Theories of International Trade and Banking Practices Training

Theories of International trade
and Banking Practices

Learning objectives
After taking of this training, the trainees will be able
to:-
• Trainees will understand theoretical and historical
development of International trade
• Trainees will understand theoretical and empirical
relationships of trade and development/growth at
various contexts.
• Trainees will understand trade agreement and trade
policy of trade
• To know about the documentation of International
Trade

Cont….
• Describe the methods of payment available
for international transactions and the
situation when each is appropriate.
• Understand when payments will be made and
the risks associated with each method of
payment both to the buyer and the seller.
• Know about trade finance methods

CONTENTS
 History of International Trade
 Theory of international trade
 The Classical Theory of International Trade
 International Trade, Development, and Growth
 Trade Agreements
 Trade policy in developing Countries and in Ethio
 History of banking
 The role of Banking to support International trade
 International Trade Payment methods
 Trade Finance Methods

1. THEORIES OF INTERNATIONAL
TRADE
1.1. Introduction
• Trade can be conducted between two countries
in order to sell surplus products and to cover
their deficits in production.
• There has been a dual view of trade; in one hand,
it gives recognition of the benefits of
international exchange.
• On the other hand, there is frustration of certain
domestic industries (or laborers, or culture)
would be harmed by foreign competition.

Cont….
• International trade has been in vogue for
centuries and all civilizations carried on
trade with other parts of the world.
• In the present context where technology
and innovation in all fields have thrown
open borders to globalization, no country
can afford to remain isolated and be self-
sufficient.

1.2. History of International Trade
• International trade economic Thought history
can be compiled as four broad period Ancient
Greek thought, scholastic and Christian
thought, mercantilism.
• The ancient Greek thought analyzed the
effects of the division of labor and of
voluntary exchange of goods, and considered
them to be beneficial to both parties involved
in the transaction.

Cont…
• Aristotelian philosophical ideas constituted the
foundation for the development of scholastic and
Christian thought and this intellectual legacy
made it possible for economic science to be born
first as a peripheral branch of ethics.
• However, philosophers and theologians of this
period were skeptical that international trade
could not be compatible with the principles of
moral philosophy.

Cont…
• Together with the emergence of the nation states,
commercial relations became increasingly more
important, for scholars and statesmen alike.
• Their main concern became increasing the welfare of
one’s own nation, which could be obtained only by
decreasing the welfare of other nations.
• The 18th Century saw the shift towards liberalism. It
was in this period that Adam Smith, the father of
Economics defined the importance of specialization in
production and brought International trade under the
said scope.

1.3. Theory of international trade
1.3.1. Mercantilism
• The first reasonably systematic body of thought
to international trade is called “mercantilism” and
emerged 17th and 18th century Europe.
• For much of this period, mercantilist writers
argued that a key objective of trade should be to
promote a favorable balance of trade.
• A “favorable” balance of trade is one in which the
value of domestic goods exported exceeds the
value of foreign goods imported.

Cont…
• The main feature of the mercantilist doctrine was that
a country could grow rich and prosperous by acquiring
more and more precious metals especially gold.
• Therefore, all the efforts of the state should be
directed to such economic activities that help a country
to acquire more and more precious metals.
• Thus, exports were viewed favorably so long as they
brought in gold but imports were looked at with
apprehension as depriving the country of its true
source of riches, i.e., precious metals.

1.3.2. The Classical Theory of
International Trade
• Adam Smith (1723 – 1790) provided the basic
building block for the construction of the
classical theory of international trade.
• The theory in terms of what is called Absolute
Advantage model.
• Another well-known classiest, David Ricardo
(1722 – 1823), articulated it and expanded it
further into what is called Comparative
Advantages model.

1.4.1. Adam Smith’s theory of
absolute advantage
• Smith was the first economist to show that
goods, rather than gold (or treasure), were the
true measure of the wealth of a nation.
• Smith also exploded the mercantilist myth
that in international trade one country gains
at the cost of other countries.
• He showed how all countries would gain from
international trade through the international
division of labor.

A. Autarky (closed economy)
situation
• For example country A produces and
consumes 50 units of rubber and 25 units of
textile where as Country B produces 25 units
of rubber and 50 units of textile with its given
technology and input supplies.
• The total production, GDP, is 75 units and this
is the maximum consumption level if we
assume that saving is zero. In Autarky each
country since consume their own production.

B. The case of open economy
• Opening trade provides the two countries an
opportunity to specialize in production. It will
lead to production and consumption gains.
• After trade both countries become richer by
Specialization in producing one product which led
to production gain from international trade.
• consumption gains to the two countries depend
up on the terms of trade (TOT) i.e. how many
units of rubber exchanged for one unit of textile
between country A and B.

1.4.2. David Ricardo's comparative
advantage model
• Ricardo, as the theory of comparative
advantage model argued that even if the
countries did not have absolute advantage in
any line of production international trade
would be beneficial for both.
• In brief, one country's comparative advantage
is greater in one line of production, and the
other country's comparative disadvantage is
smaller in the other line of production.

Cont…
• A country should specialize in the production
and export of those goods in which either its
comparative advantage is greater or its
comparative disadvantage is smaller.
• It should import those goods, in the
production of which its comparative
advantage is smaller or its comparative
disadvantage greater gains from trade.

1.4.3. The modern theory of
international trade
• The two main modern theory of international trade
are the Factor-Endowment theory named H-O
theorem and the Factor-Price theorem.
• The Factor-Endowment theory(H-O Theorem)
states a country has a comparative advantage in
the production of commodity which uses more
intensively the country's relatively abundant factor
of production.
• The Factor-Price Theorem states that the effect of
trade is to equalize factor prices between
countries.

The H-O Theorem (Factor-Endowment
theory) and its Assumptions
• According to their theory, the immediate cause of
international trade is the differences in the
relative prices of commodities which a raises
from account of the differences in the factor
supplies (endowments) in the two countries.
• On the other hand, the H-O theorem predicted
that the capital surplus country specializes in the
production and exports of capital intensive
goods, and the labor surplus country specializes
in the production labor intensive goods.

Cont…
There are two criteria price criterion and physical
criterion for defining factor abundance.
I. The Price Criterion
• According to this "price criterion" a country in which
capital is relatively cheap is regarded as the capital
abundant country, regardless of the physical quantities
of capital and viceversa.
ii. The Physical Criterion
• According to the "physical criterion", a country is
relatively capital abundant if and only if it is endowed
with a higher proportion of capital to labor than the
other country.

1.5. International Trade,
Development, and Growth
the broad effect of trade as identified in
economic theory are:
• Promote the efficient allocation of resources,
• Facilitate the diffusion of knowledge, and
foster technological progress,
• Encourage competition both in domestic and
international markets that leads to an
optimization of the production processes and
to the development of new products.

1.5.1. The Gains from Trade
• The gains from international trade can be
broadly classified into static and dynamic
gains
Static Gains of International Trade
• Static gains arise from optimum use of the
country’s factor endowments or human and
physical resources, resulting in increase in
social welfare.

Cont…
2. Increase in Welfare:
• As a result of international division of labor
and specialization, the production of goods
increases in the trading country.
3. Increase in National Income:
• When a country gains from international
specialization and exchange of goods in trade,
there is increase in its national income.

1.5.2. Dynamic Gains:
• The following are the dynamic gains from trade:
1. Efficient Employment of Resources:
• The direct dynamic gains from foreign trade are
that comparative advantage leads to a more
efficient employment of the productive resources
of the world.
2. Widens-the Market:
• The major indirect dynamic gain from trade is
that it widens the size of the market.

1.6.1. Overview of Trade Agreement
• Towards the end of the World War II, countries
started meetings in order to set out a plan to
recover from the negative effects of the war.
• In 1947, The General Agreement on Tariffs and
Trade (GATT) was signed. The main aim was
“reduction in tariffs and other international trade
barriers”.
• Sustainable development is directly linked with
international trade. Regional trade agreements
(RTAs) can be a useful tool in promoting growth.

Cont…
• Preferential trade agreements (PTAs) have
become a central instrument of regional
integration in all parts of the world.
• Beyond market access and the progressive
elimination of barriers at the border, PTAs
are increasingly being used in order to
promote cooperation in the areas of
investment, trade facilitation, as well as
wider social issues.

1.6.2. Types of Trade agreement
Trade agreements are either multilateral, involving large
countries in the world or preferential trade agreements
(PTAs), trade between two or more countries.
1. Multilateral Trade agreement
• Internationally coordinated tariff reduction as a trade
policy dates back to the 1930s. However, in an
organized way the multilateral tariff reductions have
taken place since World War II under the General
Agreement on Tariffs and Trade (GATT), in 1947.

Cont…
• On the conclusion of the Uruguay Round of Trade
Talks (1986-1994), the WTO was established in1995.
• The World Trade Organization (WTO) is a voluntary
group of nations that aggress to enforces global rules
for international trade. More than 140 nations and
have agreed to accept pre negotiated trading rules.
• The WTO describes itself as dedicated to reducing
barriers to trade and ensuring that members adhere
to predetermined rules for international trade.

Cont…
• The GATT-WTO system prohibits the imposition
of:
• Export Subsidies (except for agricultural
products)
• Import quotas (except when imports
threaten “market disruption”)
• Tariffs (any new tariff or increase in a tariff
must be offset by reductions in other tariffs
to compensate the affected exporting
countries)

Cont…
• A large group of countries get together to
negotiate a set of tariff reductions and other
measures to liberalize trade.
• On the European continent, the largest
network of PTAs revolves around the
European Union.
• African states have been able to engage in a
very wide range of negotiations, both within
and outside Africa.

Cont…
• However, the proliferation of bilateral and regional
PTAs may undermine progress toward a more open
multilateral trading system.
• The multilateralists argue that there are two main
concerns. The first is trade diversion: preferential
trade agreements, by diverting trade away from the
most efficient global producers in favor of regional
partners, may prove welfare reducing.
• The second concern, which is of greater importance,
regionalism may hinder multilateralism.

2. Preferential Trade Agreement
• Preferential trade agreements (PTAs), defined as
agreements that liberalize trade between two or
more countries but that do not extend this
liberalization to all countries or at least to a
majority of countries.
• With the Doha Round of trade negotiations ailing
in November 2001, the future of multilateral
liberalization in the near term looks bleak. By
contrast, preferential trade agreements (PTAs)
continue to multiply.

Cont…
• the GATT-WTO, through the principle of non-
discrimination called the “most favored nation”
(MFN) principle, prohibits such agreements.
However, the formation of preferential trading
agreements is allowed if they lead to free trade
between the agreeing countries.
• Currently close to 300 Preferential trade
agreement that had been notified to the World
Trade Organization (WTO) as of end-2010.

Typology of Preferential Trade
Agreements
The World Trade Organization (WTO), however,
uses the term regional trade agreements (RTA)
for all preferential agreements the different
terminology employed is explained below.
Free trade agreement (FTA). An agreement
between two or more parties in which tariffs
and other trade barriers are eliminated on
most or all trade. Each party maintains its own
tariff structure relative to third parties.

Cont…
Customs union (CU). An agreement between two or
more parties in which tariffs and other trade
barriers are eliminated on most or all trade.
• In addition, the parties adopt a common
commercial policy toward third parties.
Partial-scope agreement; an agreement between
two or more parties that offer each other
concession on a selected number of products or
sectors.

Cont…
• Economic Integration Agreement (EIA). An
agreement covering trade in services through
which two or more parties offer preferential
market access to each other.
• Preferential trade agreement (PTA). The
generic term used in this module to denote all
forms of regional trade agreements, including
bilateral and plurilateral agreements.

Some of the world known Preferential
trade agreements are
Abbreviation Name of PTA and Their Members
CEMAC, Central African
Economic and Monetary
Community
Gabon, Cameroon, the Central African Republic (CAR), Chad, the Republic of the
Congo and Equatorial Guinea.
COMESA, Common Market
for Eastern and Southern
Africa
Burundi, Comoros, D.R. Congo, Djibouti, Egypt, Eritrea, Ethiopia, Kenya, Libya,
Madagascar, Malawi, Mauritius, Rwanda, Seychelles, Sudan, Swaziland, Uganda,
Zambia, Zimbabwe
EAC, East African Community Kenya, Uganda and United Republic of Tanzania. Burundi and Rwanda, South Sudan
ECOWAS, Economic
Community of West African
States
Benin, Burkina Faso, Cape Verde, Côte d’Ivoire, The Gambia, Ghana, Guinea,
Guinea-Bissau, Liberia, Mali, Niger, Nigeria, Senegal, Sierra Leone, Togo

Cont…
EEA, European Economic Area European Union, Iceland, Liechtenstein, Norway
EFTA, European Free Trade Association Iceland, Liechtenstein, Norway, Switzerland
EU, European Union Austria, Belgium, Bulgaria, Cyprus, Czech Republic, Denmark, Estonia, Finland,
France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg,
Malta, Netherlands, Poland, Portugal,
Romania, Slovak Republic, Slovenia, Spain, Sweden, United Kingdom
GCC Gulf Cooperation Council Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates

1.6.3. Regional Trade Agreement in Developing
Countries
• until the 1970s many developing countries
attempted to accelerate their development by
limiting imports of manufactured goods to foster
a manufacturing sector serving the domestic
market.
• However, the results of import substitution have
fostered high-cost, inefficient production.
• Since the Uruguay Round, developing countries
have played a larger role in the WTO.

Cont…
• In many developing countries, regional
integration has become a key means of
promoting economic growth and fighting poverty.
• In fact, no low-income country has managed to
grow and sustainably reduce poverty without
global or regional trade integration.
• Regional integration in Sub-Saharan Africa has,
for the most part, taken the form of PTAs among
geographically contiguous countries.

Cont…
• New-generation large-scale regional trade agreements
have demonstrated the need to ensure that these
agreements complement and support the multilateral
trading system to provide an enabling environment for
all countries.
• For example in West Africa, the main regional groups
are the WAEMU, (West African Economic and
Monetary Union); ECOWAS (Economic Community of
West African States), and CEMAC, The eight WAEMU
members are all members of ECOWAS. The EU is
negotiating EPAs with ECOWAS and CEMAC.

Cont…
Some of the PTAs in Developing Countries are;
• CEMAC, Economic and Monetary Community of
Central Africa; COMESA, Common Market for Eastern
and Southern Africa; EAC, East African Community;
• ECOWAS, Economic Community of West African States,
• SAPTA/SAFTA South Asian Preferential (Free) Trade
Arrangement, SPARTECA South Pacific Regional Trade
and Economic Cooperation Agreement, SACU Southern
African Customs Union, SADC Southern African
Development Community; WAEMU West African
Economic and Monetary Union; …

1.6.3. Benefit of Trade agreement
Among the many benefit of trade agreements
where countries take advantage of the major are
listed as follow;
• International negotiation helps reduce tariffs
and avoid trade wars through remove trade
barriers.
• In the short term, regional trade contributes
to growth by expanding markets for goods and
services.

Cont…
• In the medium to long term, regional
integration contributes to growth through
improvements in productivity brought about
by the transfer of improved technology,
learning by doing, and increased competition.
• Preferential trading agreements can be good
when its effect have tendency toward
liberalization in trade creation than trade
diversion.

1.6.4. Challenges of Trade agreement
Expanding access to developing country markets may
have adverse consequences for especially the poorest
countries.
• Another is that poor farmers could be adversely
affected by large imports of relatively low priced foods.
• Africa already experiences the impact of wholly
informal rule-making on agricultural standards
imposed by European super markets, against which
there is no appeal.
• One concern is that higher and more volatile food
prices will reduce real disposable incomes for many
poor households in some developing countries.

1.7. International Commercial Terms
(INCOTERMS)
• Here’s the well-known terms mostly used in
international trade transactions: so that both
parties understand the tasks, costs, risks and
responsibilities.
• CFR – Cost and Freight - the exporter must deliver
the goods at the port of destination selected by
the importer.
• CIF – Cost, Insurance and Freight – modality
equivalent to CFR, except that the insurance costs
are born by the exporter.

Cont…
• DDP – Delivered Duty Paid - The exporter assumes a
commitment to deliver the goods, cleared for
importation, at the destination point designated by the
importer, and to pay all expenses, including taxes and
import charges.
• FCA – Free Carrier – the exporter delivers the goods,
cleared for export, into custody of the transporter, at a
location indicated by the importer, whereupon all
responsibilities of the exporter cease.
• FOB – Free on Board - the exporter must deliver the
goods, cleared for export, on board the ship indicated
by the importer, at the port of embarkation.

1.8. Trade policy in developing
Countries

1.9. Overview of Trade policy
• The academic and political debate on the
question of an adequate trade policy strategy for
Developing countries is by no means new.
• The lively and passionate discussion pursued in
the 1960s and1970s of whether to reject or
embrace global market integration, etc., only
began to abate in the 1980s with the "revival" of
the neoliberal doctrine which essentially assumes
the concept of comparative cost advantages .

Cont…
• Proactive, best-fit and coherent International
trade policy-mix needs to be mainstreamed
into national policy agendas in support of
Sustainable Development Goals.
• As a result in the history of International trade
the major holistic trade policies countries
adopt are Import substation, Import
Liberalization and Export Promotion Trade
policies.

1.9.1. Import Substitution Industrialization
• For about 30 years after World War II trade
policies in many developing countries were
strongly influenced by the belief that the best
way to create a strong manufacturing sector was
by protecting domestic manufacturers from
international competition.
• There are many means through which a country
can restrict its trade.
• Among them the most practical and most used
are; first high tariff imposition; A tariff is a tax on
importing a good or service into a country.

Cont…
• The second one is quota; the government gives out
a limited number of licenses to import items.
Moreover, the governments of importing countries
levy antidumping tariffs against dumping.
• However; Many countries that have pursued
import substitution have not shown any signs of
improvement with the advanced countries. Import-
substituting industrialization generated:
• High rates of effective protection
• Inefficient scale of production
• Higher income inequality and unemployment

1.9.3. Import Liberalization Industrlization
• Countries start to liberalize import through
lowering the level of tariff they were imposing
on imported goods.
• Thus, from then on levels of import duty in
most regions have been lowered considerably.
• Moreover, Transforming quantitative import
restrictions into import duties, does not lead
to losses of revenue but opens up a new
source of income.

Cont…
• The measures to be implemented on import
liberalization programme should have a positive
effect on the balance of payments.
• However; liberalization of foreign trade appears to be
running into difficulties in many countries. This is
because of that especially developing counties could
not assure balance of trade because of low
competitiveness mainly in export trade .
• Thus; countries become aware successful trade
liberalization requires complementary export
policies.

1.9.3. Export Promotion Industrialization
• To compensate the inefficiency of import
liblarazation it is essential to deliberately
strengthen the supply capacity of the export
sectors at the same time as carrying out trade
reforms.
• Thus, Currently Countries immerse to create
conducive environment for domestic products to
become competitive in international commodity
markets by rendering the scheme of incentives
available for export trade.

Cont…
• From the mid-1960s onward, an export of
manufactured goods, primarily to advanced
nations, was another possible path to
industrialization for the developing countries.
• However, most low-income less development
countries still rely on primary product for most
of their export earnings. Moreover, the LDC
share of these exports has been falling over
the past few decades.

1.10. International Trade policy In
Ethiopia
• According to the Ministry of Foreign Affairs
Foreign Trade Promotion Manual (MOF, 2007)
Ethiopia's foreign trade policy has three general
objectives.
• The first is developing and ensuring broad
international market for the country's agricultural
products; the second one is generating sufficient
foreign exchange፣ The third one is improving the
efficiency and international competitiveness of
domestic producers.

Cont…
• Since the implementation of the Plan for
Accelerated and Sustained Development to End
Poverty (PASDEP) in 2004/05 the performance of
foreign trade in Ethiopia has increased
significantly.
• The Government has implemented many export
incentive packages besides the reduction of tariff
rate for import of raw materials and capital goods
to the manufacturing sector.

Cont…
• Because of the export basket(types of by product)
and export destinations are limited whereas the
import demand is growing led to trade deficit is
widening.
• Thus. the export receipt of the country is so small
that it cannot finance import payments of the
country.
• For such reasons currently the government of
Ethiopia starts to encourage the private sectors to
develop market innovations with which Ethiopia has
export potential through various incentive packages.

1.10.1. The Export Incentive Promotion in
Ethiopia
According to Ethiopia export trade duty incentive
schemes proclamation No. 768/2012 to ensure economic
development by accelerating industrial growth, The
following duty incentive schemes are hereby established:
a) The duty draw-back scheme;
b) The voucher scheme;
c) The bonded export factory scheme;
d) The bonded manufacturing warehouse scheme;
e) The bonded input supplies warehouse scheme; and
f) The industrial zone scheme.

Cont…
• Duty draw-back means duty paid on raw materials and
accessories used in the production of commodities and
refunded to the payer upon exportation of the
commodity.
• Voucher book means a document printed by the
Ethiopian Customs Commission, to be used for
recording the balance of duty payable on raw materials
imported.
• Bonded export factory means a factory under the
control of the Ethiopian Customs Commission which
produces goods exclusively for export using raw
materials imported free of duty.

Cont…
• Bonded export manufacturing warehouse means a
warehouse under joint control where raw materials
imported free of duty for use in the production of
goods destined exclusively for export are stored;
• Bonded input supplies warehouse means a
warehouse under the joint control where raw
materials and accessories imported free of duty by a
licensed supplier are stored until they are sold to
producers.
• Industrial zone means an area set aside for industry
which is equipped with the necessary infrastructural
facilities.

International Trade Finance Banking
practices

• Banks play a critical role in international
trade by providing trade finance products
that reduce the risk of trade.
• Banks also play a central role in facilitating
trade, through the establishment and
management of payment mechanisms
such as telegraphic transfers and
documentary letters of credit (LCs).

2.1. History of Banking with
international finance perspective
2.1.1. World History of Banking
• The first regular institution resembling what we
call a Bank, was established at Venice, nearly
seven hundred years ago. but about the
beginning of the 15th century, similar institutions
were established at Genoa and Barcelona, cities.
• At the beginning of the 17th century, The
currency of Amsterdam consisted not only of its
own coins, but principally of the coins of all the
neighboring countries;

Cont…
• The bank of England, first chartered in 1694, is
the prototype and grand exemplar of all our
modern banks; The business which this new
corporation principally intended to do by virtue
of its charter, was the purchase and sale of bills of
exchange.
• Instead of giving coin for the bills which it
discounted, the Bank gave its own notes, which,
as they were made payable at the Bank on
demand, were received by the merchants, and
circulated among them as money.

2.1.2. Ethiopia Banking History
• Ethiopian banking history, in its modern sense,
began towards the end of the reign of Emperor
Menilek.
• The country’s first bank. Called the Bank of
Abyssinia, or in Amharic “Ye-Ityopya Bank”, it
was an affiliate of the National Bank of Egypt,
and was founded in 1905.
• Haile Sellassie, after acceding to the throne in
1930, could not accept that the country's
issuing bank was a foreign-owned share
company and decided for nationalization.

Cont…
• The Bank of Abyssinia went, therefore, into
liquidation and a new institution, the Bank of
Ethiopia, was established in 1931. wholly owned
by the Ethiopian aristocracy, becoming the first
100% African-owned bank on the continent;
• In 1963, a new banking law split the functions of
the State Bank of Ethiopia into central and
commercial banking as the National Bank of
Ethiopia and the Commercial Banks of Ethiopia
respectively.

2.2. The role of banks in supporting
international trade
• Global and local banks support international
trade through helping their customers manage
their international payments and associated
risks, and provide needed working capital.
• The term “trade finance” is generally reserved
for bank products that are specifically linked
to underlying international trade transactions
(exports or imports).

Cont…
• One of the most common and standardized forms of
bank-intermediated trade finance is a letter of credit
(L/C).
• L/Cs reduce payment risk by providing a framework
under which a bank makes (or guarantees) the
payment to an exporter on behalf of an importer once
delivery of goods is confirmed through the
presentation of the appropriate documents.
• Banks may also help meet working capital needs by
providing trade finance loans to exporters or
importers.

Cont…
• Currently, the instrumentation of trade finance is
undergoing a period of innovation. For example, the
industry recently launched the “bank payment
obligation” – a payment method that offers a similar
level of payment security to that of L/Cs, but without
banks physically handling documentary evidence.
• The principal alternative to bank trade finance is inter-
firm trade credit between importers and exporters,
• This includes open account transactions, where goods
are shipped in advance of payment, and cash-in-
advance transactions, where payment is made before
shipment.

2.3. International Banking Financial Institutions
• Many international banking activities parallel
those conducted in domestic banking operations.
• The most important element of international
banking not found in domestic banking is country
risk, which involves the political, economic, and
social conditions of countries where a bank has
exposure.
• Examiners must consider country risk when
evaluating a bank’s international operations.

• International lending is another role of bank for both
importer and exporter Credit and currency risks are
also key risks associated with international lending.
• Credit Risk refers to the potential inability of a
borrower to comply with contractual credit terms. A
key problem with assessing international credits is that
applicable information is often less readily available
and less detailed than in domestic credit files.
• Currency Risk reflects the possibility that variations in
value of a currency will adversely affect the value of
investments denominated in a foreign currency.

2.3.1. Commercial banks
• Commercial Banks are institutions that offer
deposit and credit services as well as a
growing list of newer services as investment
advice, security underwriting, selling
insurance and financial planning.
• Commercial banks play an indispensable roll in
the economic activities of every country.
Accordingly, the following are among the main
functions of the commercial banks:

Functions of Commercial Banks
 They issue banknotes, such as promissory notes;
 They process payments with the help of online banking,
telegraphic transfer, debit card, and other methods;
 Offering performance bonds, guarantees, letters of credit,
and other types of documents related to underwriting
commitments for securities;
 Providing loans through installment loans, overdrafts, and
others; and
 Selling and brokerage services related to unit trust and
insurance products and
 Foreign exchange services.
 and others ………….

Classification of Commercial Banks
The following classification is the common one.
Unit Banking
– A banking business operating a single banking office
Branch Banking
• A single bank that offers a full-fledged services in two
or more offices across the country, including offices
abroad
Correspondent Banking
• An arrangement whereby a bank maintains deposit
balance with other banks at a distant place for a variety
of services and assistance

Activities and Services of Commercial
Banks
• Activities of commercial banks can be too
much; however, the following are the main
and common activities that are crucial in the
economic and commercial system of any
country.
A. Loans and Advances
Commercial Banks gives various types of loans
and advances to various business sectors.

• The major ones include Domestic trade, Import
and export trade, Agriculture, Hotel and tourism,
Manufacturing, Construction, Transport, Services
(education, health, etc), and others.
• Most of these loans are extended to customers
on the basis of collaterals. The commonly
acceptable collaterals are: Buildings/Houses,
Motor vehicles, Bank guarantees, and
Unconditional Life Insurance at surrender value.

1. Term Loan
• A term loan is a loan granted to customers to be
repaid with interest within a specific period of
time.
• This loan is granted in three forms, i.e., short-
term, medium-term and long-term loan.
Short-term Loan
• A short-term loan is a loan that has a maturity
period of one year or twelve months from the
date the loan contract is signed.

Medium- and Long-term Loan (project loan)
• A medium-term loan is a loan which has a
maturity period exceeding one year but less
than or equal to five years from the date the
loan contract is signed.
• The purpose of these loans is to finance new
projects, support the expansion of existing
projects, investments and meet working
capital needs.

B. Credit Facilities
The main forms of credit facilities issued by the Commercial
Banks are:
Import Letter of Credit Facility
• an instrument issued by a bank whereby payments in
international trade are effected by banks through documents.
Export Credit Facility
• Export credit facility may take various forms. Some of them
are discussed below:
Pre-Shipment Export Credit
• Pre-shipment export credit is a loan granted to exporters
starting from the procurement of inputs until the date of
shipment of goods against guarantee by banks.

Cont…
Revolving Export Credit Facility
• Revolving export credit facility is an advance
extended to exporters with a limited margin until
goods are loaded on board, upon presentation of
all relevant export documents to the Bank, except
a bill of lading.
Overdraft
• The purpose of the loan is to finance the day-to-
day operational needs of a viable business.

C. Deposits Services
Commercial Banks also provide different types of deposit
services. The main ones are described in the following
section:
1. Special Demand Deposit Account
• Special Demand Deposit Account (SDDA) is a non-
interest bearing deposit account operated by a saving
like passbook and vouchers.
2. Saving Account
• It is an interest-bearing deposit account. Saving
account may be opened and operated by individuals
and organizations, resident and non-resident.

Cont…
3. Fixed (time) Deposit
• A time-deposit account is a deposit account that bears
interest based on the duration of the deposit.
4. Current Account
• Current account, also called demand deposit or
checking account, is a non-interest-bearing deposit
account that is operated by checks.
5. Diaspora Account
• These types of accounts are opened for people living
abroad

D. Money Transfers
• It is a means of transferring funds through banks to
individuals or organizations.
Types of Local Transfer
Telegraphic Transfer (TT): Transfers are made through
telephone, telegram, telex or radio.
Mail Transfer (MT): Transfers are made through post
offices.
Demand Draft (DD): Transfers are made with the use of a
special bank instrument called “draft”.
Cashier’s Payment Order: It is a special bank instrument
negotiable within six months from the date of the
issue.

E. Foreign Currency
• It involves buying and selling foreign currency,
cash notes, traveler's checks, and drafts for the
following different purposes:
• holiday travel expenses,
• Business travel allowances,
• medical expenses,
• Educational expenses, and
• seminars, workshops, symposium, conference,
and training fees, etc

F. Guarantee Services
• A guarantee is a promise to answer ' for the debt,
default or miscarriage of another' if that person
fails to meet the obligation in a contractual
agreement.
• There are various types of guarantees, Some of
them are discussed below:
Bid bond guarantee.
It is issued by the bank upon the request by the
bidder expressing the bank's commitment to meet
the claims of the beneficiary.

Cont…
• Advance payment guarantee: It is issued by
the bank in favor of the buyer who makes the
advance, at the request of the seller or
contractor who received the advance
payment;
• Customers duty guarantee: It is issued by the
bank to meet the requests of the beneficiary
in respect of customs duties;

2.4. Exchange Rates and the Foreign
Exchange Market
• Foreign exchange involves substituting one
country’s currency for another. Because
international trade and investment require the
exchange of currencies,
• the trading of one country’s money for another is
a necessary function in international banking.
• An exchange rate is the number of units of a
given currency that can be purchased for one unit
of another currency.

2.4.1. Determinants of Exchange
Rates
• In a fixed exchange rate regime, rates are
decided by its government,
• In a floating exchange rate regime the
following factors contribute for fluctuations;
• Supply and demand for any given currency,
and thus its value, are not influenced by any
single element, but rather by several.

Cont…
• Market psychology and trader
perceptions influence the foreign
exchange market in a variety of ways:
• Generally these elements fall into three
categories: economic factors, market
psychology, political conditions.

2.4.1. The Foreign Currency Exchange
Market
• Financial institutions are ideal foreign
exchange intermediaries due to their
knowledge of financial markets and
experience providing financial services.
• Importers and exporters often rely on banks to
facilitate their foreign currency transactions.
• The transactions are usually processed in the
foreign currency exchange market, which has
no specific location or hours of business.

Cont…
• It is a common practice in world currency markets
to use the indirect quotation, that is, quoting all
exchange rates per U.S. dollar.
• Further; Exchange rates are based upon the
amount of time required to exchange currencies.
For example, the British Pound Sterling is quoted
at a certain rate for immediate (spot) transactions
and another rate is quoted on the same day for
future (forward) transactions.

2.3.7. Foreign Exchange Risks
The most important types of transactions that contribute
to foreign exchange risks in international trade include
the following:
• Purchase of goods and services whose prices are stated
in foreign currency, that is, payables in foreign currency
Exchange Rates and International Trade
• Sales of goods and services whose prices are stated in
foreign currency, that is, receivables in foreign currency
• Debt payments to be made or accepted in foreign
currency

Protection against exchange rate risks
• The risk associated with such transactions is that
the exchange rate might change between the
date when the export contract was made and the
date of payment
• Shifting the Risk to Third Parties Hedging in
Financial Markets: Through various hedging
instruments, firms could reduce the adverse
impact of foreign currency fluctuations.
• This allows firms to lock in the exchange rate
today for receipts or payments in foreign
currency that will happen sometime in the future.

International Trade Payment
methods

2.5. International trade payment
methods
Five basic methods of payment are used to settle
international transactions each with a different
degree of risk to the exporter and importer.
 Cash in Advance/Prepayment
 Documentary Collections
 Letters of Credit (L/C)
 Open Account
 Combining Methods of Payment

2.5.1. Cash in Advance/Prepayment
• Cash in Advance/Prepayment occurs when a buyer sends
payment in the agreed currency and through agreed
method to a seller before the product is manufactured
and/or shipped.
• Upon receipt of payment this seller then ships the goods
and all the necessary shipping and commercial documents
directly to the buyer.
Time of Payment
• *Prior to manufacturing and/or shipping, through the
agreed upon method (cash, wire transfer, check, credit
card, etc.).
Goods Available to Buyer
• *After payment is received.

Cont…
Risks to Buyer
• *Seller does not shipper the order (quantity, product, quality,
shipping method).
*Seller does not ship when requested.
When Appropriate to Quote or Use
*Product is a special order and can only be sold to this specific
buyer since it contains company logo, etc.
*Seller is confident that importing country will impose
regulations deferring or blocking transfer of payment.
Financing
• *Buyer must have cash or financing available.

2.5.2. Documentary Collections
• Using a documentary collection process requires that
a seller ship the product and create a negotiable
document, usually a draft or bill of exchange.
• The draft and shipping documents are then
processed either through a buyer‘s bank (the
collecting bank) or through the seller and buyer‘s
banks.
• Upon arrival at the buyer‘s bank, the buyer is
notified to make payment; then the documents are
released and used to clear the shipment through
customs upon arrival.

Cont…
• There are a variety of terms associated with
documentary collections that should be understood:
• Buyer = Importer
• Seller = Exporter
• Remitting Bank = Exporter‘s Bank >> receives payment
• Collecting Bank = Importer‘s Bank >> transmits funds
from buyer to seller
• Bill of Exchange/Draft – document issued by exporter
and used for remittance of funds
• Time/Usance Bill of Exchange – tenured at 30, 60, 90,
120 or 180 days, etc.

Cont…
• Documentary collections may be more
competitive than letter of credit terms because
they are less costly and do not require the buyer
to tie up his/her local bank credit lines.
• There are four types of processes available to
buyers and sellers:
1. D/P – Documents against Payment
2. D/A – Documents against Acceptance
3. Clean Collection
4. Cash Against Documents

DOCUMENTS AGAINST PAYMENT
Exporter Importer
Remitting Bank
Presenting/Collecting
Bank
Contract
$
$
D
o
c
u
m
e
nt
s
D
o
cs
$
$
Docs
$$
Goods on Board

Cont…
• The export documents and the bill of
exchange provided to a collecting bank are
only made available to an importer when
payment is made.
• The collecting bank then transfers the
funds to the seller through the remitting
bank.
• The seller’s rights to payment are
protected under the negotiable
instruments law of that buyer’s country.

DOCUMENTS AGAINST ACCEPTANCE
Exporter Importer
Remitting Bank
Presenting/Coll
ecting bank
1. Contract
Goods on board
2
$
$
D
o
c
s
$$$$
Docs + schedule
D
o
c
s
$
$
$

Cont…
D/A – Documents against Acceptance
• The export documents and a time/
usance bill of exchange are sent to a
remitting bank.
• The documents are then sent to a
collecting bank with instructions to
release the documents against a buyer’s
acceptance of the bill of exchange.

Cont…
Clean Collection
• The exporter creates a bill of exchange, which is sent
without any export documents to a buyer for collection
through the remitting bank to the collecting bank.
• There is less security for an exporter since the
documents are sent directly to the importer.
Cash against Documents
• This process lacks the security and legal protection of a
documentary collection since the exports documents
are sent through a remitting bank to a collection bank
without a bill of exchange.

Cont…
Time of Payment
• *Either at sight of documents or acceptance as agreed to by the
parties (30, 60, 90 days after acceptance).
• *Upon arrival of goods after payment or acceptance of draft has
been made.
Risks to Seller
*Buyer delays on payment obligation.
*Delays in availability of foreign exchange and transferring of funds
from buyer’s country.
*Payment blocked due to political events in buyer’s country.
Risks to Buyer
*Seller does not shipper the order (quantity, product, quality,
shipping method).
*Seller does not ship when requested, either early or late.

Cont…
• *Seller and buyer have done some businesstogether;
*Seller has some trust that buyer will accept
shipment and pay at agreed time;
*Seller is confident that importing country will not
impose regulations deferring or blocking transfer of
payment.
Financing
• *Seller finances buyer through deferred payment
terms.
*Seller can use trade acceptances, which are
negotiable instruments, to obtain financing.

2.4.3. Letters of Credit
• A letter of credit is a bank instrument that can
be used to even the risk between a buyer and
a seller. since a seller is guaranteed to receive
payment if when he/she has complied with
the exact requirements of this buyer.
• A letter of credit offers a seller numerous
advantages but only if that seller complies
exactly with its terms and conditions of the
transaction.

Involved Parties:
• Applicant = Buyer/ Importer
• Beneficiary = Seller/Exporter
• Opening Bank = Importer’s Bank >> Issues L/C
• Advising Bank= Exporter’s Bank >> Advises L/C
• Confirming Bank = Advising Bank or 3rd Party
Bank >> Confirms L/C
• Paying Bank = Any Bank as Specified in L/C >>
Pays the Draft

B) ISSUANCE CYCLE
• Flow chart of Letter of Credit issuance cycle
Exporter Importer
Paying Bank/Exporter
Bank
Issuing Bank/Importer
Bank
Contract
Ap
pli
ca
tio
n
Issue LC
Au
th
en
tic
ate

Cont…
Activities and Terms:
• Issuance – opening of L/C
• Advice – review and approval of L/C
• Confirmed – the commercial, political and economic risk of
the transaction absorbed by the confirming bank.
• Amendment – change to L/C
• Revocable – can be changed without approval of beneficiary
or advising bank
• Irrevocable – cannot be changed without approval from
beneficiary or advising bank

B) PAYMENT CYCLE
Exporter Importer
Paying Bank/Exporter
Bank
Issuing Bank/Importer
Bank
Goods on Board
$
$
D
o
c
u
m
e
nt
s
Do
cu
m
en
ts
$
$
Documents
$$

Cont…
Activities and Terms:
• Documentation – documents required within L/C
• Discrepancy – mistake in the documentation
Draft – negotiable order to pay
– Sight Draft – payment assured upon shipment and
presentation of documents in compliance with its
terms
– Time Draft – bank assurance of payment at the
maturity of the banker’s acceptance with option of
obtaining immediate funds by discounting the BA (30,
60, 90 days at sight or acceptance)

Cont…
Risks to Seller
• Delays in availability of foreign exchange and
transferring of funds from buyer’s country if the L/C
is not confirmed.
• Payment blocked due to political events in buyer’s
country if the L/C is not confirmed.
Risks to Buyer
•Seller creates documents to comply with L/C but
does not ship actual product.
•Seller does not ship.Buyer ties up commercial lines
of credit to secure L/C.
•Upon release of documentation and payment or

2.4.4. Open Account
• Open account occurs when a seller ships the goods and
all the necessary shipping and commercial documents
directly to a buyer who agrees to pay a seller’s invoice
at a future date.
• Open account is typically used between established
and trusted traders.
Time of Payment
• As agreed between a buyer and seller,
Goods available
• Before payment (depending on how the products are
shipped and the length of payment option).

Cont…
Risks to Seller
• Buyer delays on payment obligation.
• Delays in availability of foreign exchange and
transferring of funds from buyer’s country occur.
• Payment is blocked due to political events in buyer’s
country.
Risks to Buyer
• Seller does not ship per the order (product, quantity,
quality, and/or shipping method).
• Seller does not ship when requested, either early or
late.

Cont…
• Seller has absolute trust that buyer will accept shipment
and pay at agreed time.
• Seller is confident that importing country will not
impose regulations deferring or blocking transfer of
payment.
Financing
• Seller finances buyer through deferred payment terms.
• Seller may be able to obtain bank financing through
pledge of receivables.

2.4.5. Combining Methods of Payment
• The important thing to remember about methods
of payment is that they are not absolute. They
can be combined in many ways to reduce risk for
all of the parties involved.
• They can be combined in many ways to reduce
risk for all of the parties involved.
• For example, new customer cannot afford 100%
prepayment, an exporter could offer 50%
prepayment to cover the cost of manufacturing
and 25% payment at invoice date and 25%
payment 90 days after invoice.

2.4. Trade Finance Methods
Banks have a critical role in financing International
trade parties (both Importer and Exporter) in
different ways . Among major some are;
 Accounts receivable financing
 Factoring
 Letters of credit (L /Cs)
 Banker’s acceptances
 Working capital financing
 Medium-term capital goods financing (forfaiting)
Countertrade

2.5.1. Accounts Receivable Financing
• In some cases, the exporter of goods may be
willing to ship goods to the importer with-out an
assurance of payment from a bank.
• In what is referred to as accounts receivable
financing, the bank will provide a loan to the
exporter secured by an assignment of the account
receivable.
• In the event the buyer fails to pay the ex-porter
for whatever reason, the exporter is still
responsible for repaying the bank.

Cont…
• Accounts receivable financing involves additional
risks, such as government restrictions and exchange
controls that may prevent the buyer from paying the
exporter.
• As a result, the loan rate is often higher than
domestic accounts receivable financing. The length
of a financing term is usually one to six months.
• To mitigate the additional risk of a foreign receivable,
exporters and banks often require export credit
insurance before financing foreign receivables.

2.5.2. Factoring
• When an exporter ships goods before
receiving payment, the accounts receivable
balance increases.
• Since there is a danger that the buyer will
never pay at all, the exporting firm may
consider selling the accounts receivable to a
third party, known as a factor.
• In this type of financing, the ex-porter sells
the accounts receivable without recourse.

Cont…
• The factor then assumes all administrative
responsibilities involved in collecting from the buyer
and the associated credit exposure.
• Factoring several benefits to the exporter. First, by
selling the accounts receivable, the exporter does not
have to worry about the administrative duties,
• Second, the exporter does not have to maintain
personnel to assess the creditworthiness of foreign
buyers. Finally, by selling the receivable to the factor,
the exporter receives immediate payment and
improves its cash flow.

2.5.3. Letters of Credit (L /C)
• The letter of credit (L /C) is one of the oldest
forms of trade finances still in existence.
• The L /C is an undertaking by a bank to make
payments on behalf of a specified party to a
beneficiary under specified conditions.
• Because of the protection and benefits it accords
to both exporter and importer, it is a critical
component of many international trade
transactions.
• The issuing bank is substituting its credit for that
of the importer.

Cont…
• The exporter may request that a local bank
confirm the L /C and thus assure that all the
responsibilities of the issuing bank will be met.
• The confirming bank is obligated to honor
drawings made by the beneficiary in
compliance with the L /C regardless of the
issuing bank’s ability to make that payment.

Cont…
• Letters of credit are payable either at sight (upon
presentation of documents) or at a specified
future date.
• The three most common L /C documents are as
follows. The typical documentation required
under an L /C includes a draft (sight or time), a
commercial invoice, and a bill of lading.
• Draft Also known as a bill of exchange, a draft
(introduced earlier) is an unconditional promise
drawn

Cont…
• by one party, usually the exporter, requesting
the importer to pay the face amount of the
draft at sight or at a specified future date.
• If the draft is drawn at sight, it is payable upon
presentation of documents. If it is payable at a
specified future date (a time draft) and is
accepted by the importer, it is known as a
trade acceptance.

Cont…
• Bill of Lading: the key document in an
international shipment under an L /C is the bill of
lading (B /L). It serves as a receipt for shipment
and a summary of freight charges; most
importantly, it conveys title to the merchandise.
• If the merchandise is to be shipped by boat, the
carrier will issue what is known as an ocean bill of
lading. When the merchandise is shipped by air,
the carrier will issue an airway bill.

Cont…
• A B / L usually include the following
provisions:
– A description of the merchandise
– Identification marks on the merchandise
– Evidence of loading (receiving) ports
– Name of the exporter (shipper)
– Name of the importer
– Status of freight charges (prepaid or collect)
– Date of shipment

Commercial Invoice:
The exporter’s (seller’s) description of the merchandise being
sold to the buyer is the commercial invoice, which normally
contains the following information:
• Name and address of seller
• Name and address of buyer
• Date
• Terms of payment
• Price, including freight, handling, and insurance if
applicable
• Quantity, weight, packaging, etc.
• Shipping information

2.5.4. Working Capital Financing
• The bank may even provide short-term loans beyond
the banker’s acceptance period.
• In the case of an importer, the loan finances the
working capital cycle that begins with the purchase of
inventory and continues with the sale of the goods,
creation of an account receivable, and conversion to
cash.
• With an exporter, the short-term loan might finance
the manufacture of the merchandise destined for
export (pre-export financing) or the time period from
when the sale is made until payment is received from
the buyer.

Cont…
Medium-Term Capital Goods Financing (Forfeiting)
• Because capital goods are often quite expensive,
an importer may not be able to make payment on
the goods within a short time period. Thus,
longer-term financing may be required here.
• Forfaiting refers to the purchase of financial
obligations, such as bills of exchange or
promissory notes, without recourse to the
original holder, usually the exporter.

2.5.5. Countertrade
• The term countertrade denotes all types of foreign
trade transactions in which the sale of goods to one
country is linked to the purchase or exchange of goods.
• The most common types of countertrade include
barter, compensation, and counter purchase.
• Only recently, however, has countertrade gained
popularity and importance.
• The growth in various types of countertrade has been
fueled by large balance-of-payment disequilibrium,
foreign currency shortages, the debt problems of less
developed countries and stagnant worldwide demand.

2.6. Electronic documents in
international trade
• The general idea of being able to use
electronic media instead of paper
documentation in international trade is as old
as the internet itself;
• However, that has been difficult to achieve in
practice, not just because of technical and
legal issues, but also due to security questions
which must be paramount in any viable
electronic system.

Cont…
• But the potential advantages of an electronic
system for international trade would be
enormous, making it more efficient and safer
without errors in duplication or translation,.
• Such a system would be extremely flexible,
issuing and amending the transaction or
individual documents to reach all parties
involved by the click of a button in real time.

Questions
• What is trade?
• Why countries conduct trade?
• Is free trade important?
• What is trade policy?
• What is trade agreement?
• Differentiate between spot and forward exchange rate. How can a
Ethiopian. import firm use the forward market to protect itself from the
adverse effect of exchange rate fluctuations?
• 2. What does it mean when a currency is trading at a discount to the
Ethiopian birr in the spot market?
• 3. Why do export-import firms enter the foreign exchange market?
• 4. Hedging is not always the most appropriate technique to limit foreign
exchange risks. Discuss.
• 5. Discuss the distribution of risk in the following export payment terms:
consignment, time draft.

• 6. What are the advantages and disadvantages of these payment terms: documentary collections, open account
sales, and revocable letters of credit? EXPORT-IMPORT THEORY, PRACTICES, AND PROCEDURES
• 7. State the different steps involved in a confirmed documentary letter of credit, with payment terms of ninety
days sight.
• 8. Compare and contrast documentary collections and documentary letter of credit.
• 9. The manager of the letter of credit division of Citibank in Chicago learns that the ship on which a local exporter
shipped goods to Yokahama, Japan, was destroyed by fire. He knows that the buyer in Yokahama will never receive
the goods. The manager, however, received all the documents required under the letter of credit. Should the
manager pay the exporter or withhold payment and notify the overseas customer in Japan?
• 10. Compare the role and responsibility of banks in documentary collections and letters of credit.
• 11. What is the independent principle?
• 12. Discuss the rule of strict compliance.
• 13. Provide an example of a major discrepancy in letters of credit.
• 14. Briefly describe the following: transferable L/C, back-to-back L/C, deferred L/C, standby L/C.
• Discuss and describe the difference between the five method of payment of International trade with explining the
trade risk of Each to importer and Exporter
• Draw flow chart of Documentary collection method of payment
• Draw flow chart of Letter of Credit method of payment

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