Chapter 23 International Trade Finance. Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 23-2 The Trade Relationship Trade financing shares

Chapter 23

International Trade Finance

Copyright © 2004 Pearson Addison-Wesley. All rights reserved. 23-2

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.


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 23.1 Alternative International Trade Relationships

UnaffiliatedKnown Party

A long-term customerwith which there is an

established relationship oftrust and performance

UnaffiliatedUnknown Party

A new customer which with exporter hasno historical business

relationship

AffiliatedParty

A foreign subsidiaryor affiliateof exporter

Requires:1. A contract2. Protection against non-payment

Requires:1. No contract2. No protection against non-payment

Requires:1. A contract2. Possibly some protection against non-payment

Exporter

Importer is ….


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 23.2 The Mechanics of Import and Export

Importer

Importer

Exporter

Exporter

Importer Preference

Exporter Preference

1st: Exporter ships the goods

2nd: Importer pays after goods received

1st: Importer pays for goods

2nd: Exporter ships the goods after being paid


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 23.3 The Bank as the Import/Export Intermediary

Importer

Exporter

Bank

1st: Importer obtains bank’s promise to pay on importer’s behalf.

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

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

4th: Bank pays the exporter.

6th: Importer pays the bank.

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


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


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



• 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



• 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


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.


Exhibit 23.4 The Trade Transaction Time-Line and Structure

Time and Events

Pricequoterequest

Exportcontractsigned

Goodsare shipped

Documentsareaccepted

Goodsare received

Negotiations Backlog

Documents ArePresented

Cash settlementof the transaction

Financing Period


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

Issuing Bank

Beneficiary(exporter)

Applicant(importer)

The relationship between the importer and theexporter is governed by the sales contract.

The relationship between theimporter and the issuing bank isgoverned by the terms of theapplication and agreementfor the letter of credit (L/C).

The relationship between theissuing bank and the exporteris governed by the terms of theletter of credit, as issued bythat bank.



• 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



• 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.


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

Bank of the East, Ltd.[Name of Issuing Bank]

Date: September 18, 2003L/C Number 123456

Bank of the East, Ltd. hereby issues this irrevocable documentary Letter of Creditto 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. Commercial invoice in triplicate2. Packing list3. Clean on board order bill of lading4. Insurance documents, paid for by buyer

At maturity Bank of the East, Ltd. will pay the face amount of the draft to thebearer of that draft.

Authorized Signature


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.


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.


Exhibit 23.7 Essence of a Time Draft

Name of Exporter

Date: October 10, 2003Draft number 7890

Ninety (90) days after sight of this First of Exchange, pay to the order of Bankof 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


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.


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 23.8 Steps in a Typical Trade Transaction

Exporter

Bank X Bank I

Importer

PublicInvestor

1. Importer orders goods

2. Exporter agrees to fill order

6. Exporter ships goods to Importer

4. Bank I sends L/C to Bank X

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

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

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

3. Importer arranges L/C with its bank

13. Importer pays its bank

8. Bank X presents draft and documents to Bank I

5. Bank X advises exporter of L/C 10. Bank X sells

acceptance to investor14. Investor presents acceptance and is paid by Bank I

11. Bank X pays exporter


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.


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.


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 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 23.10 Typical Forfaiting Transaction

Exporter(private industrial firm)

Importer(private firm or governmentpurchaser in emerging market)

FORFAITER(subsidiary of aEuropean bank)

Importer’s Bank(usually a private bank inthe importer’s country

Investor(institutional or individual)

Step 1

Step 3

Step 2

Step 7

Step 5

Step 4

Step 6


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.