Yesterday we published the brief paper "Prepayments Demystified". As noted by Christophe Salmon, Trafigura Group’s Chief Financial Officer in the foreword: "Natural resources such as oil are public goods that should indeed deliver public good… By publishing this "Prepayments Demystified" document, we hope that we contribute to evolving practices related to prepayment agreements." This relates particularly to prepayments made to governments and to state-owned entities.
In the paper we write:
"Commentary on STF (Structured Trade Finance) often focuses on purported undisclosed financial risks or on implications for sovereign debt management. Yet at a time when the global banking industry has been reshaped and commodities producers in emerging economies are finding it harder to finance their operations directly through the banking system or through public markets, STF is more essential than ever. It has become an indispensable tool for ensuring that commodities can be efficiently produced even in the most unpromising (or challenging) and remote jurisdictions, and reliably brought where they are needed. There is thus a public interest in ensuring that its workings and any associated risks are properly appreciated by the business and financial communities, regulators and society at large."
Differently put, producers require working capital to enable them to develop production and buyers need a reliable pipeline of commodities. And, as we write later in the paper, prepayments have become important in part because international banks have substantially reduced their exposure to emerging market lending. As a consequence, the larger trading companies have been left as one of the few sources of credit for extractive development and production.
Prepayments are also often cost-effective. They are a lot simpler than raising credit from a syndicate of banks. Above all, they remove the headache of managing currency risk: the producer can focus on its core business of producing; the buyer takes the product and converts it into US dollars that are then used to make loan repayments. Access to foreign exchange can be a crucial consideration for a producer in a country without a convertible currency or under financial constraints. A prepayments agreement offers a sure-fire way of securing dollars, rather than local currency, in exchange for commodities produced.
The issue with prepayments and other STFs with governments, it seems to me, is that they have at times resulted in unsustainable levels of debt or in debt that has not been sufficiently understood. I get this. All of us need to be involved in the conversation – governments, banks, traders, development agencies and international institutions such as the IMF and the EITI, to come together and quickly agree common rules to govern prepays and other STFs. Again, as Christophe writes in the foreword: (we) "hope that we contribute to evolving practices related to prepayment agreements".
The EITI’s Commodity Trading Working Group, where we are represented by my colleague James Nicholson, is the obvious fora for this collective push to agree rules for what should be disclosed how and when. It met yesterday, though progress is slow and we need to ensure that those involved (and impacted) participate. As part of our commitment towards improved transparency, we intend to be more active on this topic in the months to come.
You can read or download the paper here.