, the legal departments of local banks would have to undertake a substantial amount of time-consuming and original work for each transaction, whereas credit analysts would be confronted with heterogeneous requirements for mitigating risk.

Government distortion

Unpredictable governments are another inhibitor of structured commodity finance in the developing world. Today, economic management in the emerging nations is much more sophisticated than it was twenty years ago, but there is still a tendency towards state intervention through exchange-rate intervention, heavy regulation of utility suppliers, restrictions on land rights and usage and limits on the repatriation of profits, among other factors. The nature of such intervention is hard to predict and plan for, making it difficult for banks and financiers to model the variables that impact on their financing structures. In some cases, financiers had believed their exchange-rate risks were covered, because of a government guarantee that local tariffs for electricity, water or toll roads would be linked to the US dollar or another foreign currency. Often, however, when local currencies have depreciated, domestic political conditions have made it impossible to increase local tariffs quickly enough to meet  Structured commodity , finance provides, working capital in difficult environments where conventional financing methods fail such agreements. In this situation, financiers are typically paid in the local currency but, because of the depreciation, these funds are insufficient to

meet the debt service requirements.

Conclusion

Despite the obstacles, developing nations have much to gain from structured commodity finance, because it provides working capital in difficult environments and in markets where conventional financing methods fail. In doing so, structured commodity finance can boost output and employment, promoting economic development and balanced growth. In countries such as Angola, these techniques could be used much more widely. For example, in rural areas, medium-size farmers could be pre-paid for the supply of agricultural products if they agreed to deposit

them at a bank-controlled warehouse and to meet pre-defined conditions. Such arrangements would secure a market for the farmers, supplies for the retailers and new business for logistic firms, insurance companies and development banks, among others.