For Freight Trade, Credit Problems Just The Start

Market analysts are constantly searching for predictive economic indicators. Such soothsayers will point to consumer confidence, payroll levels, employment numbers, and a cocktail of other variables to support their forecasts. Over the last several weeks, one metric has gained significant traction in the industry. The Baltic Dry Index (BDI) is a number issued daily by the London-based Baltic Exchange. Each Monday through Friday, the Baltic's employees place calls to a panel of international shipbrokers to determine the cost of shipping various raw material cargoes.

The BDI condenses information from 26 shipping routes, various dead-weight tonnages, and a range of transported commodities. The index considers unprocessed inputs (such as cement, coal, and metallic ores) that serve as an outlook for production in a given economy. With markets that are increasingly driven by speculation, the BDI represents a tangible reality: people must book ships to move their commodities. As a result, the index is thought to be a valuable leading indicator of economic growth.

Back in 2003, the BDI spiked above 4,000 as emerging markets (most notably China) commanded more ships to move their freight. The index is subject to sharp movements because the supply of cargo ships is fairly inelastic. That is to say, the number of ships transporting global freight is fairly constant. It takes about 2 years to build a new cargo vessel and these freighters are too expensive to take out of circulation. As a result, global demand is the real driving force behind the BDI's rise and fall.

On Friday, the BDI closed at 851, down more than 90% since June. According to market reports, a cargo ship traveling around both southern capes cost just $6,300 per day. Earlier this year, when commodity prices were surging, the cost was some $234,000 per day. The global slowdown has eroded demand, forcing shipbrokers to hold their vessels in port or put them up for sale.

There are, however, even more alarming signs for the industry. Some of these ships have cargo already loaded, but are unable to deliver these goods to their scheduled buyers. The problem: trading partners cannot secure bank letters of credit. International transactions are supported by letters of credit, which effectively allow trading parties in different countries to secure an agreement. Banks issue letters of credit which guarantee payment for the seller once the goods have been shipped. The bank also acts on behalf of the buyer ensuring that no payment is made until confirmation of the delivery is received.

The fact that goods are piling up at certain docks has some analysts claiming that supply and demand are sufficient. Instead, the current economic climate has made it extremely difficult for anyone to secure the credit necessary for such transactions. As with many financial contracts, these international deals hinge on trust. With banks exposed to major write-downs, many ship owners are reticent to accept the few letters of credit they receive. 

Indeed, the credit freeze threatens to undermine global trade and bring the import-export economy to a grinding halt. If the current trend continues, industrial economies in Europe and East Asia will contract sharply, and developing world countries in Latin America and Africa (highly dependent on commodity exports) will face bitter losses. 

Optimistic analysts suggest that as lending rates come down (dollar LIBOR is at its lowest level since the Lehman Brothers collapse) and the financial crisis eases, the shipping economy will recover. Even still, the underlying fundamentals of the global economy are bleak. Recession in the United States and Europe is all but assured, which will shrink demand for raw materials. 

Either way, the shipping news is once again a must-read.