Thursday, October 30, 2008

Letters of credit

Thanks to the ongoing financial crisis, it wasn't so long ago that the public had to be educated on formerly esoteric finance jargon like subprime security and collateralized debt obligation (CDO).

The next finance term that the public is likely to be acquainted with depends on which shoe is the next to drop. Until recently, I had thought that it would be credit default swap (CDS), which we are hearing increasingly more of.

(Personally, I believe that CDS's had something to do with the Lehman Minibonds and DBS High Notes that we had been hearing so much in the news about. Specifically, our poor Singaporean retirees who had been bilked out of their life savings were unwittingly writing credit protection to the big banks. But I digress.)

Now, I think it likely that the next (trade) finance term the public is going to hear about is letter of credit (LOC), which strangely enough, I came across for the first time in Robert Jordan's Wheel of Time fantasy fiction novels (I swear, I'm not making this up).

Anyways, there's been a substantial amount of blogging and news about how the ongoing credit crisis is resulting in banks refusing to guarantee transactions between importers and exporters. This in turn has caused problems in shipping. All this is occuring in the background, with a plunging Baltic Dry Index in the foreground.

Recommended, but technical, reading is here, here, here and here. [And yes, in addition to being a full-time engineer, I am also something of a finance wonk.]

What's the likely fall-out from this side-effect of the financial crisis? Yves Smith from writes that it could metastasize into "Smoot-Hawley on steroids", or a manufacturing shut-down plus depression scenario (which is, no pun intended, really depressing to contemplate).

My interpretation of that is that in addition to severely depressed economic activity as a direct result of a slow-down in trade, we might also see persistent shortages of goods as well as higher prices. Inflation, or more properly, stagflation, could stage a come-back.

Of course, given the gravity of the situation, I can't imagine that governments around the world would sit back and do nothing. So perhaps such a dire situation is unlikely to come to pass. Still, it's one more thing to worry about.

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