Shop talk: Covid-19 – the new ECA and private insurance stress test
TXF spoke with Valentino Gallo, founding partner at Javalyn Partners, an independent structured asset management firm that specialises in infrastructure and trade finance, to discuss the real impact of the coronavirus pandemic on the trade and export finance market.
Private insurers and ECAs are facing the prospect of paying out an unprecedented amount of claims amid the coronavirus pandemic. With supply chains interrupted, record low oil and gas prices, and many large-sale projects under construction halted globally, financially over-leveraged borrowers will inevitably begin to default on trade and export loans as project costs overrun.
But both the ECA and private insurance markets have some level of cover via the growing trend of reinsurance, a financial instrument to increase capacity and manage capital. In fact, over the last three years more than half of the new commitments underwritten by ECAs have been reinsured in the private market. Although it is important to note, ECAs also seek reinsurance from other ECAs.
TXF spoke with Valentino Gallo, a founding partner at Javalyn Partners, an independent structured asset management firm that specialises in infrastructure and trade finance, and ex-global head of trade and export finance at Citi, to discuss these growing trends amid the coronavirus pandemic.
TXF: What lessons from previous crisis would you take into this one? Are there similarities?
Valentino Gallo (VG): The lesson from the past is that the ECAs are a very unique countercyclical economic policy tool. In emergency situations they pull all the stops, embrace the challenge proactively, are very receptive about the requests and suggestions coming from exporters and banks and introduce new tools or adapt existing tools very rapidly. In fact all ECAs around the world have been quick off the blocks granting waivers and making concessions to exporters and importers caught off guard by the unprecedented, sudden economic stop imposed by governments for the healthcare considerations associated with Covid-19.
Having said that, the nature of the Covid-19 crisis is very different from the global financial crisis of 2007/2008 and the commodity crisis of 2014/2015; its impact is going to be much more challenging to manage for the ECAs. The ECAs went through the 2007/2008 crisis essentially unscratched. At that time most of the ECA business was done in the growing economies of Asia, Middle East and Latin America which, from a credit perspective, were bright spots. The problem at that time was the evaporation of the liquidity in the banking system, which ended up affecting the global trade flows as well as the domestic supply chain in the OECD countries.
The ECAs, and for this matter also the multilateral agencies, stepped up to the plate and, through the introduction of new products such as supply chain finance and capital markets guarantees, they provided to the global trade market the much needed liquidity which prevented its halt. The emerging market credit environment was very benign and the ECA loan portfolio performed very well, with record low levels of default. The commodity markets crisis of 2014/2015 was more difficult to handle and some of the ECAs involved in offshore energy projects got embroiled in complex restructurings.
The Covid-19 crisis is made even more complex by the concurrent dramatic drop in crude prices caused by the battle between Russia and Saudi Arabia over oil prices. Covid-19 is putting tremendous pressure on the cruise-line and aviation industry, and the drop of the oil price is harmful to the energy sector including the LNG segment. ECAs have significant exposure to all such sectors. The mitigating factor is that both the cruise-line and aviation sectors were caught by the crises while in very good health and historically high levels of liquidity. In addition, several governments around the world have made available significant forms of support.
TXF: What are the biggest challenges facing the ECAs, the banks, borrowers and exporters and what advice would you give?
VG: ECAs have to manage an unprecedently delicate loan portfolio exposure and at the same time they have to provide liquidity to exporters and their supply chain.
Most of the banks got into the crisis with a very strong balance-sheet and abundant liquidity, but the massive drawdown of the RCFs, the unprecedented credit rating downgrades across several sectors and the strain on consumers is soaking up rapidly the liquidity. The hike in cross-currency swaps is also making US$ funding more expensive for the non-US banks active in export finance. Investment grade borrowers and exporters have all loaded as much liquidity as possible, the weak link are the SMEs.
The advice is: help each other, work together. Again, contrary to the global financial crisis (GFC), this time the banking system is in good health and is providing massive liquidity support to the client base. However, the health security emergency is still evolving, with no visibility about how long it will take to bring the epidemic under control and its economic impact. As a result, banks will be in need to control their liquidity levels and would greatly benefit by additional support from the ECAs in terms of liquidity and credit enhancements. There is also need for speed and innovative ways to reach the supply chain that is serving the large exporters.
Speed could be achieved through enhanced cooperation between banks and ECAs under ‘delegated authority’ arrangements which would cut dramatically the underwriting process time. The other advice is to open up the funding of export credit loans to institutional investors, as some ECAs have already done.
TXF: Can you give an example of how you have successfully managed an ECA portfolio during a crisis? What are the key aspects to bear in mind?
VG: The successful management of a crisis is strongly correlated to the value of the relationship that ties together the ECA, the banks and the borrower and to the quality of the credit, due diligence and security package. Cash flows projections, leverage and strategic nature of the financed assets are the key aspect to keep in mind.
It’s important not to forget though that this crisis has been caused by an extraordinary event with no precedents in the advanced economies.
TXF: Do you expect to see coordinated action from the banks and ECAs to extend payment holidays to borrowers facing cash flow issues? Who is best placed to coordinate this?
VG: Yes, there will be payment holidays. For the most complex and larger transactions it is in the mutual interest of the banks and the ECAs to coordinate the effort and design bespoke strategies to address the specific circumstances of each client. Generally, the international banks have a broader relationship with the borrowers and a local presence which make them best placed to coordinate the discussion with the borrowers. However, the effort will be a joint one.
TXF: How do you view the reinsurance exposure within the ECA market?
VG: It is a positive in that it increases the ECA capacity. The cooperation between ECAs and private insurers has grown significantly in recent years under the umbrella of the Berne Union. According to recent data from the Bern Union, over the last three years more than half of the new commitments underwritten by the ECAs have been reinsured in the private market.
TXF: Do you think more reinsurance framework agreements will be rolled out on the back of this crisis as ECAs look to manage their capital?
VG: ECAs are facing the prospects of having to pay massive claims. Those which have reinsurance agreements in place will be facing the current challenges from a relatively stronger position than those who are fully exposed. Crisis are the greatest learning experiences, the cooperation model between ECAs and the private insurers and potential documentation gaps will be tested, I expect the cooperation to come out stronger.
TXF: Do you see any form of planned cooperation between ECAs and private sector insurers underway?
VG: Most of the agreements in place between the ECAs and private sector insurers are private and very confidential. Banks, exporters and importers are not part to the agreements. I speculate that in a stress situation some form of consultation is required, and given the unprecedented and unique nature of the crises it is fair to assume that a high level dialogue between ECAs and private sector insurers is happening anyway. It is also fair to assume that under the current circumstances, in most of the cases, it is in the common interest of all the parties involved in large export finance transactions to make available additional liquidity and bring the projects/shipments to completion.
TXF: Are private insurers for project and trade showing signs of stress? Will there be a mass exodus from market, as there was with monolines.
VG: Clearly there is an enormous stress in the supply chain finance business where private insurers plays a major role. The strong banking sector and the unprecedented injections of liquidity by the central banks should mitigate the pressure on private insurers if the economic activity would restart relatively rapidly. In the project finance sector the activity of the private insurers is relatively limited; each project has its own story. For many projects currently under construction there could be completion delays and cost overrun issues which would require to all parties involved to sit around the table and agree on bespoke restructurings.
And if private insurers get in trouble, will they be bailed out by governments and potentially ECAs if their inability to pay out puts key projects at risk?
VG: The bailout of AIG by the US government is one of the permanent memories of the GFC which was justified by the need to avoid a domino effect via the CDS market across the global banking system. Private insurers are a major component of the global supply chain finance architecture, in particular in Europe. It is hard to envision an inability to pay scenario. The massive injections of liquidity made by the central banks are designed to help banks to extend short terms payment holidays to their clients to avoid defaults and soften the pressure along the supply chain. This should also alleviate the pressure coming from the potential claims on the credit insurers. A more likely scenario is that when the economy activities will restart, credit insurers could be more hesitant to extend new coverage, which would affect the speed of the recovery. This is the market gap that ECAs must be ready to fill.
TXF: Finally, what are your predictions for the next 12 months?
The amount of liquidity being made available to businesses by governments and official agencies, including ECAs, worldwide is unprecedented. Export finance bankers have a tremendous opportunity to help their clients to get access to innovative agency solutions and help ECAs to deploy expeditiously the funds allocated by their governments to save jobs in critical industry sectors affected by the crisis.