The Hindu Business Line : Structured financing of commodities, the solution

AS one of the fast growing significant economies, India saw a GDP growth averaging 5 per cent plus in the last five years. It is the world's third largest producer of food. Agriculture is likely to be the key growth driver in the near future. India is opening up to foreign goods as are overseas markets for Indian products.

Today, foreign trade is freer than ever before. Planners want the economy to achieve 7-8 per cent annual growth rate during the Tenth Five Year Plan period.

The National Agriculture Policy envisages a 4 per cent annual growth rate in agriculture. Without doubt, the economy has the potential to grow rapidly.

India is transiting from a stage of chronic shortage in essential commodities to one of adequate supplies as the economy is becoming increasingly market-driven. Gone are the days of shortages characterised by controls and restrictions on storage, movement, credit access, and so on. Transition to a market-economy has generated tremendous demand for funds. Agricultural trade is expanding rather rapidly; but it is constrained by, among other problems, funds crunch.

Access to and availability of funds will drive trade volumes up with consequential flow of economic benefits to stakeholders.

Commercial banks are flush with funds, but wary of financing commodity trade. Borrowers are frustrated by rigid credit limits and tardy procedures for hike in credit limits so much so that by the time limits are raised, market conditions change.

Reluctance of commercial banks to fund commodity transactions can be attributed to both historical and temperamental reasons. Banks are comfortable with funding brick-and-mortar projects that are production-oriented. Currently, they are content with so-called "safe" funding avenues.

On the other hand, funding commodity transactions is perceived as "risky". Is lack of experience/expertise as also a mind-set based on past economic conditions, turning bankers away?

However, with changing economic conditions, such orthodoxy or rigidity cannot sustain any longer. To stay in the banking business and flourish, commercial banks need to take cognisance of market conditions and mould their lending policies to meet the needs of borrowers.

Structured financing of commodity trade could be the way forward. Structured financing is transaction-based lending where the lender finances the entire chain of trade deals with effective control over goods/title documents. In this type of lending, the value at risk is determinable and the same can be hedged.

This is in contrast with the usual practice of balance-sheet-based lending under which banks fund goods or projects. Often, banks finance open position of goods without adequate control on them. Also, this results in imposition of arbitrary margin terms.

Why is structured financing superior? For the lender, that is, the commercial bank, the quality of asset in terms of risk is superior in transaction-based lending. There is traceability of funds from production to sale of goods. In addition, it is safe, especially in exchange-traded commodities.

For the borrower or trader, structured financing provides timely and adequate credit. Funding is limited to specific transactions that encourage prompt execution of trade deals that can, in turn, improve turnover and profits.

Generally, structured financing leads to measured flow of credit. Also, the application of funds is known. This can potentially curb speculative instincts.

Obviously, commercial banks desirous of expanding their business have to take a close look at structured financing. Tests of traditional bank finance have to be modified to meet current market requirements.

Importantly, structured financing demands in-depth knowledge of products and market dynamics. Collection and application of commercial information and market intelligence for the purpose are imperative.

Without the support of trade facilitators, structured financing cannot succeed. Active tie-ups with service providers, such as trade intermediaries, transporters, surveyors, warehouse-keepers, and so on, are necessary.

In sum, structured financing is an effective risk management tool for commercial banks wanting to fund commodity transactions. Banks, however, need guidance, as they are not familiar with the commodity market.

Trade promotion organisations have an opportunity to educate banks and provide them with requisite inputs about products and markets. The banks must take initiative to evolve and market innovative products with a view to effectively deploying funds.

(Edited-excerpts from the presentation by the author at the All India Cotton Trade Conference in Mumbai.)

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