International Trade Finance

Chapter 23 International Trade Finance

The Trade Relationship •

Trade financing shares a number of common characteristics with  the traditional value chain activities conducted by all firms.

•

All companies must search out suppliers for the many goods and  services required as inputs to their own goods production or  service provision processes.

•

Issues to consider in this process include the capability of  suppliers to produce the product to adequate specifications,  deliver said products in a timely fashion, and to work in  conjunction on product enhancements and continuous process  improvement.

•

All of the above must also be at an acceptable price and payment  terms.

23-2

The Trade Relationship • The nature of the relationship between the exporter and  the importer is critical to understanding the methods  for import­export financing utilized in industry. • There are three categories of relationships (see next  exhibit): – Unaffiliated unknown – Unaffiliated known – Affiliated (sometimes referred to as intra­firm trade)

• The composition of global trade has changed  dramatically over the past few decades, moving from  transactions between unaffiliated parties to affiliated  transactions. 23-3

Exhibit 23.1 Alternative International Trade Relationships Exporter Importer is ….

Unaffiliated Unknown Party A new customer which with exporter has no historical business relationship

Requires: 1. A contract 2. Protection against non-payment

Unaffiliated Known Party

Affiliated Party

A long-term customer with which there is an established relationship of trust and performance

A foreign subsidiary or affiliate of exporter

Requires: 1. A contract 2. Possibly some protection against non-payment

Requires: 1. No contract 2. No protection against non-payment 23-4

The Trade Dilemma • International trade (i.e. between and importer and  exporter) must work around a fundamental dilemma: – They live far apart – They speak different languages – They operate in different political environments – They have different religions – They have different standards for honoring  obligations • In essence, there could be distrust, and clearly the  importer and exporter would prefer two different  arrangements for payment/goods transfer (next exhibit) 23-5

Exhibit 23.2 The Mechanics of Import and Export 1st: Exporter ships the goods

Importer

Importer Preference

Exporter

2nd: Importer pays after goods received

1st: Importer pays for goods

Importer

Exporter Preference

Exporter

2nd: Exporter ships the goods after being paid 23-6

The Trade Dilemma • The fundamental dilemma of being unwilling  to trust a stranger in a foreign land is solved by  using a highly respected bank as an  intermediary. • The following exhibit is a simplified view  involving a letter of credit (a bank’s promise to  pay) on behalf of the importer. • Two other significant documents are an order  bill of lading and a sight draft. 23-7

Exhibit 23.3 The Bank as the Import/Export Intermediary 1st: Importer obtains bank’s promise to pay on importer’s behalf.

Importer 6th: Importer pays the bank.

Bank 5th: Bank ‘gives’ merchandise to the importer.

2nd: Bank promises exporter to pay on behalf of importer.

4th: Bank pays the exporter.

Exporter 3rd: Exporter ships ‘to the bank’ trusting bank’s promise.

23-8

Benefits of the System • The system (including the three  documents discussed) has been  developed and modified over centuries to  protect both importer and exporter from: – The risk of noncompletion  – Foreign exchange risk – To provide a means of financing

23-9

Elements of an Import/Export Transaction • Each individual trade transaction must cover three  basic elements: description of goods, prices, and  documents regarding shipping and delivery  instructions. • Contracts: – An import or export transaction is by definition a contractual  exchange between parties in two countries that may have  different legal systems, currencies, languages, religions or  units of measure – All contracts should include definitions and specifications for  the quality, grade, quantity, and price of the goods in question

23-10

Elements of an Import/Export Transaction • Prices: – Price quotations can be a major source of  confusion – Price terms in the contract should conform  to published catalogs, specify whether  quantity discounts or early payment  discounts are in effect, and state whether  finance charges are relevant in the case of  deferred payment, and should address other  relevant fees or charges 23-11

Elements of an Import/Export Transaction • Documents: – Bill of lading – issued to the exporter by a common carrier  transporting the merchandise – Commercial invoice – issued by the exporter and contains a  precise description of the merchandise (also indicates unit  prices, financial terms of the sale etc.) – Insurance documents – specified in the contract of sale and  issued by insurance companies (or their agents) – Consular invoices – issued in the exporting country by the  consulate of the importing country – Packing lists

23-12

International Trade Risks • The following exhibit illustrates the sequence  of events in a single export transaction. • From a financial management perspective, the  two primary risks associated with an  international trade transaction are currency risk  (currency denomination of payment) and risk  of non­completion (timely and complete  payment). • The risk of default on the part of the importer  is present as soon as the financing period  begins. 23-13

Exhibit 23.4 The Trade Transaction Time-Line and Structure Time and Events

Price quote request

Export contract signed

Negotiations

Goods are shipped

Documents Goods are are accepted received

Cash settlement of the transaction

Backlog

Documents Are Presented

Financing Period

23-14

Letter of Credit (L/C) • A letter of credit (L/C) is a bank’s conditional  promise to pay issued by a bank at the request  of an importer, in which the bank promises to  pay an exporter upon presentation of  documents specified in the L/C. • An L/C reduces the risk of noncompletion  because the bank agrees to pay against  documents rather than actual merchandise. • The following exhibit shows the relationship  between the three parties. 23-15

Exhibit 23.5 Parties to a Letter of Credit (L/C)

Issuing Bank The relationship between the issuing bank and the exporter is governed by the terms of the letter of credit, as issued by that bank.

The relationship between the importer and the issuing bank is governed by the terms of the application and agreement for the letter of credit (L/C).

Beneficiary

Applicant

(exporter)

(importer) The relationship between the importer and the exporter is governed by the sales contract.

23-16

Letter of Credit (L/C) • The essence of the L/C is the promise of the issuing bank to pay  against specified documents, which must accompany any draft drawn  against the credit. • To constitute a true L/C transaction, all of the following five elements  must be present with respect to the issuing bank: – Must receive a fee or other valid business consideration for issuing  the L/C – The L/C must contain a specified expiration date or definite  maturity – The bank’s commitment must have a stated maximum amount of  money – The bank’s obligation to pay must arise only on the presentation of  specific documents – The bank’s customer must have an unqualified obligation to  reimburse the bank on the same condition as the bank has paid 23-17

Letter of Credit (L/C) • Commercial letters of credit are also classified: – Irrevocable versus revocable – Confirmed versus unconfirmed • The primary advantage of an L/C is that it reduces risk  – the exporter can sell against a bank’s promise to pay  rather than against the promise of a commercial firm. • The major advantage of an L/C to an importer is that  the importer need not pay out funds until the  documents have arrived at the bank that issued the L/C  and after all conditions stated in the credit have been  fulfilled. 23-18

Exhibit 23.6 Essence of a Letter of Credit (L/C)

Bank of the East, Ltd. [Name of Issuing Bank] Date: September 18, 2003 L/C Number 123456

Bank of the East, Ltd. hereby issues this irrevocable documentary Letter of Credit to Jones Company [name of exporter] for US$500,000, payable 90 days after sight by a draft drawn against Bank of the East, Ltd., in accordance with Letter of Credit number 123456. The draft is to be accompanied by the following documents: 1. 2. 3. 4.

Commercial invoice in triplicate Packing list Clean on board order bill of lading Insurance documents, paid for by buyer

At maturity Bank of the East, Ltd. will pay the face amount of the draft to the Authorized Signature bearer of that draft. 23-19

Draft • A draft, sometimes called a bill of exchange (B/E), is  the instrument normally used in international  commerce to effect payment. • A draft is simply an order written by an exporter  (seller) instructing and importer (buyer) or its agent to  pay a specified amount of money at a specified time. • The person or business initiating the draft is known as  the maker, drawer, or originator. • Normally this is the exporter who sells and ships the  merchandise. • The party to whom the draft is addressed is the drawee. 23-20

Draft •

If properly drawn, drafts can become negotiable instruments.

•

As such, they provide a convenient instrument for financing the  international movement of merchandise (freely bought and sold).

•

To become a negotiable instrument, a draft must conform to the  following four requirements: – It must be in writing and signed by the maker or drawer – It must contain an unconditional promise or order to pay a  definite sum of money – It must be payable on demand or at a fixed or determinable  future date – It must be payable to order or to bearer

•

There are time drafts and sight drafts. 23-21

Exhibit 23.7 Essence of a Time Draft

Name of Exporter Date: October 10, 2003 Draft number 7890

Ninety (90) days after sight of this First of Exchange, pay to the order of Bank of the West [name of exporter’s bank] the sum of Five-hundred thousand U.S. dollars for value received under Bank of the East, Ltd. letter of credit number 123456.

Signature of Exporter 23-22

Bill of Lading (B/L) • The third key document for financing  international trade is the bill of lading or B/L. • The bill of lading is issued to the exporter by a  common carrier transporting the merchandise. • It serves three purposes: a receipt, a contract,  and a document of title. • Bills of lading are either straight or to order.

23-23

Documentation in a Typical Trade Transaction • A trade transaction could conceivably be  handled in many ways. • The transaction that would best illustrate the  interactions of the various documents would be  an export financed under a documentary  commercial letter of credit, requiring an order  bill of lading, with the exporter collecting via a  time draft accepted by the importer’s bank. • The following exhibit illustrates such a  transaction. 23-24

Exhibit 23.8 Steps in a Typical Trade Transaction 3. Importer arranges L/C with its bank

1. Importer orders goods

2. Exporter agrees to fill order

Exporter

11. Bank X pays exporter

6. Exporter ships goods to Importer

7. Exporter presents draft and documents to its bank, Bank X

Importer

12. Bank I obtains importer’s note and releases shipment

13. Importer pays its bank

8. Bank X presents draft and documents to Bank I

Bank X

Bank I 9. Bank I accepts draft, promising to pay in 60 days, and returns accepted draft to Bank X

5. Bank X advises exporter of L/C

4. Bank I sends L/C to Bank X 10. Bank X sells acceptance to investor

Public Investor

14. Investor presents acceptance and is paid by Bank I 23-25

Government Programs to Help Finance Exports •

Governments of most export­oriented industrialized countries  have special financial institutions that provide some form of  subsidized credit to their own national exporters.

•

These export finance institutions offer terms that are better than  those generally available from the competitive private sector.

•

Thus domestic taxpayers are subsidizing lower financial costs for  foreign buyers in order to create employment and maintain a  technological edge.

•

The most important institutions usually offer export credit  insurance and a government­supported bank for export financing.

23-26

Export Credit Insurance in India • Provided by  Export Credit & Guarantee  Corporation of India (ECGC). • ECGC provides a range of services to  exporters against loss of goods. • Offers guarantees to banks and financial  institutions which are involved in export  financing. • Provided overseas investment insurance  to Indian companies investing abroad. 23-27

EXIM Bank of India Exim Bank of India, provides financial assistance to promote  Indian exports through: 2. Direct financial assistance,  3. Overseas investment finance,  4. Term finance for export production and export development,  5. Pre­shipping credit,  6. Buyer's credit,  7. Lines of credit,  8. Relending facility,  9. Export bills redixcounting,  10. Refinance to commercial banks.  11. The Exim Bank also extends non­founded facility to Indian  exporters in the form of guarantees.  •

23-28

Setting Up EOUs • The Government amended in November 1983 a  concession scheme to facilitate the setting up  of export­oriented units (EOUs) in order to  enable them to meet requirements of foreign  demand in terms of pricing, quality, precision  etc.  • EOUs can be set up anywhere in the country  and may be engaged in the manufacture and  production of software, floriculture,  horticulture, agriculture, aquaculture, animal  husbandry, pisciculture, poultry and sericulture  or other similar activities.  23-29

Marketing Finance from EXIM Bank • Exim Bank seeks to create and enhance export  capabilities and international competitiveness  of Indian companies.  • Under the lending programme for Export  Marketing Finance, the Banks addresses the  term finance reqirement for a structured and  strategic export marketing and development  effort of companies. 

23-30

Trade Financing Alternatives • In order to finance international trade  receivables, firms use the same financing  instruments as they use for domestic trade  receivables, plus a few specialized instruments  that are only available for financing  international trade. • There are short­term financing instruments and  longer­term instruments in addition to the use  of various types of barter to substitute for these  instruments. 23-31

Forfaiting • Forfaiting is a specialized technique to eliminate the  risk of nonpayment by importers in instances where the  importing firm and/or its government is perceived by  the exporter to be too risky for open account credit. • The following exhibit illustrates a typical forfaiting  transaction (involving five parties – importer, exporter,  forfaiter, investor and the importers bank). • The essence of forfaiting is the non­recourse sale by an  exporter of bank­guaranteed promissory notes, bills of  exchange, or similar documents received from an  importer in another country. 23-32

Exhibit 23.10 Typical Forfaiting Transaction Step 1

Exporter

Importer (private firm or government purchaser in emerging market)

(private industrial firm)

Step 2

Step 4

FORFAITER (subsidiary of a European bank)

Step 5

Step 3

Step 6

Investor (institutional or individual)

Importer’s Bank Step 7

(usually a private bank in the importer’s country 23-33

Countertrade • The word countertrade refers to a variety of  international trade arrangements in which goods and  services are exported by a manufacturer with  compensation linked to that manufacturer accepting  imports of other goods and services. • In other words, an export sale is tied by contract to an  import. • The countertrade may take place at the same time as  the original export, in which case credit is not an issue;  or the countertrade may take place later, in which case  financing becomes important. 23-34

International Trade Financing by Commercial Banks in India. •

 Indian commercial banks offer Trade finance related fund needs  for both pre shipment and post shipment activities. 

  3. Various schemes to provide financing to exporters are as follows.             Rupee Export Credit (Pre­Shipment and Post­Shipment)  •  Pre­Shipment Export Credit  •  Post­Shipment Export Credit  •  Pre­Shipment Credit in Foreign Currency (PCFC)  •  Getting Started ­ Opening a PCFC  •  Operating PCFC  •  Export Bill Rediscounting  •  Letter of Credit  4. Various schemes to provide financing to importers are as follows. •  Foreign Currency import credit   •  Supplier's credit   23-35