The International Chamber of Commerce (ICC) 2015 Trade Register Report shows a spike in default rates in regions impacted by sanctions and unrest. Henri D’Ambrières, Senior Technical Adviser on the Trade Register, ICC Banking Commission, explains how the trade finance industry can protect itself against the default of counterparties based in these regions

While trade finance and export finance default rates remain low overall, certain regions still experience default spikes. This is particularly the case in states of the former Soviet Union, or ex- Commonwealth of Independent States (ex-CIS) – with the spike starting in 2013, especially in countries such as Kazakhstan and Ukraine.

A key component of the upsurge in defaults has been the decline in creditworthiness of Financial Institutions (FIs) in the region – the very counterparties trade finance relies upon. That said, corporate defaults in Russia are also a concern – some linked to the sanctions enforced by the EU and US. Certainly, shocks such as armed insurgencies, political instability and the imposition of economic sanctions are causing a material decline in trade finance relationships in the region. Yet, to every cloud there is a silver lining – and corporates can mitigate against the risk of credit defaults in a sanctioned region.

Impact of sanctions and defaults

Default rates for the ex-CIS region reached 4% in 2014 – whereas all other regions had default rates well below 2% at the time (see figure 1). That said, the former Soviet Union is not the region with the highest default rates. That dubious accolade goes to the Middle East – in large part thanks to the sanctions imposed against Iran (recently lifted).

FIGURE 1

For instance, in the Middle East, the customer default rate between 2007 and 2014 was the highest worldwide – at 2.84%, significantly higher than 1.28% in ex-CIS, 0.41% in Africa and 0.44% in Asia Pacific.

What’s more, the Trade Register also illustrates the effects of idiosyncratic shocks (such as political violence and sanctions) on overall default rates. When transactions related to Ukraine, Kazakhstan and Iran were excluded from the whole data sample, the overall transaction default rate between 2007 and 2014 fell from 0.71% to 0.46% and from 1.43% to 0.17% for FIs (see figure 2).

Figure 2

Mitigating risk

So, what can corporates and banks do to protect themselves against counterparty defaults in a region experiencing idiosyncratic shocks? First, they should realise that they may well be covered. Idiosyncratic shocks primarily affect medium to long-term (MLT) transactions, which are largely backed by Export Credit Agency (ECA) cover.  ECA-backed products were included in the Trade Register, whereby ECAs are government-sponsored and typically have investment grade ratings – providing a guarantee of cover in the event of a default.

While ECA cover certainly helps, there is still more corporates can do to safeguard their positions. Indeed, banks and corporates should aim to increase their understanding of the composition of a given portfolio with regards to underlying asset classes and geographical distribution, which they can do by strengthening contracts and improving due diligence.

Finally, we should not underestimate the power of diversification. Putting all your eggs in one basket is a sure-fire way to increase risk – particularly if all, or most, of your counterparties are based in a politically volatile region.

Looking towards a range of markets – both developed and emerging – will help to lower the risk (or at least the impact) of a counterparty default. Transaction default rates from 2007 to 2013 in Asia Pacific, Africa, and Central and South America are 0.29%, 0.39% and 0.5% respectively – significantly lower than those rates in ex-CIS (1.28%) and the Middle East (2.43%). By engaging in trade finance activities in a range of markets, banks and corporates can reduce the risk of overall defaults.

It should also be noted that the transaction level default rate in ex-CIS is higher than the customer default rate in this region, showing a concentration of defaulted transactions with a small number of counterparties. As such, diversification of trading partners within each region is also important. Of course, the added benefit of diversifying markets and trading partners is that it also helps to further globalise trade – bringing more entities into global trading patterns and improving the gene-pool of trade finance.

Certainly, trade finance is having to absorb the increasing use of sanctions as a political weapon. Yet these idiosyncratic shocks should not result in disaster for corporates with counterparties in sanctioned regions. There are steps corporates can take to protect themselves against counterparty defaults – though the key safety valve, as ever, remains diversification.