33 Financing International Trade

Dr. Savita

1. Learning Objective

After completing this module, you will be able to:

i. Understand the meaning and concept of Financing International Trade

ii. Know about the role of commercial banks in Financing International Trade, and

iii. Understand various instruments of financing international trade

2. INTRODUCTION

International trade transactions involve at least two parties; i.e., seller (exporter) and buyer (importer). The nature of international transaction is altogether different from domestic trade in respect of payment, delivery and maturity. For example, both importer and exporter being resident of different countries, they are living- top far to each other, speaking different languages, living in different political environment. using different currencies, having different culture and religion etc. Further, they both know that they have different standard of honouring obligations to each other. In case of default, the other party will have a hard time catching up to seek redress. Hence, foreign trade transactions involve more risk in comparison to home trade. Since due to long distance, it is not possible to simultaneously handover goods with one hand and accept payment with the other, the importer would prefer the following:

If this is done, then all risk is shifted to the exporter, which he may not agree. The exporter would like the opposite of this. Being stranger to each other, (importer and exporter) and unwilling to trust a stranger, the problem would be solved by using a highly respected bank as intermediary.

In that situation the importer obtains the bank’s promise to pay on his behalf, knowing the exporter will trust the bank then the exporter ships the goods to the importer’s country. Title of the goods is given to the bank on a document. The exporter asks the bank to pay for the goods to the importer’s country. Title of the goods is given to the bank on a document.

The exporter asks the bank to pay for the goods and the bank does so. After that the bank, having paid for the goods, now passes title to the importer whom the bank trusts. The importer reimburses the bank. In brief, it is observed that a strong exporter can finance the entire trade from his own funds by extending credit until the importer pays in cash. Alternatively, the importer can finance the entire by paying cash in advance to the exporter. However due to risk factors, some in between approach is followed, i.e., involving one or more financial intermediaries.

3. ROLE OF COMMERCIAL BANKS IN FINANCING INTERNATIONAL TRADE

Commercial banks play a pivotal role in the development of international trade. Without commercial banks, the international finance and import-export industry would not exist. Commercial banks make possible the reliable transfer of funds and translation of business practices between different countries and different customs all over the world. The global nature of commercial banking also makes possible the distribution of valuable economic and business information among customers and the capital markets of all countries. Commercial banking also serves as a worldwide barometer of economic health and business trends. The following instruments are offered by commercial banks for meeting the requirements of importers and exporters:

1. Letter of Credit (L/C)

Letter of Credit is an instrument issued by a bank at the request of the importer, in which the bank promises to pay a particular sum of amount to beneficiary presenting specified document in the letter of credit. Letter of credit is also known as “Commercial Letter of Credit”, a Documentary Letter of Credit; or simply a Credit. It means letter of credit reduces the risk of non-completion of the transaction.

Essence of the agreement

The L/C is a letter addressed to the seller written and signed by a bank acting on behalf of the buyer. The essence of L/C is the promise by a bank to pay against specific documents which must a company any draft drawn against the credit. The letter of credit is not a guarantee of the underlying transaction between a bank and a designated beneficiary and separate from the commercial transaction. For a true L/C, following elements must be present with respect to the issuing bank.

The bank must receive a fee for issuing the letter of credit.
L/C must contain a specified expiration date or a definite maturity.
The L/C must specify stated maximum amount of money to pay.
Bank’s obligation must arise only on presentation of specified documents.
The customer’s (Importer) unqualified obligation to reimburse the bank on the same condition as the bank has paid.

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Types of Letter of Credit

The following are various types of letter of credit:

i) Revocable Letter of Credit

A revocable letter of credit may be revoked or modified for any reason, at any time by the issuing bank without notification. It is rarely used in international trade and not considered satisfactory for the exporters but has an advantage over that of the importers and the issuing bank. There is no provision for confirming revocable credits as per terms of UCPDC, hence they cannot be confirmed. It should be indicated in L/C that the credit is revocable. if there is no such indication the credit will be deemed as irrevocable.

ii) Irrevocable Letter of Credit

In this case it is not possible to revoked or amended a credit without the agreement of the issuing bank, the confirming bank, and the beneficiary. Form an exporters point of view it is believed to be more beneficial. An irrevocable letter of credit from the issuing bank insures the beneficiary that if the required documents are presented and the terms and conditions are complied with, payment will be made.

iii) Confirmed Letter of Credit

Confirmed Letter of Credit is a special type of L/C in which another bank apart from the issuing bank has added its guarantee. Although, the cost of confirming by two banks makes it costlier, this type of L/C is more beneficial for the beneficiary as it doubles the guarantee.

iv) Sight Credit and Usance Credit

Sight credit states that the payments would be made by the issuing bank at sight, on demand or on presentation. In case of Usance credit, draft is drawn on the issuing bank or the correspondent bank at specified Usance period. The credit will indicate whether the Usance drafts are to be drawn on the issuing bank or in the case of confirmed credit on the confirming bank.

v) Back to Back Letter of Credit

Back to Back Letter of Credit is also termed as Countervailing Credit. A credit is known as back to back credit when a L/Cis opened with security of another L/C. A back to back credit which can also be referred as credit and counter credit is actually a method of financing both sides of a transaction in which a middleman buys goods from one customer and sells them to another. The parties to a Back to Back Letter of Credit are:

1) The buyer and his bank as the issuer of the original Letter of Credit.

2) The seller/manufacturer and his bank,

3) The manufacturer’s subcontractor and his bank.

vi) Transferable Letter of Credit

A transferable documentary credit is a type of credit under which the first beneficiary which is usually a middleman may request the nominated bank to transfer credit in whole or in part to the second beneficiary. The L/C does state clearly mentions the margins of the first beneficiary and unless it is specified the L/C cannot be treated as transferable. It can only be used when the company is selling the product of a third party and the proper care has to be taken about the exit policy for the money transactions that take place.

This type of L/C is used in the companies that act as a middle man during the transaction but don’t have large limit. In the transferable L/C there is a right to substitute the invoice and the whole value can be transferred to a second beneficiary. The first beneficiary or middleman has rights to change the following terms and conditions of the letter of credit:

Reduce the amount of the credit.
Reduce unit price if it is stated
Make shorter the expiry date of the letter of credit.
Make shorter the last date for presentation of documents.
Make shorter the period for shipment of goods.
Increase the amount of the cover or percentage for which insurance cover must be effected.
Substitute the name of the applicant (the middleman) for that of the first beneficiary (the buyer).

2. The Draft

Commonly used in international trade ‘a draft’ is also called a bill of exchange (B/E) or ‘First of exchange’. It is unconditional order written by an exporter (seller) instructing an importer (buyer) or his agent to pay a specified amount of money at a specified time. A draft can become a negotiable instrument if the following requirements are fulfilled.

1) It must be in writing and signed by the maker or drawer or originator.

2) It must contain an unconditional promise to pay.

3) Amount must be specified and certain to pay

4) It must be payable on demand or at a definite future date.

5) It must be payable on demand to order or to bearer.

In brief, there are usually three parties to a draft; one who signs and sends the draft to second called the drawee; payment is made to the third party the payee. Normally the drawer and the payee may be the same person. Drafts are of two types: sight draft and time drafts. A sight draft is payable on presentation to the drawee. It means the drawee must pay at once or dishonour the draft. On the other hand, when drafts are payable at specified future date, and as such become a useful financing device. It is also known as ‘Usance’ or ‘Tenor’ draft. When a time draft is drawn on and accepted by a bank, it becomes a banker’s acceptance. If the draft is drawn on and as accepted by business fulfill, then it becomes a trade acceptance. Further a draft can be clean or documentary. A clean draft is that draft which is not accompanied by any paper and normally is used in non-trade remittances. A documentary draft is accompanied by documents that are to be delivered to the drawee on payment or acceptance of the draft. Normally these documents include the bill of lading in negotiable form, the commercial invoice, the consular invoice and insurance certificate etc.

3. Bill of Lading

Another important document in international trade is the ‘bill of lading’ (B/L). The bill of lading is issued to the exporter by a common carrier transporting the goods (merchandise). It serves three purposes such as a receipt, a contract and a document of title.

(1) As a receipt.

The bill of lading indicates that carrier (transporter) has received the goods from the exporter described on the face of document. Usually the carrier is not responsible for ascertaining that the containers hold what is alleged to be their contents. So description of goods on the bill of lading is usually short and simple.

(2) As a Contract

The bill of lading describes the contract between the carrier and exporter in which the former agrees to carry the goods from port of shipment to port of destination in return for certain charges.

(3) As a document of title.

The bill of lading is used to obtain payment or a written promise of payment before the goods are released to the importer. It is also used as collateral against which funds may be advanced to the exporter by its local banker.

A bill of lading can be either straight or to order. Former consigns the goods to a specific party normally the importer, and is not negotiable. Since the title cannot be transferred to third party in this, hence, it is not good collateral or title, and is used only when no financing is involved under an order bill of lading; the goods can be consigned to the order of a named party, usually the exporter. In this way, the exporter retains title until it endorses the B/L on the reverse side.

4. OTHER TECHNIQUES OF FINANCING OF INTERNATIONAL TRADE

The following are the other important techniques which are available to MNCs for financing their trade:

1. Bankers’ Acceptances (B/A)

Bankers’ acceptance is an important method of assisting international trade in which a banker accepts ‘the time draft’ drawn on it by the exporter. By accepting the draft, the bank makes an unconditional promise to pay the holder of the draft a stated amount on a specified date. In this way, by accepting the draft, it creates a negotiable instrument which is freely traded in the money market.

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Mechanism of the Banker’s acceptance

Important steps which are taken in creating the banker’s acceptance have been discussed here in brief:

Firstly, an importer of merchandise seeks credit to finance its purchase until the goods can be resold. For this purpose, he requests the banker (home country) to issue a letter of credit on its behalf, authorising the foreign exporter to draw a ‘time draft’ on the bank in payment for the goods.
Secondly, after getting the authorisation from the importers’ bank then the exporter ships the goods on an order bill of lading (B/L) made out to itself and presents a time draft and the endorsed documents to its banker (exporter country bank).
Thirdly, the exporter’s bank, after that sends all these documents to the importer’s bank.

Documents include the time draft, shipping documents, etc. The importer’s bank then accepts the draft, and thus, creates a banker’s acceptance and sends back to the exporter’s banker

Fourthly, the exporter discounts the draft with the accepting bank, and receives payment for the ‘shipment.
Fifthly, the shipping documents are delivered to the importer and the importer may now claim the shipment.
Sixthly, the accepting bank may now either buy (discount) the banker’s acceptance (B/ A) and hold it in its own portfolio investment or sell (rediscount) the B/ A in the money market.

The maturities of bankers’ acceptances vary and normally range from 30 days to 180 days with the average being 90 days. Maturities should cover the entire period needed to ship and dispose of the goods financed. On the maturity date, the accepting bank will pay the current holder the stated amount on the draft. The holder of B/A can recover his full amount from the last endorser in case the importer is not willing to pay at maturity. Authenticity of B/ A is separated from the underlying transaction and that B / A is not dishonoured for reason of a dispute between the exporter and the importer. As a result, this factor enhances marketability of B/ A and reduce its riskiness.

2. Discounting

As we have seen that the trade draft has been accepted by the importer’s bank, then draft takes the shape of Banker’s acceptance. Even if a trade draft is not accepted by a bank, the exporter can still convert the trade draft into cash by means of ‘discounting’. Hence, discounting is another technique of getting funds other than from the importer’s bank like financial institutions, or other banks. The exporter gets the amounts of the draft less interest and commission on the same. Normally the shipping documents and other papers are duly insured from a insurance agency against both commercial and political risks. In case of losses, the insures will reimburse the exporter or any other financial institution to which the exportee transfers the draft.

The discount rate on these papers is normally lower to interest rate on over-draft facilities, bank loans and other funding techniques. This is partly due to government’s policy to promote exporters. The discounting can be of two types like with-recourse and without recourse. In case of with recourse, the discounting bank ‘can collect from the exporter if the importer fails to pay on the maturity whereas in non-recourse, the bank bears the collection risk of the draft.

3. Factoring

Factoring is another important technique of financing foreign trade. In this technique, the firm or exporters sell their accounts receivables to the ‘Factor’ at a discount to enhance the liquidity. By issuing a factor, a firm can ensure that its terms are in accord with the local practice and are competitive. Usually, under factoring customers can be offered payment on open account rather than being asked for a letter of credit or stiffer credit requirements.

Factoring can be with recourse and non-recourse. In with recourse factoring, the exporter assumes the risks if the debtors do not make payment to the factor whereas in non-recourse factoring, the factor assumes all the credit and political risks except for those involving dispute between the transaction parties. Most factoring in practice is done on the basis of non-recourse. Factor charges a fee for his service rendered to the exporter. This fee is decided on an individual company basis and is normally related to the annual turnover. In general this fee varies from 1.75% to 2% of sales.

4. Forfaiting

Forfaiting is another specialised factoring technique used in the case of extreme credit risk. In the field of export financing when the accounts receivable of an exporter are factored whereby the exporter gives up the right to receive payment in favour of forfaiter the transaction is known as forfaiting. In other words, forfaiting is normally without recourse which is discounting of medium term export receivable denominated in fully convertible currencies like US dollar, Swiss, Franc, Pound, deutsche mark etc. This technique is used normally in capital goods exports with a five year maturity and repayments in semi-annual instalments. The forfaiting fee is set at a fixed rate, normally 1.25 percent above London inter-bank rate (LIBOR) or local cost of funds. This technique is very much popular in western countries.

5. Institutional Financing

In export financing, most of the governments of developed and non-developed countries have attempted to provide their domestic exporters with a competitive edge in the form of low-cost assistance and concessionary rates on political and economic risk insurance. Normally government itself or through any agency like export-import bank and other financial institutions provide financial assistance to the exporters. This assistance is normally classified into two categories, i.e., Pre-shipment credit and Post shipment credit.

SUMMARY

In this module we have learnt that about various financing instruments used international trade. As we have discussed commercial banks play a pivotal role in financing International Trade. Without commercial banks, the international finance and import-export industry would not exist. Commercial banks make possible the reliable transfer of funds and translation of business practices between different countries and different customs all over the world. The global nature of commercial banking also makes possible the distribution of valuable economic and business information among customers and the capital markets of all countries. Commercial banking also serves as a worldwide barometer of economic health and business trends. Letter of Credit, Bill of lading, Banker’s Acceptance, Discounting, Draft, Factoring, Forfaiting etc., are some of the instruments discussed in this module, which are used for financing international trade transactions. In export financing, most of the governments of developed and non ¬developed countries have attempted to provide their domestic exporters with a competitive edge in the form of low-cost assistance and concessionary rates. This assistance is normally classified into two categories, i.e., Pre-shipment credit and Post shipment credit.

Suggested Readings:

Levi MauriceD. (2009). International Finance. Routledge.
Conklin David w. (2011). The Global Environment of Business. Sage Publications.
Mithani D M. (2009). Economics of Global Trade and Finance. Himalaya Publishing House New Delhi.
Cherunilam Francis (2011). International Business Environment. Himalaya Publishing House, New Delhi.
Saleem Shaikh (2010). Business Environment. Pearson Education, New Delhi.
Sundharam K.P.M. and Datt Ruddar (2010). Indian Economy, S. Chand & Sons, New Delhi.
Sharan Vyptakesh (2003). International Business: Concept, Environment and Strategy. Pearson Education, New Delhi
Cullen. (2010). International Business. Routledge.
Bennett Roger (2011). International Business. Pearson Education, New Delhi
Paul Justin (2010). Business Environment-Text and Cases. Tata McGraw Hill, New Delhi.
Cherunilam Francis (2010). International Business. Prentice Hall of India Private Limited. New Delhi.
Cherunilam Francis (2013). Global Economy and Business Environment. Himalaya Publishing House, New Delhi.