The Existing Infrastructure is Under Stress: How Coronavirus is Impacting Supply Chains.
When Coronavirus took centre stage in January this year, our strategy shifted its focus from analysing the causes to planning for consequences. With the US election, trade wars, Brexit negotiations and the Saudi Arabia/Russia “game of chicken” taking up global conversations, nobody paid enough attention to the level of impact contamination from Covid19 might have on the world. However, to date in excess of 100 countries stand effected by it, with this number growing daily.
As international borders started to shut down and people were forced to disburse, remote working measures across all industries and sectors created inefficiencies in all communication channels, testing firewalls and slowing down carefully constructed IT platforms. This is when the potential for coronavirus to escalate and materially affect the economy in China, Asia, and beyond, started to sink in.
The level of uncertainty around the coronavirus is extremely high. No matter how much data one tries to assimilate, its unpredictability is impossible to quantify, and therefore measuring the gravity of its impact is currently entirely academic. However, we need to practically prepare for its impact by taking action, not purely speculating on the outcome.
As managers of the commodity supply chain, at Czarnikow we have adopted the planning rather than forecasting mentality. These are the key risks we see impacting the immediate business future for all involved in the supply chain management and finance:
- Disruption to transportation channels and the physical movement of goods
- Escalating counterparty payment risk
- Potential liquidity crunch in the borrowing waterfall
Below, we will explore these in more detail and discuss how they can best be managed.
Disruption to Transportation Channels and the Physical Movement of Goods
The impact of the coronavirus epidemic on worldwide production and movement of goods, together referred to as the supply chain, will soar by mid-March and continue to rise. That’s when stockpiled supplies will dry up, and manufacturing and production will slow down or stop because of the lack of ingredients available. The availability of these products is reliant upon a number of factors, all of which have been impacted by the virus. Crops may go unharvested as labour becomes unavailable, possible ports close as a result of shut borders, resulting in the procurement and movement of goods becoming increasingly challenging.
The widening epidemic is already affecting ports, and we have seen potential closures in Algeria and other geographies impact our own decision making. As quoted in the press, Allard Castelein, the CEO of Rotterdam harbour said: “The effect of the coronavirus is already visible. The number of departures from Chinese ports has decreased by 20% these days. Activity at the French port of Le Havre is also slowing and could drop by 30% within two months. The anticipated impact on the U.S. ports is starting to be factored into financial analyses. In summary, we should brace for a major effect on production worldwide which could last for months”.
Despite these challenges, the general population and global governments rely on supply chains continuing to provide the population with necessary goods. Trade and movement is happening, just not in the ways we would normally expect. We have found that patterns of supply and demand have already shifted considerably, prompting supply chains to adjust to this changing landscape with lateral thinking and an entrepreneurial approach.
Escalating Counterparty Payment Risk
Delayed shipments translate into delayed deliveries, which in turn cause delayed production, and ultimately repayments. This relationship between supply chain efficiency and pressured liquidity is one that ordinarily ensures benefits for all concerned parties. However, in times of crisis it can create problems. Let’s look at this in more detail:
A manufacturer seeks a loan in order to purchase the component ingredients needed to make their product. This is agreed on certain terms, reliant on repayment within a specific time window (e.g 60 days). Once the manufacturer has received their funding, they are able to source the necessary ingredients, make their product, and ship it off for the consumer to purchase. They then use the capital created by these end sales to repay their lender, and the pattern of mutual benefit continues.
However, if there is a delay with the delivery of their ingredients, or ingredients becomes unavailable, the manufacturer is in trouble. Often products can’t be re-formulated quickly with new ingredients at short notice, adding further strain and creating consequences with labelling. They cannot make their product and therefore are unable to pay the lender back, as they lack their final capital. This increases their liquidity risk and leaves both the manufacturer and the lender in a very challenging situation. The lender’s counterparty risk becomes increased, and all involved come under enormous pressure.
As entire financing community manages their loan asset books on the basis of a repayment schedule, this situation is alarming and leads to the main point of this article, which is liquidity. There is a common challenge facing supply chains and banks: how can they ensure liquidity while also dealing with the pressure the coronavirus has placed upon them?
Potential Liquidity Crunch in the Borrowing Waterfall
When we talk about a ‘waterfall’, we mean the debt maturity profile in a company’s loan portfolio. Ordinarily, this is made up of a group of loans that will mature at different times, allowing the company to draw and repay them gradually over a number of months or years. What is happening as a result of the coronavirus pandemic is credit migration, where everyone wants to draw their loans at once rather than gradually, placing pressure on the banks. Banks do not hold all of their assets as cash – they also hold a number of debts themselves and borrow from each other at a percentage called a Libor (London Inter Bank Offered Rate).
Financial markets have experienced one of their worst months since the financial crisis in 2008, meaning policymakers are acting in unison by taking actions beyond monetary policy to cushion the supply chain disruption and keep illiquid firms solvent.
On March 15th, the Federal Reserve slashed its target range for the Fed funds rate by 100 basis points to “act as appropriate to support the economy”, with the Bank of England and the European Central Bank following suit. In total, global policy rates have been cut by 55 basis points year-to-date. “From the beginning of the year through March 18th, 16 central banks have cut rates. As of that date, we forecast 24 more rate cuts by central banks by mid-year and at least 15 out of 22 emerging markets (EM) central banks will ease further. In total, EM central banks could potentially ease by another 80 basis points.” said Joyce Chang, Chair of Global Research at J.P. Morgan.
As the banks slash their rates to offer support to the economy, a liquidity crunch is created. This is a situation where the margin between the rates companies have borrowed from banks at and the fees they place on their underlying asset increases, offering an opportunity to make increased return on investment.
However, it’s not as positive as it may seem and there is a paradox. While companies seek to draw down on their debt, they are less discerning about the type of loans they draw down upon. This means that loans that are normally more expensive because they are unsecured and thus not always fully drawn, are now drawn down in addition to secured loans.
Because this is an unprecedented situation for banks, they are at maximum capacity in managing these loans which have become fully drawn. Liquidity therefore becomes a risk, as capital cannot flow as freely and steadily as normal.
What we need in this situation is for companies to avoid drawing down on liquidity ‘just in case’ of disaster. It is a challenging and anxious landscape, but it is only through clear communication and collaboration that we will be able to work our way through it. As we have seen in the social sphere, it is pertinent to remember that by acting in other people’s interest, we can also help our own situation. Once this first wave of pressure has subsided, we think that the key players in the banking space will remain stable even while new entrants will exit.
In conclusion, planning for what may happen appears to be a more compelling strategy vs trying to forecast what will happen next. This places businesses in the strongest possible position in the face of current challenges. In our opinion, the three most pronounced changes coronavirus will irreversibly introduce into our society in the immediate future are:
- the requirement for diversification in the sourcing and distribution channels
- proximity of component stocks to consumer markets
- flexibility in “just in time” delivery models.
Forcing the industry back to basics, it will bring the focus back to stockpiling at origin and at destination, safeguarding the integrity and values of socially responsible farming, forcing efficiency back into transportation and production chains, and protecting the brand image of all involved. The situation has proven that multiple sourcing channels are an advantage. Where clients have bought from only one source in the past, in the current climate anyone with an in-demand product can enter the market. Multiple sources becoming important plays to our strength as a business and demonstrates that single supply chain models have more risk.
Similarly, with transportation, we will see a diversification of channels and must think creatively about how to move goods in new ways. Taking into consideration the level of impact and contamination of conronavirus and the speed with which the world contains it, growth is expected to resume in China in Q2, with Asia to follow.
Everyone has become familiar with the concept of flattening the curve to give hospitals more time to prepare for the peak.
The banking system is no different – everyone drawing down on loans now is like everyone rushing to hospital just in case they might have Covid-19. The system needs more time to be able to focus on those companies that really need help such as airlines and leisure sector. The tide will subside.
The evidence of this is already emerging in the logistics infrastructure. On 26th March, Ministry of Transport in Malaysia issued a press release advising that while “The Government is committed to fight the Covid-19 outbreak… in order to keep its Malaysians safe by temporarily limiting their freedoms to congregate and move about, the Government also wants to ensure … that their daily necessities will continue to be met and their households will not be placed under any more stress than is necessary. Any movement of essential goods must not be curtailed or delayed from reaching those who need them in the market.” To allow for the goods to be moved and delivered to their final destinations, there have been exemptions introduced for ports, freight forwarders and haulage companies to allow for movements.
This is the start of the calm, as the industry adjusts itself to the new order.
As the virus retreats, revived household consumption and transportation connectivity will lead to resumed supply chain logistics, and travel will facilitate better transparency in the assessment of storage and transit risk for banks traditionally financing it. To help with enhanced structured in the flows for banks, we expect the use of liquidity to become more non-discretionary, deployed in identified locations, supporting identified logistical flows. It used to be called transactional finance, designed to support the just-in-time delivery business models. This is the traditional way of financing and supporting the real economy. At Czarnikow, we facilitate the movement of raw materials and ingredients for food and packaging from where they are produced to where they are needed, and this is exactly how we do it.
Author: Tanya Epshteyn, Head of Structured Finance
Images: Cuttersnap, Christian Wiediger