With bank liquidity under pressure, non-bank players must lead

By Mark Smyth, Chief Investment Officer, Tawreeq Holdings

Trade has always been at the center of commercial life in the Arabian Gulf. From the earliest history till the present day when most small and medium-sized firms are involved in some form of import-export activity, trade remains the mainstay of the economy. Whilst major efforts to diversifying the economic base have been altering the equation in recent years, the basic formula of energy exports paired with import and distribution of finished goods has underpinned the region’s stellar growth and development.

And even casual visitors to the region will observe that whilst manufacturing remains at relatively low levels, the wide availability of every conceivable consumer product remains an obvious feature of the region’s culture. In short the strong dollar-linked currencies afford an affluent population the ability to purchase the best of what the world has to offer. The import volumes for the UAE alone run to over $250b.

Financing these enormous trade flows has traditionally been a lucrative business for the region’s banks. The pricing has generally been favorable and using traditional methods, trade finance comes with a considerable amount of related processing fees. This comfortable state of affairs has always concealed a systemic flaw in that:

The credit was never adequately targeted at SMEs, which whilst not a unique challenge for the GCC, it is in many ways especially worrisome for two reasons: One is related to the longstanding strategic challenge of how to create meaningful employment for a growing and youthful population. This is universal challenge, but for rapidly growing and youthful countries it is of exponentially greater importance. Secondly, there is a special twist for the GCC in that most young entrepreneurs retain their cultural preference to be involved in import-export activities, an area dependent on efficient working capital; and

As SMEs, these young business people, like SMEs everywhere, do not have the large balance sheets required to receive bank credit, though their balance sheets may be perfectly adequate for their given business activity; leading to a situation whereby,

Banks naturally “price this risk” accordingly, charging rates higher than the SME’s operating margin, a model that hurts more than helps, eventually runs the SME into bankruptcy or locks them into a debt-trap where continued refinancing is required to keep pace.

Despite the efforts of the banks, according to the International Finance Group’s analysis of 2010*, the formal SME credit gap in the MENA region is estimated between $160-$180 billion.

And more recently the traditional bank failings with respect to SMEs have become more acute than ever given the dramatic fall in oil prices, which in crude terms, has nearly halved government revenues. These falling prices have now worked their way through the system, such that government deposits are being withdrawn from regional banks in increasingly large volumes to cover development project costs; in short, bank liquidity is on the wane with less money now available for financing trade.

Given the already enormous SME funding gap and the over-priced and spotty coverage for funding trade in the region, the impact is worrying for its effects on economic growth and youth employment. As is the case everywhere it is the SMEs who are the key to job creation, which in the GCC often means traders, who are now more than ever “un-bankable” and therefore unable to grow their businesses, contribute to trade volumes, and ultimately hire more workers.

It is to these large and layered problems that a ready solution has presented itself in the form of Supply Chain Finance (SCF), an approach popular in Europe and other developed markets whereby credit is

directed at the transaction level (not through open-ended term loans/lines of credit);

without recourse to the SME; and which

is backed by real economic trade and real assets;

where a risk transfer is possible to the larger, more credit worthy buyer;

and where through the use of credit default insurance, the price and overall cost to borrowers can be greatly reduced, protecting SME margins from which flow increased trade, profitability, and job creation.

Whilst Supply Chain Finance is new to the market, its arrival is well-timed given the inability of banks to sufficiently meet the needs of SMEs and traders, at least not on terms that aide the growth prospects of their clients and advance the broader economic aims of the countries where they operate. Given the increased regulatory burden being placed on banks, it is clearly the non-bank financial institutions that are best positioned to structure and bring the concept to the region.

Fortunately for the free market economies of the GCC, SCF is not a government program, charitable contribution or form of grant finance; but rather, on the other side, an incredibly interesting and helpful way to gain yield on sagging fixed income portfolios. Though thought to be gradually rising soon, in a world seemingly resigned to historically low interest rates, investors into SCF programs now have a new and compelling option to better their yields for only incremental risk, thus helping meet the fixed income returns necessary to stabilize pension schemes and bond portfolios.

It is time to give greater attention to the benefits of Supply-Chain Finance in the GCC as it holds benefits for SMEs (cheaper credit), governments (greater growth), and investors (better yields).

* Overcoming Constraints to SME Development in MENA Countries and Enhancing Access to Finance, IFC, 2010