EM and trade finance: a good match

Trade finance supports the production of goods and facilitates their movement along the value chain, both domestic and cross-border. Emerging markets (EM) boast unique attributes, including the potential for higher returns, faster economic growth and access to commodities. The two intersect in a way that deserves more investor attention. 

Many countries and regions within developing markets are fundamentally underserved in terms of access to credit. That provides an ideal environment for trade finance, which can serve both as a source of alternative capital and offer investors attractive potential return despite the risks.

Rising share of world trade

Over the last two decades, globalization has shifted a significant amount of industrial activity and supply chains from developed to developing markets. The result is a substantial growth of emerging markets’ share of global trade. Between 2000 and 2019, it rose from 32% to 46% and EM’s portion of foreign direct investment climbed from 15% to 46%. 

The Organization for Economic Co-operation and Development says the majority of the world’s GDP growth now occurs in emerging markets, supported by younger populations and a fast-growing middle class. These factors have transformed production and consumption patterns. EM have increasingly become a destination for — as well as an originator of — trade flows. Many EM countries are rich in natural resources, such as oil and gas, metals and agricultural products, and are leading producers of primary goods.

Effective risk mitigation 

Despite the improvement, many investors remain wary of emerging markets because of the exposure to jurisdictional and country-specific risks, such as geopolitical instability, less-developed regulatory systems and macroeconomic volatility. But these challenges can be mitigated to make investing more palatable.

For example, the risk to portfolio credit quality from fluctuations in the US dollar can be lessened by investing in hard-currency transactions. Employing market-standard English and New York law-governed legal documentation can address idiosyncrasies in local laws. And incorporating features like the offshore routing of cash flows or advance waivers of immunity can help protect against nonpayment, convertibility and transferability risks.

But financing remains an issue

Emerging markets don’t have access to the breadth of funding available in developed markets, with banks usually the primary source of credit. Here is where trade finance can step in. In contrast to investments in public credit markets, it is not beholden to a fixed universe of issuers. Strategies independently select where and when to deploy capital, and which companies and projects to back. in underserved EM capital markets, this flexibility has the potential to result in attractive risk-adjusted returns for investors. Indeed, the intersection between the two presents a host of opportunities.