Trade Financing

Gargi Sanati NIBM_PGPBF, 2011

Why Financing International Trade?

International commercial transaction is similar to the domestic commercial transaction from the credit aspect, except certain risks like counter party risk, country risk (exchange rate risk, political risk and financial risk)

To facilitate the major agents (exporter, importer and bank) international trade financing has come up with different payment options along with some structured products

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 The challenge associated with it Complicated for a number of reasons: the time taken by the voyage, the hazards of the loss/damage of goods in transit, customs formalities in both exporters and importers countries import/export and exchange control regulations
The major risk associated with it The time of realization of export proceeds is different than the contract of sales established between buyer and seller, along with the payment period exposed to the risk of Exchange Rate Fluctuation Possible solutions? Other risk associated counter party risk and country risk

Regulatory Framework
There are two regulatory bodies of GOI for monitoring foreign exchange Transactions
Ministry of Commerce
Indirectly operates via DGFT
Foreign Trade Policy Handbook of Rules and Procedures (volume I & II) ITC HS Code ( unique product code No: uniform in the world assigned to each product, which are traded internationally.) IEC no (customer code assigned to importer and exporter.)

Ministry of Finance
Monitors the financial/remittance aspect of an international transaction Indirectly operates via RBI, Customs, Enforcement Directorate

Inspection of the Goods before Shipment Cultural and Language Difference

According to the Contracts for the Sale of International goods (CSIG) the General Rule for the Inspection of the goods before shipment is that If the parties have agreed that the buyer is entitled to inspect the goods before shipment, the seller must notify the buyer within a reasonable time before the shipment that the goods are ready for inspection at the agreed place.

Case 1:
An Australian importer of clothing recounts the following story: He had ordered custom shipment of 5000 rugby shirts from a foreign supplier. He requested a sample shirt to test the cotton content in the fabric. He cut off one of the sleeves of the shirt at the elbow, extracted a few fibres and tested them. Satisfied, he returned the shirt with the notation: ok send shipment as agreed Several months later he received an irate call from a major clothing distributor, to whom the shipment had been sent directly. The client had received 5000 rugby shirts each missing one sleeve!
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Parties in International Trade Finance

a) Exporter and Importer In documentary credit the seller/exporter is alternatively referred to as: Beneficiary because it is the seller who receives payment from the letter of credit. Shipper because the seller ships the goods. Consignor again, because the seller ships the goods sometimes referred to as consignment in international transport The buyer/importer is alternatively referred to as : Opener because the importer opens the credit to begin the process. Applicant because the importer must begin the process by submitting a credit application to a bank. Account party because the importers application to open a credit creates an account relationship with the issuing bank, and is supervised by an account officer.

Payment Methods
Principal Payment Methods Advanced Payment Open Account and Consignment sale Documentary Collection/Bills for collection Documentary Credit/ Letters of Credit (LCs)

With each of these methods, risk and security levels of both importer and exporter vary. Depending upon the bargaining power of buyers and sellers, their convenience, requirements, conventions, regulatory framework and sophistication, many forms of payment settlement have emerged. Maximum transactions of international trade do not happen through L/C transactions. Why?

Prepayment or Advance Payment

Under the prepayment method, the exporter will not ship the goods until the buyer has remitted payment to the exporter. Riskiest proposal for the importer
Credit rating of the seller may be called for ?

Exporter insists for advance payment

If he is the only seller monopoly situation is doubtful about the importer who is the first time buyer whose creditworthiness is unknown. or whose countries are in financial difficulty because of financial, economical and political risk.

This method affords the supplier the greatest degree of protection. Most buyers, however, are not willing to bear all the risk by prepaying an order. Many a times the advance is paid partly.

Open Account
Buyers market Exporter dispatches goods directly to importer on an agreement of payment on later date. Payment made after the goods are sold by the buyer Risk of non payment fully lies with exporter Legal remedies to enforce payment is very difficult No bank finance involved Cheapest method of payment receiving Take place usually among subsidiary-parent companies, Creditworthy buyers or buyers with long standing trade relationship. Also, when buyer has the monopsony power and would like to execute it. Despite the risks involved, open account transactions are widely utilized, particularly among the industrialized countries in North America and Europe.

Documentary Collection
It is an operation in which a bank channelizes documents between exporter and importer. Most trade transactions handled on a draft basis are processed through banking channels. In banking terminology, they are known as documentary collections.
Two types of collection
Collection under Documents against Payment Collection under Documents against Acceptance Advantage Over Open Account Sellers bank acts as sellers agent Buyers bank/subsidiary of sellers bank acts as buyers agent Governed by the ICC Uniform Rules for Collections From the sellers point of view if the seller needs to take action against non-payment they can take legal action From the buyers point of view payment is made only after the goods have been received

Draft
A draft (or bill of exchange) is a promise drawn by the exporter, instructing the buyer to pay the face amount of the draft upon presentation. The draft represents the exporters formal demand for payment from the buyer. A draft affords the exporter less protection than an L/C, since the banks are not obligated to honor payments on the buyers behalf. In a documentary collection transaction, banks on both ends act as intermediaries in the processing of shipping documents and the collection of payment. They do not give any guarantee of payment or of performance on the part of the seller or the buyer.

Documents against Payment (D/P)

Documents against Payment (D/P) - If shipment is made under a sight draft, the collecting bank is instructed to deliver documents only against the payment for the goods. It is a practice that provides the exporter with some protection, since the banks will release the shipping documents only according to the exporters instructions. The buyer needs the shipping documents to pick up merchandise. If the goods are not at per the ordered quality importer would lose as payment is already made. If for any reason, the collecting bank overlooks these instructions and delivers documents before getting paid it faces the risk of having to recompense the seller for loss.

Document against Acceptance (D/A)

If a shipment is made under a time draft, the exporter provides instructions to the buyers bank to release shipping documents against acceptance (signing) of the draft. This method of payment is sometimes referred to as documents against acceptance. By accepting the draft, the buyer is promising to pay the exporter at the specified future date. In this type of transaction, the buyer is able to obtain the merchandise prior to paying for it. It is the buyers responsibility to honor the draft at maturity. In this case, the exporter is providing the financing and is dependent upon the buyers financial integrity to pay the draft at maturity. Shipping on a time draft basis provides some added comfort in that banks at both ends are used as collection agents. The added risk is that the buyer fails to pay the draft at maturity; the bank is not obligated to honor payment. The exporter is assuming all the risk and must analyze the buyer accordingly. Sometimes after checking goods importer refuses to pay, so seller may have to arrange some other customer in the same country or in different country.

Consignment
Under a consignment arrangement, the exporter ships the goods to the importer while still retaining actual title to the merchandise. The importer has access to the inventory but does not have to pay for the goods until they have been sold to a third party. The exporter is trusting the importer to remit payment for the goods sold at that time. If the importer fails to pay, the exporter has limited recourse since there is no draft involved and the goods have already been sold. As a result of the high risk, the consignment method is seldom used except affiliated and subsidiary companies trading with the parent company. Some equipment suppliers allow importers to hold some equipment on the sales floor as demonstrator models. Once the models are sold or after a specified period, payment is sent to the supplier.

Letter of Credit
A letter of Credit (L/C) is an instrument issued by a bank on behalf of the importer (buyer) promising to pay the exporter (beneficiary) upon presentation of shipping documents in compliance with the terms stipulated therein. In effect, the bank is substituting its credit for that of the buyer. The exporter is assured of receiving payment from the issuing bank as long as it presents documents in accordance with the L/C. It is important to point out that the issuing bank is obligated to honor drawings under the L/C regardless of the buyers ability or willingness to pay. On the other hand, the importer does not have to pay for the goods until shipment has been made and documents are presented in good order. However, the importer must still rely upon the exporter to ship the goods as described in the documents, since the L/C does not guarantee that the goods purchased will be those invoiced and shipped.

A Comparison
Method Risk to Exporter Risk to importer

Prepayment

None

Relies completely on exporter to ship goods as ordered

Letter of credit

Very little or none, Assured shipment made, but depending on credit terms relies on exporter to ship goods described in documents

Sight draft; documents If draft unpaid, must dispose Same as above unless importer against payment of goods can inspect goods before payment

Time draft; documents Relies on buyer to pay drafts Same as above against acceptance

Consignment

Allows importer to sell None; improves cash flow of inventory before paying buyer exporter Relies completely on buyer to None pay account as agreed

Open account

Basic Terminology: International Chamber of Commerces (ICC) Uniform Custom Practice (UCP)

Payment With and Without Recourse Without Recourse Payment represents a cessation of legal obligations, means transaction ends when goods are exchanged for money. Without recourse means without the right to go back to the other party (seller) for the money.
Goods

Buyer A Drawee

Sight

Seller B Drawer

Act of Payment (Without Recourse)

Role of Banks
Issuing (or opening) bank The bank which receives the importers application and agrees to issue the credit. The issuing bank is commonly, but not necessarily, located in the importers country. By issuing the credit, the bank is making an irrevocable undertaking to pay the beneficiary the value of the draft and/or other documents, provided that the terms and conditions of the credit are complied with. Nominated bank The bank which is stipulated in a credit as authorized to honour (pay, issue a deferred payment undertaking or accept drafts) or negotiate. Unless a credit expressly states that it is available only with the issuing bank, it should nominate some other bank. If the credit is of the freely available variety, any bank qualifies as a nominated bank. A nominated bank is not normally bound to pay under the credit, unless it has added its confirmation to the credit and become a confirming bank

Role of Banks
Advising bank The bank which notifies or advises the exporter that a credit has been opened in the exporters favour. By advising a credit, the bank is only acting as a outlet for the issuing bank; the advising bank does not take any further risk, and only has the responsibility of satisfying itself as to the apparent authenticity of the credit and ensuring that the advice of the credit (to the beneficiary) accurately reflects the terms and conditions of the credit received. The advising bank is commonly, but not necessarily, located in the exporters country. Confirming Bank - The bank (normally also the advising bank) which adds its own irrevocable undertaking (known as confirmation) in addition to that given by the issuing bank. The confirmation allows the exporters own country, or by a bank which the exporter otherwise trusts. The confirming bank irrevocably commits itself to paying the exporter upon presentation of conforming documents.

Role of Banks
Negotiating bank the bank which examines the documents presented by the exporter, then negotiates the credit (i.e., in the case usance draft, either advances or agrees to advance funds to the beneficiary on or before the maturity date of the draft). Difference between Confirming bank and Negotiating bank. This negotiation is usually done with recourse, which means that if the issuing bank fails to reimburse the negotiating bank, the negotiating bank will recover the funds advanced to the exporter. When confirming bank negotiates, it is without recourse.

Types of Letter of Credit (L/C)

Irrevocable and Revocable
An irrevocable letter of credit can not be amended or cancelled without the consent of the issuing bank, confirming bank (if any) and the exporter. This allows the exporter to procure the goods or prepare them for shipment with the assurance that payment will be received if the stipulated documents are presented and comply with the terms and condition of the credit. A credit issued, subject to The Uniform Customs and Practices of Documentary Credits, 2007 Revision, ICC Publication No. 600 (UCP), is irrevocable credit, even if there is no indication to that effect

A revocable letter of credit allows importer to amend or even cancel the LC and it provides no security to the exporter and it is hardly practiced.

Letter of Credit
Flowchart of Shotz trading L/C to Kazakhstan

Shotz Trading Ltd (UK) Applicant/Buyer

4. Goods Exported

Steel Basherov (Kazakhstan) Beneficiary/Exporter

Sales Order
3. L/C advised 1. L/C issued

2. L/C Sent

Bank of Global Ttrade (UK) Issuing Bank

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7. Telex of Documentary compliance 9. US$ Reimbursement

ABC Bank (Kazakhstan) Advising/Negotiating Bank

6. Documents Checked

Gargi Sanati_NIBM_Financing International Trade

8. Process of Negotiation in US$

5. Document Presented

Bill of Lading
A document issued when goods are entrusted to a shipping company for carriage. It can be used for the following functions Formal receipt for the goods by the shipowner: evidence of the delivery of the goods An evidence of the contract of carriage: contains the terms of the contract carriage Documentary evidence of control over the goods: represents the right to delivery of the goods The holder or the consignee of the bill has the right to claim delivery of the goods from the shipping company when they arrive at the port of destination Bill of lading may be negotiable (order bill of lading) or nonnegotiable (straight bill of lading) May be distinguished by the mode of transport of shipment

Bill of Lading
Order bill of lading should be endorsed by the exporter and transferable by delivery. Negotiable instrument means transferring control over the goods. But not fully negotiable. Once the goods arrive at their destination, they will be released to the bearer of one original bill of lading As an alternative to order B/L, the name and the address of the importer may appear as the consignee. In such case only the importer can obtain the goods, once the goods have arrived in their destination, by presenting the original B/L, together with identification. This bill of lading is known as the straight B/L Normally B/L are made out to order and endorsed by the exporter