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Chapter 22
International Trade Finance
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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.
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The Trade Relationship
• The nature of the relationship between the exporter and the importer is critical to understanding the methods for import-export financing utilized in industry.
• There are three categories of relationships (see next exhibit):
– Unaffiliated unknown
– Unaffiliated known
– Affiliated (sometimes referred to as intra-firm trade)
• The composition of global trade has changed dramatically over the past few decades, moving from transactions between unaffiliated parties to affiliated transactions.
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Exhibit 22.1 Financing Trade: The Flow of Goods and Funds
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Exhibit 22.2 Alternative International Trade Relationships
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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)
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Exhibit 22.3 The Mechanics of Import and Export
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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.
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Exhibit 22.4 The Bank as the Import-Export Intermediary
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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
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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 non-completion (timely and complete payment).
• The risk of default on the part of the importer is present as soon as the financing period begins.
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Exhibit 22.5 The Trade Transaction Timeline and Structure
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Key Documents: 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.
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Exhibit 22.6 Parties to a Letter of Credit (L/C)
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Key Documents: Letter of Credit (L/C)
• A letter of credit (L/C) is a bank’s promise to pay issued by a bank at the request of an importer (the applicant/buyer), in which the bank promises to pay an exporter (the beneficiary of the letter) upon presentation of the 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 essence of an L/C is the promise of the issuing bank to pay against specified documents, which must accompany any draft drawn against the credit.
• The L/C is not a guarantee of the underlying commercial transaction, but rather a separate transaction from any sales or other contracts on which it might be based.
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Key Documents: 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.
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Exhibit 22.7 Essence of a Letter of Credit (L/C)
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Key Documents: 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.
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Key Documents: 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.
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Key Documents: 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.
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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.
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Exhibit 22.8 Steps in a Typical Trade Transaction
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Government Programs to Help Finance Exports
• Governments of most export-oriented 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 government-supported bank for export financing.
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Government Programs to Help Finance Exports
• The exporter who insists on cash or L/C payment for foreign shipments is likely to lose orders to competitors from other countries that provide more favorable credit terms.
• Competition between nations to increase exports by lengthening the period for which credit transactions can be insured my lead to a credit war and to unsound credit decisions.
• In the United States, export credit insurance is provided by the Foreign Credit Insurance Association (FCIA), an unincorporated association of private commercial insurance companies operating in cooperation with the Export-Import Bank.
• The Export-Import Bank of the U.S. (Eximbank) is another important agency of the U.S. Government established to facilitate the foreign trade of the United States.
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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 short-term financing instruments and longer-term instruments in addition to the use of various types of barter to substitute for these instruments.
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Trade Financing Alternatives
• Some of the shorter term financing instruments include:
– Bankers Acceptances
– Trade Acceptances
– Factoring
– Securitization
– Bank Credit Lines Covered by Export Credit Insurance
– Commercial Paper
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Forfaiting
• Forfaiting is a longer term financing instrument.
• 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 non-recourse sale by an exporter of bank-guaranteed promissory notes, bills of exchange, or similar documents received from an importer in another country.
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Exhibit 22.10 Typical Forfaiting Transaction
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Mini-Case Questions: Crosswell
• How are pricing, currency of denomination, and financing interrelated in the value chain for Crossewll’s penetration of the Brazilian market? Can you summarize them using Exhibit B?
• How important is Sousa to the value chain of Crosswell? What worries might Crosswell have regarding Sousa’s ability to fulfill his obligations?
• If Crosswell is to penetrate the market, some way of reducing its prices will be required. What do you suggest?
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Additional Chapter Exhibits
Chapter 22
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Exhibit 22.9 Instruments for Financing Short-Term Domestic and InternationalTrade Receivables
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Exhibit 1 Export Pricing for the Precious Diaper Line to Brazil
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Exhibit 2 Export Payment Terms on Crosswell’s Export to Brazil
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Exhibit 3 Competitive Diaper Prices in the Brazilian Market (in Brazilian Reais)