Financing Of International Trade: Need, Method & Practical Implications
International Trade in today’s world has become extremely intrinsic and has led to rise in the living standards, generating more employment and has also brought in a market wherein the consumers have the option to choose from a vast variety of goods.
The fact of International Trade taking place is not something exclusive to this era, since, the practice has been in place since the earliest civilization where trade used to happen, the key difference being that now the nature of International Trade has become more complex and import and export have also become a key contributor in the GDP of the countries.
Often, questions are posed as to why we need international Trade, why does any sovereign nation want to import or export goods from another sovereign nation. It would be worthwhile to mention here, that, not all nations are blessed with naturally available abundant raw materials, for instance, Oil in Qatar, Congo has diamonds, Butter in New Zealand etc. Therefore, what has become a general practice is that, the nations tend to export more goods which are produced by the abundant use of local factor endowments; and import the goods where resources within the nation are scarce.
Nowadays, International Trade is no more restricted to Government to Government end trade, but has expanded with even the Multi-National Corporations and other private entities disrupting into the trade process now.
Trade cannot take place without money, and most of the entities indulging into trade place heavy reliance on external capital for the purposes of financing costs for numerous business activities like advertising, intermediate input purchases, inventories, payment to the workers and other such costs.
Export activities require incurring of additional upfront expenditures which more or less constrain the companies to look for external finance due to the various stages involved in the export process that require incurring of expenses on duties, freight cost, insurance, trade costs. Moreover, International Trade involves cross border delivery which not only would take a longer time but would also lead to an increase in the requirements of the working capital.
Thus, trade finance is an important aspect when it comes to international Trade and considering the role played by capital in it the governments and various financial institutions have come up with different kinds of instruments to provide trade finance.
For instance, if we look at HSBC Bank, it provides with export finance facilities. These facilities primarily aid the exporter in informing him and also protecting him against the emerging market risks, the assessment thereof. The Bank since has global presence all around the globe, and have trade specialists who help in improving the cash-flow, managing risks associated with international trade even more effectively. These kind of instruments thus, are tailor-made for the needs and in a manner best suited to the exporters.
Trade Finance primarily has two purposes to serve; firstly, it acts as a source for providing working capital which is of utmost need for traders and other companies involved therein that require liquid assets; secondly, it also provides protection in the form of credit insurance against various prevalent risks like political risks, currency fluctuations and other trade risks.
When it comes to trade finance, the financial managers involved therein responsible for providing measures of financing trade have to make sure to use such instruments/methods, the deployment of which would in effect maximize the value of an MNC.
Mostly, banks of the nations or the destinations where trade is taking place are involved in the trade financing activities. Generally, as the practice is, the banks towards both the sides of the trade transaction, i.e., the exporter and the importer’s side play a major role in the financing of trade taking place therein. There are various methods through which the trade specialists help in financing trade. The most popular ones being;
Accounts Receivable Financing; this is a kind of an asset financing arrangement wherein the company (or exporter in the present case) uses it’s outstanding money or invoices owed by the customer to them for the purpose of securing loan from the bank.
Thus, there may be times, when the customer of the exporter pay the invoices in 30 to 60 days, however, in order to continue with their export and to incur expenses therein the exporter requires capital, thus, it is in these kinds of situations that the exporter can seek loan from the bank by the assignment of the amounts receivables. In this situation, the bank makes a loan to the exporter based on the exporter’s creditworthiness in the eyes of the bank. However, this method although fosters the exporter in carrying out his trade activities uninterruptedly, but at the same time since there is absence of any assurance regarding the payment from the customer’s end, the exporter is always at risk of not receiving any payment from the exporter. The exporter, even though is not assured of payments, is still bound to repay the loan to the bank.
There is presence of further additional risks like the government imposing restrictions and exchange restraints which may further hinder completion of payment from the customer’s side to the exporter. As a consequence thereof, the rate at which the bank provides the loan is often higher than the domestic rates prevalent in the account receivable financing. Further, since there are risks pertaining to currency fluctuations, government restrictions, which are generally beyond the control of the parties, there is an additional requirement to obtain credit insurance as a safety measure prior to financing foreign receivables.
Another method is that of Factoring, under this method the exporter (or business as used in this context in common parlance) sells its receivables, invoices to a third party, who is called a “factor”. This selling/assignment to the factor enables him to collect the payments on behalf of the exporter from the business’s customers. Factoring is beneficial to the exporter in several ways. As first, this act of selling/assignment relieves the exporter of the administrative duties involved therein for maintaining and monitoring the account receivables for the purposes of accounting ledger. Secondly, by such assignment the entire credit exposure is given to the factor and the exporter therefore, is relieved from taking efforts to assess the creditworthiness of the foreign buyer as the task is assigned to the factor. Thirdly, this sale to the factor, enables and improves the cash flow of the exporter as he obtained immediate payment from the factor upon such selling/assignment.
The factor here, since pays money to the exporter, is therefore dependent on the import buyer for repayment to the factor which places the responsibility of assessment of credit risk on the factor. Thus, in order for the factor to ensure that the importer is creditworthy, cross border factoring is often put to use. The factor of the exporter contacts a corresponding factor in the buyer/importer’s country to assess the creditworthiness of the importer and also the consequent handling of receivables.
These factoring services are generally provided by commercial banks or commercial finance companies set up for these purposes having factoring subsidiaries. Export credit insurance is usually obtained by these factors in order to mitigate the risks arising due to foreign receivables.
The next method used is that of Letters of Credit. These Letter of Credit (L/C) is generally found to be beneficial and affords protection to both the buyer as well as the exporter, which is primary for international trade transactions. The Letter of Credit basically is an undertaking from a bank, wherein the bank undertakes to make payments on behalf of one party (involved in the trade transaction) to another party being the beneficiary, under the specified conditions, generally upon fulfillment of specified conditions. The process of making payment by way of a Letter of Credit , generally works in a manner that the beneficiary therein (exporter) gets paid after presenting the specified documents in accordance with and as required in the terms of the Letter of Credit. The payment method by way of Letter of Credit involves two banks generally, one bank each in each party’s country, i.e., the exporter’s bank and the bank of the importer. The issuing bank substitutes its credit for the importer. The reason for wide usage of the Letter of Credit lies in the fact that it more or less provides a guarantee of payment to the exporter, provided there is proper compliance with the terms and conditions of the Letter of Credit.
One problem that generally arises in this process is the lack of ability to trust. Now, there might be a case that the exporter is skeptical in trusting the importer’s bank, and this is very genuine also, since, the importer’s bank is situated in a foreign country and the exporter getting apprehensive in trusting this bank located in a foreign country is very normal. Even in cases, where the issuing bank is a well known bank all over the world, there still remain chances that by virtue of being in different country, that particular government may impose certain restrictions which may hamper the payment process in favor of the exporter, thereby causing loss to the exporter. Thus, the exporter due to these apprehensions may even request a local bank to confirm the Letter of Credit, thereby assuring the exporter that all the responsibilities/obligations of the issuing bank would be duly met. In such a situation, the confirming bank gets obligated to honor the drawings therein made by the beneficiary in accordance/ compliance with the terms of the Letter of Credit irrespective of the ability of the issuing bank to be able to make the payment or not.
Generally, the Trade related Letters of credit are also termed as Commercial letter of credit or export/import letters of credit. Basically, there are two types of letters of credit, one being revocable and the other one being irrevocable. The revocable letter of credit may be cancelled or be revoked at anytime without any prior notice to the beneficiary. On the other hand, an irrevocable letter of credit cannot be so amended or cancelled without the consent of the beneficiary. The bank which issues the Letter of Credit is known as the issuing bank. The corresponding bank located in the country of the beneficiary to which this issuing bank send the letter of credit so issued is referred to as the advising bank. An irrevocable letter of credit creates an obligation on the issuing bank to honor all the drawings drawn thereto in accordance with the terms of the letter of credit. The International Chamber of Commerce issues the “Uniform Customs and Practice for Documentary Credits” which contain provisions governing the issuance of the letter of credit, and the letters of credit are usually issued in compliance with these provisions also.
The bank that issues the letter of credit makes the payment after the requisite documentation is presented to it with full compliance with the terms and conditions of the letter of credit. The importer is required to make payment to the issuing bank of the amount mentioned in the letter of credit with the addition of the fee so accrued in obtaining the letter of credit. The general practice followed is that the importer usually has an account opened with the issuing bank which is to be drawn upon for payment, in order to prevent the issuing bank from tieing its own funds. Surprisingly, even if the importer does not have enough/sufficient funds in the account, still, the issuing bank is under an obligation to honor the drawings so made against the letter of credit. This, is the reason that the importer’s creditworthiness is ascertained and analysed before the bank issues a letter of credit in order to protect itself from such situations. The importer in such circumstances is obligated to repay to the bank both the principal amount and also the amount of interest at the time of maturity. All these measures have been devised and put to use for the purposes of providing an extended payment term to the buyer when their is an insistence from the exporter’s side to make the payment at sight.
The bank which issued the letter of credit has to make payment to the beneficiary once, all the documents as required by the terms of the Letter of credit have been presented before the bank. There is an option for payment by way of letters of credit. It can either be made at sight or on a specified future date. The documents that comprise a Letter of Credit generally are a collation of a draft, a bill of lading and a commercial invoice. Rest, depending on the terms of the agreement, country or the product or other documents (like the inspection certificate, packing list, certificate of origin or even the insurance certificate) may also be required.