Why Bank Guarantees are Important in International Trade

Trading across the globe can be risky, exporters are challenged with shipping goods to buyers who potentially may not pay for the goods, and importers face the reverse — the prospect of paying for goods that never arrive. To overcome this uncertainty, banks guarantee the security of trade, often by providing letters of credit. Bank guarantees, therefore, play a fundamental role in international trade. Any changes in behavior from banks can have a considerable impact on trade trends. During times of crisis, in particular, this impact can be significant.

Banks reduce the risk of international trade

When embarking on a new trading relationship, particularly when entering a new market, there is a lot of uncertainty for both parties involved. Goods may arrive that are of lower quality than expected, are damaged, or they may never arrive at all. On the other hand, exporters who send goods without upfront payment risk never settling their invoices. Without the role of banks who offer specific trade finance products to guarantee the security of international trade, far fewer deals would be completed and international trade would be limited.

Letters of credit are fundamental to mitigating export risks

A recent study by the Centre for Economic Policy Research (CEPR) revealed that the issuing of letters of credit has a direct impact on US export growth. Data show that if the number of letters of credit available in a certain destination drop by just one standard deviation (17%) compared with the previous quarter, then US exports to that destination fall an average of 1.5%. This effect doubles in times of financial crisis and is elevated for exports to smaller and poorer countries — a one standard deviation drop in the supply of letters of credit leads to a 5.8% reduction in trade under these circumstances.

Given that many of the world’s strongest economies have faced a troubled few years since the Covid-19 pandemic drastically changed our day-to-day lives, bank guarantees have become particularly important. International trade dropped by 8.9% during 2020, and there is an increasing risk of global economic recession in 2023. For international trade to grow stronger, banks will likely continue to play a vital role.

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