Trade finance chp


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Trade finance chp

  1. 1. CHAPTER 8 AN INTRODUCTION TO TRADE FINANCEThe absence of an adequate trade finance • Trade Financing Instruments;infrastructure is, in effect, equivalent to a barrier to • Export Credit Insurances; andtrade. Limited access to financing, high costs, and • Export Credit Guaranteeslack of insurance or guarantees are likely to hinderthe trade and export potential of an economy, and 1. Trade Financing Instrumentsparticularly that of small and medium sizedenterprises. The main types of trade financing instruments are asAs explained in Chapter 1, trade facilitation aims at follows:reducing transaction cost and time by streamlining a) Documentary Credittrade procedures and processes. One of the mostimportant challenges for traders involved in a This is the most common form of the commercialtransaction is to secure financing so that the letter of credit. The issuing bank will make payment,transaction may actually take place. The faster and either immediately or at a prescribed date, upon theeasier the process of financing an international presentation of stipulated documents. Thesetransaction, the more trade will be facilitated. documents will include shipping and insurance documents, and commercial invoices. TheTraders require working capital (i.e., short-term documentary credit arrangement offers anfinancing) to support their trading activities. internationally used method of attaining aExporters will usually require financing to process or commercially acceptable undertaking by providing formanufacture products for the export market before payment to be made against presentation ofreceiving payment. Such financing is known as documentation representing the goods, makingpre-shipping finance. Conversely, importers will need possible the transfer of title to those goods. A lettera line of credit to buy goods overseas and sell them of credit is a precise document whereby the importer’sin the domestic market before paying for imports. In bank extends credit to the importer and assumesmost cases, foreign buyers expect to pay only when responsibility in paying the exporter.goods arrive, or later still if possible, but certainly notin advance. They prefer an open account, or at least A common problem faced in emerging economies isa delayed payment arrangement. Being able to offer that many banks have inadequate capital and foreignattractive payments term to buyers is often crucial in exchange, making their ability to back thegetting a contract and requires access to financing for documentary credits questionable. Exporters mayexporters. require guarantees from their own local banks as an additional source of security, but this may generateTherefore, governments whose economic growth significant additional costs as the banks may bestrategy involves trade development should provide reluctant to assume the risks. Allowing internationallyassistance and support in terms of export financing reputable banks to operate in the country and offerand development of an efficient financial documentary credit is one way to effectively solve thisinfrastructure. There are many types of financial tools problem.and packages designed to facilitate the financing oftrade transactions. This Chapter will only introducethree types, namely:
  2. 2. 60 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCEb) Countertrade and overhead costs. It is especially needed when inputs for production must be imported. It alsoAs mentioned above, most emerging economies face provides additional working capital for the exporter.the problem of limited foreign exchange holdings. Pre-shipment financing is especially important toOne way to overcome this constraint is to promote smaller enterprises because the international sales cycleand encourage countertrade. Today’s modern counter is usually longer than the domestic sales appears in so many forms that it is difficult to Pre-shipment financing can take in the form of short-devise a definition. It generally encompasses the idea term loans, overdrafts and cash credits.of subjecting the agreement to purchase goods orservices to an undertaking by the supplier to take on e) Post-Shipping Financinga compensating obligation. The seller is required toaccept goods or other instruments of trade in partial Financing for the period following shipment. Theor whole payment for its products. ability to be competitive often depends on the trader’s credit term offered to buyers. Post-shipmentSome of the forms of counter trade include: financing ensures adequate liquidity until the • Barter – This traditional type of purchaser receives the products and the exporter countertrade involving the exchange of receives payment. Post-shipment financing is usually goods and services against other goods and short-term. services of equivalent value, with no f) Buyer’s Credit monetary exchange between exporter and importer. A financial arrangement whereby a financial • Counterpurchase – The exporter undertakes institution in the exporting country extends a loan to buy goods from the importer or from a directly or indirectly to a foreign buyer to finance the company nominated by the importer, or purchase of goods and services from the exporting agrees to arrange for the purchase by a third country. This arrangement enables the buyer to make party. The value of the counterpurchased payments due to the supplier under the contract. goods is an agreed percentage of the prices g) Supplier’s Credit of the goods originally exported. • Buy-back – The exporter of heavy A financing arrangement under which an exporter equipment agrees to accept products extends credit to the buyer in the importing country manufactured by the importer of the to finance the buyer’s purchases. equipment as payment. 2. Export Credit Insurancec) Factoring In addition to financing issues, traders are also subjectThis involves the sale at a discount of accounts to risks, which can be either commercial or political.receivable or other debt assets on a daily, weekly or Commercial risk arises from factors like themonthly basis in exchange for immediate cash. The non-acceptance of goods by buyer, the failure of buyerdebt assets are sold by the exporter at a discount to a to pay debt, and the failure of foreign banks tofactoring house, which will assume all commercial and honour documentary credits. Political risk arises frompolitical risks of the account receivable. In the factors like war, riots and civil commotion, blockageabsence of private sector players, governments can of foreign exchange transfers and currencyfacilitate the establishment of a state-owned factor; devaluation. Export credit insurance involves insuringor a joint venture set-up with several banks and exporters against such risks. It is commonly used intrading enterprises. Europe, and increasing in importance in the United States as well as in developing markets.d) Pre-Shipping Financing The types of export credit insurance used vary fromThis is financing for the period prior to the shipment country to country and depends on traders’ perceivedof goods, to support pre-export activities like wages needs. The most commonly used are as follows: TRADE FACILITATION HANDBOOK FOR THE GREATER MEKONG SUBREGION
  3. 3. CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE 61 • Short-term Export Credit Insurance – An export credit guarantee is issued by a financial Covers periods not more than 180 days. institution, or a government agency, set up to Protection includes pre-shipment and promote exports. Such guarantee allows exporters to post-shipment risks, the former covering the secure pre-shipment financing or post-shipment period between the awarding of contract financing from a banking institution more easily. until shipment. Protection can also be Even in situations where trade financing is covered against commercial and political commercially available, companies without sufficient risks. track records may not be looked upon favourably by • Medium and Long-term Export Credit banks. Therefore, the provision of financial Insurance – Issued for credits extending guarantees to the banking system for purveying export longer periods, medium-term (up to three credit is an important element in helping local years) or longer. Protection provided for companies go into exporting. The agency providing financing exports of capital goods and this service has to carefully assess the risk associated services. in supporting the exporter as well as the buyer. • Investment Insurance – Insurance offered to 4. The Role of Governments in Trade exporters investing in foreign countries. Financing • Exchange Rate Insurance – Covers losses as a result of fluctuations in exchange rates The role of government in trade financing is crucial between exporters’ and importers’ national in emerging economies. In the presence of currencies over a period of time. underdeveloped financial and money markets, traders have restricted access to financing. Governments canThe benefits of export credit insurance include: either play a direct role like direct provision of trade • Ability of exporters to offer buyers finance or credit guarantees; or indirectly by competitive payment terms. facilitating the formation of trade financing enterprises. Governments could also extend assistance • Protection against risks and financial costs in seeking cheaper credit by offering or supporting of non-payment. the following: • Access to working capital. • Central Bank refinancing schemes; • Protection against losses from foreign exchange fluctuations. • Specialized financing institutes like Export-Import Banks or Factoring Houses; • Reduction of need for tangible security when borrowing from banks. • Export credit insurance agencies; • Assistance from the Trade PromotionExport credit insurance mitigates the financial impact Organisation; andof the risk. There are specialized financial institutionsavailable that offer insurance cover, with premiums • Collaboration with Enterprise Developmentdependent on the risk of the export markets and Corporations (EDC) or State Tradingexport products. Enterprises (STE). 3. Export Credit Guarantees a) Central Bank Refinancing Schemes Under this type of schemes, the Central Bank willExport credit guarantees are instruments to safeguard rediscount the commercial bills of exporters atexport-financing banks from losses that may occur preferential rates. This will provide the cheapfrom providing funds to exporters. While export post-shipment financing necessary for exporters tocredit insurance protects exporters, guarantees protect quickly turn around funds for further export business.banks offering the loans. They do not involve the Here, the government is subsidizing the cost of fundsactual provision of funds, but the exporters’ access to that exporters have to pay if they rediscount their billsfinancing is facilitated. with commercial banks. TRADE FACILITATION HANDBOOK FOR THE GREATER MEKONG SUBREGION
  4. 4. 62 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCEIn a similar scheme, government could also offer d) Support from Trade Promotion Organisationsfactoring services at subsidized rates. (TPOs)b) Export-Import Bank (EXIM Bank) As explained earlier, banks are often reluctant to lend to exporters because of their lack of knowledge aboutThe Export-Import Bank (EXIM Bank) specifically the creditworthiness of the traders, and as a result maycaters to the needs of exporters and importers and raise interest to compensate for the risks taken. TPOsthose of investors in foreign markets. It offers various are in a position to know the strengths and weaknessesservices, including long-term direct loans to foreign of the individual trading houses and exporters, andbuyers for loans and equipment sales of sufficient could share information with financial institutions tosizes. facilitate access to financial services.Several countries, including developed nations, have TPOs are the government agencies that are mostEXIM banks. For example, the United States EXIM directly involved with the trading community, oftenBank was created in 1934 and established under its supporting promising trading and exportingpresent law in 1945. Its primary role is to aid in enterprises. The support and assistance given by thefinancing US exports, and for medium-term TPOs could act as a signal to banks as to which(181 days to 5 years) transactions, it co-operates with companies are creditworthy companies. In addition,US commercial banks by providing export credit TPOs could establish network of financialguarantees. In setting up the EXIM Bank, the US institutions, identify their credit requirement, andrecognized that job creation is a consequence of match trading enterprises and financial institutionsexports. Its main customers are SMEs in the United based on these requirements.States.c) Export Credit Insurance Agencies e) Export Development Corporation and State Owned EnterprisesExport credit insurance agencies act as bridges In most emerging economies, there are a few keybetween banks and exporters. In emerging economies conglomerates with a diverse range of products,where the financial sector is yet to be developed, substantial export capacity and sustainable financialgovernments often take over the role of the export resources. They could be private sector exportcredit insurance agent. Governments traditionally development corporations (EDCs) or state-ownedassume this role because they are deemed to be the enterprises (SOEs).only institutions in a position to bear political risks.Several countries in Asia and Africa have such an Governments could harness these enterprises asorganization. However, the viability of such an mechanisms to assist other local firms, especiallyorganization depend on the volume of business and SMEs, to export their products or import goods.income from insurance premium. In that context, Unlike the SMEs, the EDCs and the SOEs have thecredit insurance policies vary according to the type financial resources and trade expertise needed toof exports. For example, short term policies on the participate in trading activities. Smaller exporterssale of raw materials on 180 days terms are covered could sell their products to the EDCs and SOEs andup to 95 per cent for commercial risk and 100 per receive payment earlier than if they exported directlycent for political risk. Such trades are considered by themselves. Small importers could also purchaserelatively secure. Nonetheless, it is good practice to goods from the EDCs and SOEs, which have theget the exporter to bear a certain portion of the risk. financial strength to bulk purchase from abroad. TRADE FACILITATION HANDBOOK FOR THE GREATER MEKONG SUBREGION
  5. 5. CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE 63 Box 8.1 Trade Finance Trends in Asia The recent economic slowdown is making the need for sound trade finance policies and strong financial systems more acute. Many companies are trying to preserve cash by delaying payment and the number of SMEs in emerging Asian economies with high credit risk is growing. This is partly the result of a regional trend toward unsecured, open-account type transactions. Large Western buyers are asking that their Asian suppliers sell goods on open-accounts terms, instead of using guarantees like letters of credit (LCs). These buyers simply do not want to bear the extra cost of payment guarantees and will source their goods from somewhere else if they are not given open-accounts. These open-accounts allow the buyers to delay payments as needed, rising the need for credit for Asian companies who choose to supply them. The economic slowdown also has made many companies rethink their commitment to electronic trading and payment systems. While these systems may cut significant costs out of the labor-intensive trade finance process, they also make payment delays more difficult to justify. Large Western buyers are not the only ones delaying payments. In fact, many companies prefer dealing with these buyers than with the thinly capitalized buyers commonly found in many emerging Asian economies, mainly because these large buyers remain relatively punctual and have very low credit risk (i.e., even if they delay payment a little, they will pay). With the internationalization of supply chains, a Hong-Kong, China based transformer manufacturer may sell its products to Chinese buyers sub-contracted by Dell or IBM to manufacture PCs. The Chinese sub-contractor may ask to buy from the manufacturer on open-account terms on the basis that payment from Dell or IBM is a sure thing. This kind of arrangement increases the financial risk exposure of the transformer manufacturer, and typically results in payment delays measured in weeks and sometime months. Because LCs or factoring in China and many other countries in Asia are not yet commonly used or available, Asian suppliers can often do very little to protect themselves in regional cross-border transaction, increasing the cost of regional trade transactions relative to that of direct transactions with Western companies. Source: Moiseiwitsch, J., CFO Asia, Trade Finance – Time Bandits, November 2001, 5. Conclusion increasingly be challenged by competing countries as unfair export subsidies under existing and futureThis Chapter has explained the need for trade finance WTO rules.and introduced some of the most common tradefinance tools and practices. A proactive role of The role of the government and other parties involvedgovernments in trade finance may alleviate the lack in trade finance will need to evolve along with theof trade finance in emerging GMS economies and country’s economy. Underlying the functionscontribute to trade expansion and facilitation. provided by the different players is the need for a clearHowever, the best long-term solution in resolving the and effective legal environment. The commercialconstraints in trade financing is to encourage the legal system must be transparent. Laws of property,growth and development of a vibrant and competitive contract and arbitration must be clear. Thefinancial system, comprising mainly private sector commercial legal environment must be integratedplayers. This point is important as some of the with the financial infrastructure framework in ordergovernment-supported trade financing schemes may for it to be effective. TRADE FACILITATION HANDBOOK FOR THE GREATER MEKONG SUBREGION
  6. 6. 64 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE 6. For Further Reading... mobilizing domestic finance for development is addressed in the joint ESCAP-ADB report• One illustration of government’s proactive role available at: in trade finance in Asia and the Pacific is the rpt2001.pdf. creation by the Australian government of the Export Finance and Insurance Corporation • The International Trade Center (ITC), a joint (EFIC) in 1991. ( initiative of UNCTAD and the WTO, is a source of practical guides and manuals on• A well-developed domestic financial system can international trade finance issues (http:// go a long way toward facilitating trade by making trade financing easier. The issue of TRADE FACILITATION HANDBOOK FOR THE GREATER MEKONG SUBREGION