Training Modul Revised.pdf

INTERNATIONAL TRADE AND
BANKING PRACTICE
Training Manual
Complied By:
AzimeAdem (PhD)
Habtamu Woldehana
Sofonias Makonnen
Tadele Asfaw

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Contents
1. International Trade ...............................................................................................................................1
1.1 Introduction ..................................................................................................................................1
1.2 History of International Trade ......................................................................................................2
1.3 Theory of international trade .......................................................................................................6
1.3.1 Mercantilism .........................................................................................................................6
1.3.2 The Classical Theory of International Trade .........................................................................7
1.3.3 The modern theory of international trade .........................................................................20
1.4 International Trade, Development, and Growth ........................................................................23
1.4.1 International Trade and Growth.........................................................................................24
1.4.2 The Gains from Trade..........................................................................................................25
1.5 Preferential Trade Agreements...................................................................................................28
1.5.1 Overview of Trade Agreement............................................................................................28
1.5.2 Types of Trade agreement..................................................................................................29
1.5.3 Regional Trade Agreement in Developing Countries..........................................................38
1.5.4 Benefit of Trade agreement................................................................................................40
1.5.5 Challenges of Trade agreement..........................................................................................40
1.5.6 International Commercial Terms (INCOTERMS) .................................................................41
1.6 Trade policy in developing Countries..........................................................................................43
1.6.1 Overview of Trade policy ....................................................................................................43
1.6.2 Import Substitution Industrialization..................................................................................44
1.6.3 Import Liberalization Industrlization...................................................................................46
1.6.4 Export Promotion Industrialization.....................................................................................47
1.7 International Trade policy In Ethiopia.........................................................................................48
1.7.1 The Export Incentive Promotion in Ethiopia.......................................................................50
1.8 Controversies in Trade policy......................................................................................................52
1.9 Chapter summary........................................................................................................................53
2 International Trade Finance of Banking Principle...............................................................................55
2.1 History of Banking with international finance perspective ........................................................56

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2.1.1 World History of Banking....................................................................................................56
2.1.2 Ethiopia Banking History.....................................................................................................57
2.2 The role of banks in supporting international trade...................................................................58
2.3 International Banking and Financial Institutions ........................................................................60
2.3.1 Overview of International Banking .....................................................................................60
2.3.2 Commercial banks...............................................................................................................63
2.4 Exchange Rates and the Foreign Exchange Market:...................................................................75
2.4.1 Foreign exchange................................................................................................................75
2.4.2 The Foreign Currency Exchange Market.............................................................................76
2.4.3 Foreign Exchange Trading...................................................................................................77
2.4.4 Determinants of Exchange Rates........................................................................................78
2.4.5 Foreign Exchange Risks .......................................................................................................81
2.4.6 Protection against exchange rate risks...............................................................................82
2.5 International trade payment methods .......................................................................................85
2.5.1 Cash in Advance/Prepayment.............................................................................................86
2.5.2 Documentary Collections....................................................................................................87
2.5.3 Letters of Credit ..................................................................................................................89
2.5.4 Open Account......................................................................................................................92
2.5.5 Combining Methods of Payment ........................................................................................93
2.6 Trade Finance Methods ..............................................................................................................93
2.6.1 Accounts Receivable Financing...........................................................................................94
2.6.2 Factoring .............................................................................................................................94
2.6.3 Letters of Credit (L /C).........................................................................................................95
2.6.4 Working Capital Financing ................................................................................................102
2.6.5 Medium-Term Capital Goods Financing (Forfaiting).........................................................102
2.6.6 Counter trade....................................................................................................................103
2.7 Electronic documents in international trade............................................................................105
Bibliography ..............................................................................................................................................109

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1. International Trade
Learning objective
 Trainees will understand theoretical and historical development of 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
1.1 Introduction
International trade is one of the oldest main branches of economic thought. From the ancient
Greek philosophers to the present, government officials, intellectuals, and economists have
considered and identified the major factors of trade between countries. More importantly, they
attempted to examine whether trade bring benefits or harm the nation. In addition they have tried
to endorse what trade policy is best for any particular country.
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. Different
conclusions are drowning about having free trade depending upon the overall gains from trade or
the losses on trade. However, economists have likened free trade to technological progress:
although some narrow interests may be harmed, the overall benefits to society are significant.
Still, as evidenced by the intense debates over trade today, the tensions inherent in this dual view
of trade have never been overcome.
International trade has been in vogue for centuries and all civilizations carried on trade with
other parts of the world. The need for trading exists due to the variations in availability of
resources and comparative advantage. 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.

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1.2 History of International Trade
Up until the middle Ages, philosophers and theoreticians did not undertake any systematic study
of international trade, and early theories are rather fragmented, laced with ethical and political
considerations. Within this pre-doctrinal period, four subsequent periods can be delineated:
Ancient Greek thought, scholastic and Christian thought, mercantilism, and Physiocracy.
The most important ideas concerning international trade in Ancient Greek thought are found in
the works of Plato, Xenophon, and Aristotle. They 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. In 380 BC, in The Republic, Plato discussed the practical
impossibility of self-sufficiency for a city state, and explained that the division of labor brings
about a higher productivity and higher output than autarky, as well as allows individuals to
specialize according to their natural aptitudes and available natural resources. In 340 BC,
Xenophon, in following Plato, also mentioned the benefits of the price arbitrage carried out by
traders in search of profit, as well as the advantages of larger, international markets for the
merchants of the Greek city states.
Notwithstanding these considerations, the Greeks did not declare themselves in favor of
international commercial relations. As one example, around 350 BC, Aristotle was already
arguing in Politics for a certain degree of economic self-sufficiency—in fact, as high as possible.
For Aristotle, this self-sufficiency was necessary to limit not only foreign commerce, but also
any unwanted contact with foreigners. Thus, he argued, part of the city rulers‘ duty was to decide
which exports and imports are absolutely necessary, and furthermore, to insure the fairness of
these exchanges through some type of commercial treaties with other cities.
Aristotelian philosophical ideas constituted the foundation for the development of scholastic and
Christian thought between the 13th and 15th centuries, and this intellectual legacy made it
possible for economic science to be born first as a peripheral branch of ethics. However, this also
meant that philosophers and theologians of this period were skeptical that international trade
could be compatible with the principles of moral philosophy.

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They agreed that the peoples and regions of the world were not endowed by nature with all the
things necessary for survival, and thus that foreign commerce was, at least to a certain degree,
indispensable. However, they also considered that commerce in general, and especially
commerce with foreigners, could have alarming moral consequences. As early as the 5th century,
theologian St. Augustine echoed the opinion of Greek philosophers, according to which
commercial activities foster avarice and fraud; however, unlike the Greeks, St. Augustine did not
wish people to become autarchic from a cultural point of view.
These prejudices continued to influence medieval scholastic thought, albeit gradually losing
their importance. In Summa Theological (written between 1265 and 1274), Thomas Aquinas
accepted the idea that imports and exports are beneficial to society, but was careful to argue that
foreigners might have a deleterious influence on local communities. Material gain in itself never
came to be considered virtuous or necessary, but in time, its connotations were no longer
undoubtedly immoral. Finally, the natural law philosophy which followed the scholastic works
of the 16th century was the first to systematically lay the foundations for commercial freedom. In
1608, Hugo Grotius proclaimed the benefits of the total freedom of international trade, freedom
that no state had the right to oppose. In a similar fashion, in 1612, Francisco Suarez explained
that free commercial exchanges are an unalienable right of every individual, and of every nation.
As a result, they argued, respecting this right not only did not bring any economic or cultural
damage, but was in fact in the interest of the entire human society.
Together with the emergence of the nation states, commercial relations became increasingly
more important, for scholars and statesmen alike. Against this background, mercantilism sprang
up as a profoundly nationalist movement, reaching the peak of its popularity in 16th and 17th
century England through the writings of Thomas Mun (1664) and Gerard de Malynes (1622), as
well as through the protectionist policies of Jean-Baptiste Colbert in France. Mercantilists
believed that states were in a perpetual economic and political conflict with each other, and as a
result, they portrayed international trade as a zero-sum game. Their main concern became
increasing the welfare of one‘s own nation, which could be obtained only by decreasing the
welfare of other nations.

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The accumulation of precious metals such as gold and silver in a country‘s treasury was the
foremost means to achieve this goal. Governments were thus encouraged to come to the aid of
national producers, as well as promote exports of manufactured goods and imports only of raw
materials, via price controls, tariffs, and other trade barriers. These policies were supposed to
encourage the inflow of gold while hampering the outflow, insuring a favorable balance of trade.
Such policies remained popular for more than two centuries, but mercantilism began to lose its
relevance once its consistent implementation led to the economic decline of these nations. Most
importantly, however, mercantilist trade thought was exposed as a spurious doctrine by the harsh
criticism of 19th
century liberals.
More importantly, international trade has a rich history starting with barter system being replaced
by Mercantilism in the 16th
and 17th
Centuries. The 18th
Century saw the shift towards liberalism.
It was in this period that Adam Smith, the father of Economics wrote the famous book ‗The
Wealth of Nations‘ in 1776 where in he defined the importance of specialization in production
and brought International trade under the said scope. David Ricardo developed the Comparative
advantage principle, which stands true even today.
All these economic thoughts and principles have influenced the international trade policies of
each country. Though in the last few centuries, countries have entered into several pacts to move
towards free trade where the countries do not impose tariffs in terms of import duties and allow
trading of goods and services to go on freely.
The 19th
century beginning saw the move towards professionalism, which petered down by end
of the century. Around 1913, the countries in the west say extensive move towards economic
liberty where in quantitative restrictions were done away with and customs duties were reduced
across countries. All currencies were freely convertible into Gold, which was the international
monetary currency of exchange. Establishing business anywhere and finding employment was
easy and one can say that trade was really free between countries around this period.
The First World War changed the entire course of the world trade and countries built walls
around themselves with wartime controls. Post world war, as many as five years went into

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dismantling of the wartime measures and getting back trade to normalcy. But then the economic
recession in 1920 changed the balance of world trade again and many countries saw change of
fortunes due to fluctuation of their currencies and depreciation creating economic pressures on
various Governments to adopt protective mechanisms by adopting to raise customs duties and
tariffs.
The need to reduce the pressures of economic conditions and ease international trade between
countries gave rise to the World Economic Conference in May 1927 organized by League of
Nations where in the most important industrial countries participated and led to drawing up of
Multilateral Trade Agreement. This was later followed with General Agreement on Tariffs and
Trade (GATT) in 1947.
However once again, depression struck in 1930s disrupting the economies in all countries
leading to rise in import duties to be able to maintain favorable balance of payments and import
quotas or quantity restrictions including import prohibitions and licensing.
Slowly the countries began to grow familiar to the fact that the old school of thoughts were no
longer going to be practical and that they had to keep reviewing their international trade policies
on continuous basis and this interns lead to all countries agreeing to be guided by the
international organizations and trade agreements in terms of international trade.
Today the understanding of international trade and the factors influencing global trade is much
better understood. The context of global markets have been guided by the understanding and
theories developed by economists based on Natural resources available with various countries
which give them the comparative advantage, Economies of Scale of large scale production,
technology in terms of e-commerce as well as product life cycle changes in tune with
advancement of technology as well as the financial market structures.

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1.3 Theory of international trade
1.3.1 Mercantilism
The first reasonably systematic body of thought devoted to international trade is called
―mercantilism‖ and emerged in seventeenth and eighteenth century Europe. An outpouring of
pamphlets on economic issues, particularly in England and especially related to trade, began
during this time. Although many different viewpoints are expressed in this literature, several core
beliefs are pervasive and tend to get restated time and time again.
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. Trade with a given
country or region was judged profitable by the extent to which the value of exports exceeded the
value of imports, thereby resulting in a balance of trade surplus and adding precious metals and
treasure to the country‘s stock. Scholars later disputed the degree to which mercantilists confused
the accumulation of precious metals with increases in national wealth. But without a doubt,
mercantilists tended to view exports favorably and imports unfavorably.
Even if the balance of trade was not a specific source of concern, the commodity composition of
trade was. Exports of manufactured goods were considered beneficial, and exports of raw
materials (for use by foreign manufacturers) were considered harmful; imports of raw materials
were viewed as advantageous and imports of manufactured goods were viewed as damaging.
This ranking of activities was based not only on employment grounds, where processing and
adding value to raw materials was thought to generate better employment opportunities than just
extraction or primary production of basic goods, but also for building up industries that would
strengthen the economy and the national defense.
Mercantilists advocated that government policy be directed to arranging the flow of commerce to
conform to these beliefs. They sought a highly interventionist agenda, using taxes on trade to
manipulate the balance of trade or commodity composition of trade in favor of the home country.
But even if the logic of mercantilism was correct, this strategy could never work if all nations

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tried to follow it simultaneously. Not every country can have a balance of trade surplus, and not
every country can export manufactured goods and import raw materials.
The economic philosophy that prevailed during the 17th
and 18th
centuries was that of the
Mercantilism. 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, and, 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. According to the mercantilist school of economists, if
international trade is not properly regulated then people might exchange gold for commodities of
daily use or require for a luxurious living. This would lead to the depletion of the stock of
precious metals within the nation. 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.
Taxing imports was often justified as a way of creating jobs and income for the national
population. Imports were supposed to be bad because they had to be paid for, which might cause
the nation to lose spices (gold or silver) to foreigners if it imported a greater value of goods and
services than it sold to foreigners. Imports were also to be feared because those same foreign
goods might not be available in time of war.
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. He enunciated 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. The models of Smith
and Ricardo together constitute what is sometimes referred to as the supply version of the
classical theory of trade, because Smith and Ricardo paid almost exclusive attention to
considerations of supply or production costs in the determination of terms of trade and the gains
from trade.
The modern version of the classical theory of trade, however, treats supply and demand with
equal weight. John Stuart Mill (1806 -1873), another renowned classical economist, was the first

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to indicate that demand considerations must be incorporated into Comparative advantage model.
But Mill was not very clear or articulate. The vagueness in Mill‘s principle of Reciprocal
Demand was removed in the 19th
century, first by F.Y. Edgeworth and later by Alfred Marshall.
Both Marshal and Edgeworth are credited with originating and developing the theory of offer
curves, which is a geometric technique of demonstrating the theory of reciprocal demand. All
these contributions of Smith, Ricardo, Mill, Edgeworth and Marshall, put together, would
constitute the modern version of the classical theory of comparative advantage, which is the
oldest and the most famous model of international trade.
1.3.2.1 Adam Smith’s theory of absolute advantage
Adam smith challenged the mercantilists views on what constituted the wealth of Nations, and
what contributed to "nation building" or increasing the wealth and welfare of nations. Smith was
the first economist to show that goods, rather than gold (or treasure), were the true measure of
the wealth of a nation. He argued that the wealth of a nation would expand most rapidly if the
government would abandon mercantilist controls over foreign trade. 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.
Adam Smith, in his Wealth of nations (1776), argued that a country could certainly gain by
trading with other nations. Just as a tailor does not make his own shoes but exchanges a suit for
shoes, and hence both the tailor and the shoe maker gain by trading, in the same manner, Smith
argued that a country as a whole would gain by having trade relations with other countries.
According to Smith, if one country has an absolute advantage over another in one line of
production, and the other country has an absolute advantage over the first country in another line
of production, then both countries would gain by trading. Let's discuss the Smiths model by
taking a simplistic world of two countries A and B both producing Rubber and Textile.

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Assumptions
1. There are constant returns to scale in the production of both goods in the two countries
(i.e. constant marginal opportunity cost conditions).
2. The production possibilities are such that both countries can produce both the goods if
they wish.
3. The countries are endowed with X amounts of factors of production such that:
a) With X factors of production country A can produce either 100 units of rubber or 50
units of textile, or any other mix of rubber and textile, that satisfies the opportunity cost
ratio of 2:1
b) With X factors of production country B can produce either 50 units of rubber or 100
units of textile, or some other combinations of rubber and textile subject to the
opportunity cost ratio of 1:2
From the above production possibilities (or supply conditions) it is quite clear that country A has
an absolute advantage in the production of rubber, and country B has an absolute advantage in
the production of textile. This means there is symmetrical factor distribution between the two
countries so that there is scope for specialization in production and also a scope for establishing
mutually beneficial trade between the two countries.
A. Autarky (closed economy) situation
The table to the right implies that country A produces and consumes 50 units of rubber and 25
units of textile with the given production technology and input supply. The total production,
GDP, is 75 units and this is the maximum consumption level if we assume that saving is zero.
Country B produces 25 units of rubber and 50 units of textile with its given technology and input
supplies.

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Table 1: Production and Consumption Levels under autarky Situation.
The total production of country B is 75 units and total consumption will also be 75 units if
savings are assumed to be zero. For our simple world of two countries, therefore, world
production and consumption will be 150 units.
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. These effects can be seen in the following table. Country
A will specialize in the production and export of rubber and B will specialize in the production
and export of textile. Trade will enable the countries to realize production and consumption
gains.
After trade both countries become richer by 25 units than their situation without trade and this is
due to production gain from international trade. The world GNP has also increased from 150 to
200 units. Country A has specialized in the production of rubber and country B has specialized in
the production of textile.
Country Commodities in units Units of output
(GDP )
Opportunity cost
ratio
(R:T)
Rubber Textile
A 50 25 75 2:1
B 25 50 75 1:2
World 75 75 150

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Table 2: Production Levels after international trade.
What about consumption gains? After trade, have the consumer in the two countries been
happier as a result of their countries becoming richer and more specialized in terms of
production? This depends on how the gains from production are distributed between the two
countries. In other worlds 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.
Case 1. Trade at TOT = 1:1
At this TOT country A agree with country B to exchange 1 unit of rubber for 1 unit of textile.
Then depending up an the taste pattern in the two countries and up on how much or how little
they want to trade each other's goods, the consumption gains can be determined.
 If the two countries want to consume all that they have produced, it means that their
consumers have no taste for the product of the other country then, there will be no
trade between countries.
 But if each country wants to consume some mix of both goods; then the countries will
trade each other‘s goods. Country A could export, say; 40 units of rubber for 40 units
of textile import from country B (at terms of trade 1:1). The result of this trade can be
depicted in table 3 below.
Country Commodities in units Units of output
(GDP )
Rubber Textile
A 100 0 100
B 0 100 100
World 100 100 200

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Country A, after trade, has produced 100 units of rubber (see table 2) consumers in country A
want to consume 60 of rubber, which means that this country can export 40 units of rubber to
country B in exchange for 40 units textile imports.
As a result, their consumption will increase by a total of 25 units than the case without trade (see
table 1). Similarly, country B's consumption level will also increase by 25 units than the
situation without trade However, if the terms of trade is equal to the cost ratio of country A, all
the gains from trade will be attributed to country B.
Table 3: consumption shares after international trade at TOT=1:1
Note: Import of country A is export of country B
Conversely, if the term of trade is equal to the cost ration of county B, all the gains from trade
will be attributed to country A. Any other terms of trade between the cost ratios of the two
countries may lead to unequal gains to country A and B. The country whose domestic cost ratio
is larger by small amount than the TOT will gain the smaller share and vice versa i.e. if TOT
closer to the domestic opportunity cost ratio of country A, country A will gain the smaller and B
will gain larger.
Case 2: Trade at TOT =Domestic opportunity cost ratio of country A = 2:1
All the consumption gains from international trade go to country B because the TOT is equal to
the domestic opportunity cost ratio of country A. Thus such a TOT is favorable to country B but
does not bring any change in welfare level of A.
Country Commodities in units Total
consumption
consumptio
n
Rubber Textile
A 60 import 40 100 25
B import 40 60 100 25
World 100 100 200 50

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All the consumption gains from international trade go to country A because the TOT is equal to
the domestic opportunity cost ratio of country B. Thus such a TOT is favorable to country A. It
does not bring any change in the consumption level of country B.
The welfare of country B before and after trade remains constant.
Case 4: Trade at TOT = 2:3
Most of the consumption gains from international trade go to country A because the TOT is
closer to the domestic opportunity cost ratio of country B than country A. Thus such a TOT is
more favorable to country A than country B.
consumption
Consumption
gain
Rubber Textile
A 50 import 25 75 0
B import 50 75 125 50
World 100 100 200 50
consumption
Consumption
gain
Rubber Textile
A 75 import 50 125 50
B Import 25 50 75 0
World 100 100 200 50

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Case 5: Trade at TOT = 3:2
Most of the consumption gains from international trade go to country B because the TOT is
closer to the domestic opportunity cost ratio of country A than country B. Thus such a TOT is
more favorable to country B than country A.
It is important to note that production gains alone are not sufficient to determine the profitability
of international trade from the standpoint of an individual member country. The consumption
gains (welfare gains) are also equally important. How the consumption gains are determined is
crucial in determining whether the economic well-being (standard of living measured by
consumption gains) of a member country has gone up as a result of international trade.
International TOT, therefore, plays a very important part in determine the welfare gains from
trade. International trade would be beneficial and profitable for a country if it results in
consumption gains. Production gains alone do not bring profitable trade from the stand point of
the country concerned, but it may from world point of view.
consumption
Consumpti
on gain
Rubber Textile
A 60 import 60 120 45
B import 40 40 80 5
World 100 100 200 50
consumption
Consump
tion gain
Rubber Textile
A 40 import 40 80 5
B import 60 60 120 45
World 100 100 200 50

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1.3.2.2 David Ricardo's comparative advantage model
Ricardo, in relation to Adam Smith‘s absolute cost advantage model of international trade, went
farther, and argued that even if the countries did not have absolute advantage in any line of
production over the others, international trade would be beneficial; leading to gains from trade to
all the participating countries. Ricardo‘s model is termed as comparative advantage model.
Ricardo‘s modal is a further refinement of Smiths‘ model.
Assumption of Ricardo’s Model
1) A simple model of the world with two countries each producing two goods, rubber and
textile.
2) Both countries can produce both goods if they wish ( i.e., dependence on each other is not
mandatory)
3) Constant returns to scale in production of both goods in the two countries (constant
marginal opportunity cost condition)
4) One country‘s comparative advantage is grater in one line of production and the other
country‘s comparative disadvantage is smaller in the other line of production.
In simple example the countries are endowed with X amount of factors of production such
that:
a) With x factors of production A can produce, say, 120 units of rubber or 120 units
of textile or any mix of rubber and textile conditioned by the opportunity cost
ratio of 1:1. The cost of producing a unit of either commodity is the same in
this country.
b) With X factors of production B can produce either 40 units of rubber or 80 units
of textile or any mix of rubber and textile conditioned by the opportunity cost ratio
of 1:2. Producing rubber costs two times producing textile.
From the above production possibilities (or supply condition) it is quite clear that countyA has an
absolute advantage over country B in both lines of production and country B has an absolute
disadvantage over country A in both lines of production. In terms of relative or comparative
advantage, country A has a greater comparative advantage in the production of rubber as

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compared with the production of textile. B's comparative disadvantage is smaller in the
production of textile compared with the first line of production (rubber). Using a given quantity
of factor inputs country A can produce 3 units of rubber whereas country B produces only 1 unit
of rubber using the same unit of factor input. In case of textile production country A can
produce 1.5 times what country B can produce using the same quantity of factor input.
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. International trade
would bring production and consumption gains, when the two countries enter into trade with
each other.
Let's see with the help of numerical models, how international trade will benefit countries in a
situation where countries differ in both absolute and comparative advantages. In other words,
how countries will benefit from international trade in a situation where one country has a larger
comparative advantage in the production of one good and the other country has a smaller
comparative disadvantage in the production of the other good.
Table 8 production possibilities in country A and B
Absolute advantage
 Country A has absolute advantage in the production of both textile and rubber over country
B.
 Country B has absolute disadvantage in the production of both goods over country A.
Country Commodities in units Opportunity
cost ratio
(R:T)
Rubber Textile
A 120 120 1:1
B 40 80 1:2
World 160 200

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Relative (comparative) advantage
 Country A's comparative advantage over country B is greater in the production of Ruber
(3:1) as compared to Textile (1.5:1)
 Country B's comparative disadvantage, in relation to country A, is lower in the production
of Textile (1:1:5) as against Rubber (1:3)
In addition country B can produce rubber at a far higher cost of production than textile. For
country B the cost of producing 1 unit of rubber equals the cost of producing 2 units of textile.
Hence country A would specialize in product of rubber and country B in production of textile.
The theory of comparative advantage suggests that 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 is greater there by a country
would be able to maximize its production (GNP) and consumption (economic welfare) gains
from trade.
Case 1 Autarky Situation
Table 9 indicates that country a produces and consumes 80 units of rubber and 40 units of textile
with the given production technology and input supply. The total production, GDP, is 120 units
and this is the maximum consumption level if we assume that saving is zero.
Table 9 production and consumption under Autarky
Country B produces 20 units of rubber and 40 units of textile with its given technology and input
supplies. The total production of country B is 60 units and total consumption will also be 60
Country Commodities in units Total output
or GDP
Rubber Textile
A 80 40 120
B 20 40 60
World 100 80 180

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units if savings are assumed to be zero. For our simple world of two countries, therefore, world
production and consumption will be 180 units.
After trade country B becomes richer by 20 units than the autarky situation and the world GNP
increases from 180 units to 200 units. This is due to the fact that trade enables country A to
specialize in the production of Rubber, for which it has a greater,
Table 10 production levels after international trade
Comparative advantage and country B has specialized in the production of textile for which it
has a smaller comparative disadvantage.
As in the case of Smith‘s model, the distribution of production gains from international trade
among trading countries for consumption depends on the terms of trade. The following tables
illustrate the distribution of consumption gains at different terms of trade.
The gains are equally distributed to country A and B at TOT = 3:4. This TOT is exactly half way
between internal cost ratios of country A (1:1) and country B(1:2).From table 10 and 11 we
observe that, although the production gains are obtained entirely by country B, the consumption
gains are distributed equally between country A and B. This is due to the equitable terms of
trade.
or GDP
GNP gains
Rubber Textile
A 120 0 120 0
B 0 80 80 20
World 120 80 200 20

19
Table 11 consumption levels after It at TOT = 3:4
All the gains in consumption are appropriated by country B due to the reason that TOT is equal
to the internal opportunity cost ratio of country A. In this situation, country A will not gain
anything from international trade, because the cost of importing the good is the same as the cost
of producing that good domestically,
Table 12 consumption levels after IT at TOT = 3:4
All the gains in consumption are appropriated by country A due to the reason that TOT is equal
to the internal opportunity cost ration of country B.
or GDP
GNP gains
Rubber Textile
A 120 0 120 0
B 0 80 80 20
World 120 80 200 20
Consumption
Consumption
Gains
Rubber Textile
A import
B import
World

20
Table 13 consumption levels after IT at TOT = 3:4= OCRB OF B
1.3.3 The modern theory of international trade
The two main propositions of the modern theory of international trade are the Factor-
Endowment theory (Heckscher-Ohlin theorem, hereafter named H-O theorem in this module)
and the Factor-Price equalization theorem.
The Factor-Endowment theory (H-O Theorem) states that a country has a comparative
advantage in the production and exports of that commodity which uses more intensively the
country's relatively abundant factor of production.
The Factor-Price Equalization Theorem states that the effect of trade is to equalize factor
prices between countries, thus serving as substitute for international factor mobility.
1.3.3.1 The H-O Theorem (Factor-Endowment theory) and its Assumptions
Recent contributions to the pure theory of international trade have relied heavily on the factor
proportions analysis developed by the two Swedish economists, Eli Heckscher (1919) and Bertil
Ohlin (1933). According to their theory, the immediate cause of international trade is, the
differences in the relative prices of commodities between the countries, and these differences in
the commodity prices arise on account of the differences in the factor supplies (endowments) in
the two countries.
The H-O model is based upon the following assumptions:
 There are only two factors of production-labor and capital.
 There are only two countries and they are different in factor abundance, e.g. one country is
capital abundant but labor scarce and the other country is labor abundant but capital scarce.
In other words, the two countries differ in factor endowments.
Consumption
Consumption
Gains
Rubber Textile
A 90 import
60 140 20
B import
30 20 60 0
World 120 80 200 20

21
 There are only two commodities. Both goods involve the use of both factors. The
production functions are such that the relative factor intensities are the same for ach good
in the two countries. In other words, regardless of what the factor proportions or factor
prices are in the two countries, one commodity is always capital intensive in both countries
and the other commodity is labor intensive in both countries.
On the basis of these assumptions, 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 and exports of labor intensive goods. We will now proceed to
demonstrate this well-known structure of trade prediction of the H-O model. In order to
demonstrate this prediction we need to define the term factor abundance.
Factor Abundance
There are two alternative definitions that have been given for the term 'factor abundance base on
the criterion used to define the term. There are two criteria for defining the term factor
abundance. These are price criterion and physical criterion.
i. The Price Criterion
According to this "price criterion" a country in which capital is relatively cheap and labor is
relatively more expensive, is regarded as the capital abundant country, regardless of the physical
quantities of capital and labor available in this country compared with the other country; in the
same way, a labor abundant country would be defined as one where labor is relatively cheaper
and capital is more expensive.
For the fact that price of a factor is the result of demand and supply forces in the factor market,
this criterion takes into account the supply and demand conditions for the two factors of
production in the two countries.
ii. The Physical Criterion
Factor abundance can be defined in physical terms. 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. In other words, if the capital to labor ratio of country A is
larger than the capital to labor ratio of country B, country A is a capital surplus country and
country B is a labor surplus country. This criterion takes into account only the supply (physical

22
quantities) of factors as a base for defining factor abundance. It does not take factor demand into
account.
These two alternative definitions are not equivalent. The Heckscher-Ohlin prediction with regard
to the structure of trade would follow only if we use the price criterion but it does not necessarily
hold well if we use the physical criterion to define factor abundance. Ohlin himself defined
relative factor abundance using the price criterion. He thought that if capital is relatively cheap in
one country, that country must be abundant in capital supply; and if labor is relatively cheap in
the other country, it must be a reflection of the labor abundance in that country.
It now remains for us to show that one country, say country A, is capital abundant and it exports
capital-intensive good, and the other country, say country B, is labor abundant and, therefore, it
will export labor intensive good. We shall examine these Heckscher- Ohlin proposition about the
structure of trade under each definition of factor abundance separately.
Critical evaluation of the H-O theorem
Although the factor proportions theorem developed by Heckscher and Ohlin provides a thorough
and plausible explanation of international trade as compared with the classical comparative
advantage model, yet it is not free from criticism. The H-O theorem has been criticized mainly
along the following three lines of arguments.
 Factor intensity reversal argument
 Leontief‘s Paradox, i.e. the results obtained by empirical tests conducted by Leontief and
others on the capital to labor ratios of exports and imports of developed countries like USA
and Japan.
 Demand reversal argument. We have already seen how the H-O theorem will turn out-to be
invalid when the demand reversal takes place.
Factor intensity reversal argument
The H-O theorem was based on the assumption of no factor intensity reversal. That is, the
production functions are different for different goods but they are identical for each good in the
two countries. This, in other words, means that one good is capital intensive (with higher capital-
labor ratio) and the other good is labor-intensive (with lower capital-labor ratio); but the same
good, which is capital-intensive in one country, must be capital intensive in the other country

23
also, and the labor intensive good remains labor intensive in both countries. This assumption is
guaranteed when the two production isoquants of the capital-intensive and the labor intensive
goods-cut each other only once but not more than once.
Leontief paradox
The first comprehensive and detailed examination of the H-O theorem was the one undertaken
by Leontief. You will recall that the theory of factor proportions predicted that the capital
abundant country exported capital-intensive goods and imported labor-intensive goods, and the
labor surplus country did the opposite. It is commonly agreed that the United States is a capital
rich and labor scarce country. Therefore, one would expect exports to consist of capital-intensive
goods and imports to consist of labor-intensive goods. Leontief made an extensive study of the
US structure of trade and the results were startling. Contrary to what the H-O theory had
predicted, Leontiefs study showed that the US exports consisted of labor-intensive goods and the
imports, (or more precisely import competing products) consisted of capital-intensive goods. In
Leontiefs own words, "America's participation in division of labor in international trade is based
on its specialization in labor intensive rather than capital-intensive lines of production. In other
words, the country resorts to foreign trade in order to economize its capital and dispose of its
surplus labor, rather than vice versa‖.
Demand reversal argument
The production and consumption biases operate in the same direction in each country, a capital
surplus country will go for specializing in the production of capital intensive good but it will
export a labor intensive good and a labor surplus country will go for exporting capital intensive
good. This structure of trade is contrary to the H-O prediction. Therefore, if demand reversal
takes place in both countries, the H-O prediction about the structure of trade will be invalid
1.4 International Trade, Development, and Growth
International Trade: -International trade is the exchange of goods and services between two
and more countries. One country produced goods and service exported to other country by
air, land or by boat transport. Under this process the goods and services must finished the
customs procedure of exported and imported countries.

24
Economic Development versus Economic Growth
Economic Development Economic Growth
Implications Implies an upward movement of the entire social
system in terms of income, savings and investment
along with progressive changes in socioeconomic
structure of country (institutional and technological
changes).
refers to an increase over time in a
country`s real output of goods and
services (GNP) or real output per
capita income.
Factors Development relates to growth of human capital
indexes, a decrease in inequality figures, and
structural changes that improve the general
population's quality of life.
Growth relates to a gradual increase
in one of the components of Gross
Domestic Product: consumption,
government spending, investment, net
exports.
Measurement Qualitative. HDI (Human Development Index),
gender- related index (GDI), Human poverty index
(HPI), infant mortality, literacy rate etc.
Quantitative. Increases in real GDP
Effect Brings qualitative and quantitative changes in the
economy
Brings quantitative changes in the
economy
Relevance Economic development is more relevant to
measure progress and quality of life in developing
nations.
Economic growth is a more relevant
metric for progress in developed
countries. But it's widely used in all
countries because growth is a
necessary condition for development.
Scope Concerned with structural changes in the economy Growth is concerned with increase in
the economy's output
1.4.1 International Trade and Growth
 Growing theoretical evidence of positive relationships between trade and growth in many
developed nations;

25
 Economic theory has identified the well-known channels through which trade can have an
effect on growth:
 promote the efficient allocation of resources,
 allow a country to realize economies of scale and scope,
 facilitate the diffusion of knowledge,
 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
 Such relationship is somehow vague in Least Developed Countries (LDCs). In Africa? In
Ethiopia?
1.4.2 The Gains from Trade
International trade gives rise to a world economy, in which prices, or supply and demand,
affect and are affected by global events.
 International trade brings about improvement in production and promotes economic
development in the participating countries.
 It prevents monopolies.
 It is beneficial to consumers by providing them new and cheap commodities. It also
facilitates international payments.
 The gains from international trade can be broadly classified into static and dynamic
gains
A. Static Gains of International Trade
Static gains arise from optimum use of the country‘s factor endowments or human and physical
resources, so that the national output is maximized resulting in increase in social welfare. You
can consider a simple model of international trade with two countries A and B both producing
wheat and cotton.

26
1. Maximization of Production:
According to the classical economists, the gains from trade result from the advantages of
division of labor and specialization both at the national and international levels. Given the
resources and technology in a country, it is specialization in production on the basis of
comparative advantage and trading which enables each country to exchange its goods for the
goods of another country. Thus it reaps greater gain than without trade. Each country exports
those goods which it produces cheaper in exchange for what other countries produce at a lower
cost. According to Ricardo, ―The gain from trade consisted in the saving of cost resulting from
obtaining the imported goods through trade instead of domestic production.‖ Thus trade
maximizes production.
2. Increase in Welfare:
As a result of international division of labor and specialization, the production of goods increases
in the trading country. As a result, the consumption of goods increases and so does the welfare of
the people. As pointed out by Ricardo, ―The extension of international trade very powerfully
contributes to increase the mass of commodities and, therefore, the sum of enjoyments.‖
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. This, in turn, raises its level of output and growth rate of the
economy.
4. Vent for Surplus:
The gain from trade also arises from the existence of idle land, labor, and other resources in a
country before it enters into international trade. With its opening (vent) to world markets, its
resources are used to produce a surplus of goods which would otherwise remain unsold. This is
Adam Smith‘s vent for surplus gain from trade.
B. 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:

27
The major indirect dynamic gain from trade is that it widens the size of the market. By enlarging
the size of the market and scope of specialization, international trade makes a greater use of
machines, encourages inventions and innovations, raises labor productivity, lowers costs and
leads to faster growth.
3. Development of Other Activities:
When a country starts producing goods for export and importing goods for domestic
consumption, other economic activities also develop. There is expansion of infrastructure
facilities in power, and building highways, bridges, fly-overs, etc. Shopping and housing
complexes are built along with industrial centers. The primary sector develops into business
sector for export of raw materials and for domestic use. Tertiary sector expands in the form of
banks, communications, insurance, etc.
4. Increase in Investments:
Foreign trade encourages the setting up of new units for assembling and production of variety of
goods. Supplementary and ancillary units are established. Production for exports leads to
backward and forward linkages in developing other activities referred to above. All these
increase autonomous and induced investments in the country.
 Dynamic gains refer to those benefits, which promote economic growth and economic
development of the participating countries.
International trade promotes economic development in the following ways.
1) Developing countries can import capital goods in exchange for their exports that are mostly
agricultural exports. The capital goods then will increase the productive capacity of these
countries and promote the process of industrial development.
2) A country can also import technical know-how, technical skills, managerial talent and
entrepreneurship through foreign trade and collaboration.
3) International trade has brought about a tremendous movement of capital from developed
countries to developing countries. Thus, foreign trade facilitates the payment of interest or

28
repatriation of capital. The existence of large volume of foreign trade serves as a guarantee
for the payment of interest and the principal for lenders.
1.5 Preferential Trade Agreements
1.5.1 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 at the end of the Bretton Woods meetings. The main aim was
―reduction in tariffs and other international trade barriers‖.
Sustainable development is directly linked with international trade and free trade agreements. In
the era of globalization, each economy of the world is trying to achieve sustainable development
through international trade.
Regional trade agreements (RTAs) can be a useful tool in promoting growth. RTAs structure
trade in a way that can increase domestic productive capacity, promote upward harmonization of
standards, improve institutions, introduce technical know-how into the domestic market and
increase preferential access to desirable markets. These are outcomes that could benefit
developing economies in general and particularly the least developed countries (LDCs) and other
low-income countries.
Trade agreements are either multilateral, involving large countries in the world or preferential
trade agreements (PTAs), trade between two or more countries. They are usually intended to
lower trade barriers between participating countries to increase the degree of economic
integration between the participants.
Regarding the extent of trade agreements in a free trade area, tariff and non-tariff barriers to
trade between member countries are removed. Trade barriers with the rest of the world differ
among members and are determined by each member‘s policy makers. In customs unions, trade
barriers between members are eliminated and identical barriers to trade with nonmembers are
established, typically by common external tariffs. A common market is a customs union in which

29
the free movement of goods and services, labor, and capital is also permitted among member
nations. An economic union is the most complete form of economic integration. National
agricultural, social, taxation, fiscal, and monetary policies are harmonized or unified among
member countries, and a common currency may be adopted.
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 to address a host of behind-the-border issues, also
known as ―deep integration‖ issues, in order to promote cooperation in the areas of investment,
trade facilitation, competition policy, and government procurement, as well as wider social
issues related to the regulation of the environment and the protection of labor and human rights.
All at all, Regional integration is increasingly recognized as a key avenue for promoting
economic growth and reducing poverty.
1.5.2 Types of Trade agreement
1.5.2.1 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), established in 1947 and located in Geneva.
The GATT continued operating for about fifty years with the purpose of arranging rules for
international trade of goods and especially diminishing tariffs and quotas. It was not an
institution but had a permanent organization that comprised of some rules within a particular
framework. Negotiations within the GATT continued until the Uruguay Round was completed in
1994. Then, around 60 agreements and separate commitments (called schedules) were covered
within the set of Uruguay Round negotiations. On the conclusion of the Uruguay Round of Trade
Talks (1986-1994), the WTO was established on January 1, 1995.
The World Trade Organization (WTO) is a voluntary group of nations that negotiates, monitors,
and enforces global rules for international trade. More than 140 nations have joined the WTO
and have agreed to accept pre negotiated trading rules. The WTO describes itself as dedicated to

30
reducing barriers to trade between nations and ensuring that members adhere to predetermined
rules for international trade.
WTO members agree to execute ―a non-discriminatory trading system that spells out their rights
and their obligations‖ covering issues that range from trade of goods and services to intellectual
property, dispute settlement and policy reviews. Each member is guaranteed to face a fair
treatment for its exports in other members‘ markets and guarantees to treat imports equally in its
own market. Besides, the needs of developing countries are recognized and these countries are
allowed some flexibility so that they can rely on their commitments.
The GATT-WTO system is a legal organization that embodies a set of rules of conduct for
international trade policy. 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)
The world‘s economic activities are now organized through global value chains and strategic
networks, rather than through arm‘s length sales between vertically-integrated buyers and sellers
in different countries. The most obvious evidence of that trend lies in the percentage of world
trade made up of intermediate goods –a nearly 60 percent share of world imports. More and
more of, the impact of global value chains extends well beyond the higher volume of trade in
intermediates. Global value chains draw ―a broader range of establishments, firms, workers, and
countries into increasingly complex and dynamic divisions of labor,‖ which has driven a much
deeper and more far-reaching change in the organization of production globally and the basis of
competition.
A large group of countries are 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. The EU itself, by virtue of successive enlargements (most recently,

31
from 25 to 27 countries in 2007), has been part of a changing network of PTAs in the region. The
EFTA states and Turkey, by virtue of their association with the EU, have continued to expand
their own PTA networks both within and outside the region. Since enlarging to 27 member
states, the EU has continued to expand its relationship with south Eastern Europe and with
countries in the Mediterranean Basin.
Africa has played a prominent role in the WTO and negotiations for a successor to the current
trade regime with the European Union (EU) are under way. African states have been able to
engage in a very wide range of negotiations, both within and outside Africa. Trade integration
with in the Southern African Development Community (SADC), the Common Market for
Eastern and Southern Africa (COMESA) and WAEMU West African Economic and Monetary
Union is already under way.
The proliferation of bilateral and regional PTAs may undermine progress toward a more open,
transparent, and rules-based multilateral trading system. The multilateralists argue that, although
regionalism may increase trade, its effects on welfare and on the world trade system are likely to
be harmful.
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, is that regionalism
may hinder multilateralism, leading to a bad equilibrium in which several regional trade blocs
maintain high external trade barriers. Regionalism can also undermine multilateralism simply by
diverting limited government resources from multilateral negotiations.
1.5.2.2 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.

32
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. Regionalism becomes the most active mode of trade liberalization. The
regionalization of trade is of serious concern to many international economists who view
multilateralism‘s far superior to regionalism for improving welfare. At issue is the preferential
nature of regional agreements, which could divert trade and reduce the potential for future
multilateral liberalization.
The rapid increase in preferential trade agreements (PTAs) has been a prominent feature of
international trade policy in recent times. Nations establish preferential trading agreements under
which they lower tariffs with respect to each other but not the rest of the world. However, the
GATT-WTO, through the principle of non-discrimination called the ―most favored nation‖
(MFN) principle, prohibits such agreements. The formation of preferential trading agreements is
allowed if they lead to free trade between the agreeing countries.
Preferential trade agreements (PTAs) have become a cornerstone of the international trade
system. The surge in their number and scope is fast reshaping the architecture of the world
trading system and the trading environment of developing countries. This diverse agreement that
facilitates the expansion of trade is likely to be one of the main challenges facing the world
trading system in the coming years.
However, the recent empirical literature is tackling the question of how trade liberalization has
been affected by the formation of PTAs. Although the verdict is not yet in, the evidence indicates
that regionalism is broadly liberalizing. A trade diversion versus trade creation has attempted to
provide answers to the question of whether bilateralism is bad. If regionalism is moving world
trade away from natural trade patterns, thus reducing world welfare, more diversion will be
observed; if regionalism is pushing trade in the right direction, we should observe little diversion.
The analyses also offer an indirect check on the effect of regional agreements on trade
liberalization. If regional members tend to raise barriers to nonmembers, there should be strong
evidence of trade diversion—increased trade with members at the expense of nonmembers. By

33
contrast, if regional members tend to lower barriers to nonmembers in concert with PTAs,
diversion should be limited.
Typology of Preferential Trade Agreements
Care should be taken when categorizing preferential trade agreements (PTAs), given the
differences in terminology used by institutions and researchers. In this module, we use the
generic term PTA to refer to all preferential 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): it is 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. Examples are the North American Free Trade Agreement
(NAFTA) and the Japan–Singapore New-Age Economic Partnership Agreement.
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 that includes the establishment of a common external tariff. Thus,
products entering the customs union from third parties face the same tariff regardless of the
country of entry. Examples are the Southern Cone Common Market and the agreement between
the European Union (EU) and Turkey.
Partial-scope agreement: an agreement between two or more parties that offer each other
concession on a selected number of products or sectors. Examples are the Asia-Pacific Trade
Agreement (APTA) and the agreement between the Lao People‘s Democratic Republic and
Thailand.
Economic Integration Agreement (EIA): An agreement covering trade in services through which
two or more parties offer preferential market access to each other. Examples are the U.S.–Peru
and Thailand–Australia PTAs. Typically, services provisions are contained in a single PTA that
also covers goods. An EIA may be negotiated sometime after the agreement covering goods; for

34
example, the Caribbean Community (CARICOM) and the European Free Trade Association
(EFTA) have negotiated separate services protocols.
Preferential trade agreement (PTA): The generic term used in this module to denote all forms of
reciprocal preferential trade agreements, including bilateral and plurilateral agreements.
PTAs covering trade in goods should be notified to the WTO in force. Thus, from the report of
WTO free trade agreement FTAs are by far the most common type, accounting for 83 percent of
all PTAs. Customs unions, a deeper form of integration, require significant policy coordination
between their parties. They are more time consuming to negotiate, are less common, and make
up only 10 percent of all PTAs. Partial-scope agreements account for the remaining 7 percent.
Hundreds of preferential agreements free trade agreements and customs unions that involve tariff
reductions are currently in force, including close to 300 that had been notified to the World
Trade Organization (WTO) as of end-2010.
Some Preferential trade agreements in the world 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

35
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
EAEC, Eurasian Economic
Community
Belarus, Kazakhstan, Kyrgyz Republic, Russia, Tajikistan
ECO, Economic Cooperation
Organization
Afghanistan, Azerbaijan, Islamic Republic of Iran,
Kazakhstan, Kyrgyz , Republic, Pakistan, Tajikistan, Turkey,
Turkmenistan, Uzbekistan
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
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 Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab

36
Council Emirates
LAIA/ALADI Latin American
Integration Association/
Asociación Latinoamericana
de Integración
Argentina, Bolivia, Brazil, Chile, Colombia, Cuba, Ecuador,
Mexico, Paraguay, Peru, Uruguay, República Bolivariana de
Venezuela
MSG Melanesian Spearhead
Group
Fiji, Papua New Guinea, Solomon Islands, Vanuatu
NAFTA North American Free
Trade Agreement
Canada, Mexico, United States
OCT Overseas Countries and
Territories
Anguilla, Aruba, British Antarctic Territory, British Indian
Ocean Territory, British Virgin Islands, Cayman Islands,
Falkland Islands, French, Polynesia, French Southern and
Antarctic Territories, Greenland, Mayotte, Montserrat,
Netherlands Antilles, New Caledonia, Pitcairn, Saint Helena,
Saint Pierre and Miquelon, South Georgian and South,
Sandwich Islands, Turks and Caicos Islands, Wallis and
Futuna Islands
PAFTA Pan-Arab Free Trade
Area
Algeria, Bahrain, Egypt, Iraq, Jordan, Kuwait, Lebanon,
Libya, Morocco, Oman, Palestinian Authority, Qatar, Saudi
Arabia, Sudan, Syrian Arab, Republic, Tunisia, United Arab
Emirates, Republic of Yemen
PATCRA Papua New
Guinea–Australia Trade and
Commercial Relations
Agreement
Australia, Papua New Guinea

37
PICTA Pacific Island
Countries Trade Agreement
Cook Islands, Fiji, Kiribati, Federated States of Micronesia,
Nauru, Niue, Papua New Guinea, Samoa, Solomon Islands,
Tonga, Tuvalu, Vanuatu
PTN Protocol relating to
Trade Negotiations among
Developing Countries
Bangladesh, Brazil, Chile, Egypt, Israel, Republic of Korea,
Mexico, Pakistan, Paraguay, Peru, Philippines, Romania,
Tunisia, Turkey, Uruguay, former Yugoslavia
SACU Southern African
Customs Union
Botswana, Lesotho, Namibia, South Africa, Swaziland
SADC Southern African
Development Community
Angola, Botswana, Democratic Republic of Congo, Lesotho,
Madagascar, Malawi, Mauritius, Mozambique, Namibia,
Seychelles, South Africa, Swaziland, Tanzania, Zambia,
Zimbabwe
SAPTA/SAFTA South Asian
Preferential (Free) Trade
Arrangement
Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan, Sri
Lanka
SPARTECA South Pacific
Regional Trade and Economic
Cooperation Agreement
Australia, Cook Islands, Fiji, Kiribati, Marshall Islands,
Federated States of Micronesia, Nauru, New Zealand, Niue,
Papua New Guinea, Samoa, Solomon Islands, Tonga, Tuvalu,
Vanuatu
WAEMU West African
Economic and Monetary
Union
Benin, Burkina Faso, Côte d‘Ivoire, Guinea-Bissau, Mali,
Niger, Nigeria, Senegal, Togo, Guinea, Guinea-
Bissau,Liberia,Mali,Senegal,Sierra Leone

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1.5.3 Regional Trade Agreement in Developing Countries
Since the Uruguay Round, developing countries have played a larger role in the WTO. Of the
140WTO member countries, 105 are classified as developing and, of those, 29 are least
developed. Although developing countries differ in many ways, they have much in common and,
since the 1960s, have attempted to influence trade negotiations by forming coalitions with
common objectives, such as increasing access to industrialized country markets.
From World War II 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. Then, Developing countries have become more active participants in
regional trade agreements, which raise questions about how the benefits of integration are
distributed. A key concern is whether countries at the low end of the income spectrum are able to
capture development gains from integration.
As the result, the multitude of PTAs is becoming cumbersome to manage for many developing
countries. As agreements proliferate, countries become members of several different agreements.
The average African country, for instance, belongs to four different agreements, and the average
Latin America country belongs to seven. This creates what has been referred to as a ―spaghetti
bowl‖ of overlapping arrangements, often with different tariff schedules, different exclusions of
particular sectors or products, different periods of implementation, different rules of origin,
different customs procedures, and so on.
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. Bilateral or regional
integration can be an important engine of trade competitiveness, both for small, very poor,
landlocked countries and for less regionally integrated or diversified middle-income countries.
Regional integration in Sub-Saharan Africa has, for the most part, taken the form of PTAs
among geographically contiguous countries. SACU, the world‘s oldest customs union, is

39
engaged in negotiating PTAs and recently notified an agreement with EFTA. Other efforts at
creating intraregional and extra regional partnerships have fallen short of their ambitious
statements of intent. In several cases, membership of regional groupings is defined by political
alliances rather than market access goals, resulting in overlapping memberships that create
difficulties in implementation.
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, all three of which are customs unions in force or in the
making. The eight WAEMU members are all members of ECOWAS. The EU is negotiating
EPAs with ECOWAS and CEMAC.
Negotiations for an economic partnership agreement with the EU, although intended to
strengthen regional integration, have created further confusion in eastern and southern Africa
because memberships of the EPA groups and the regional agreements are different. With regard
to the current state of play of the EPA negotiations, in June 2009, an interim EPA was signed
between the EU and Botswana, Lesotho, and Swaziland (part of the SADC EPA); Mozambique
joined soon afterward. An interim EPA was initialed between the EU and the Seychelles,
Zambia, and Zimbabwe in November 2007 and with the Comoros, Madagascar, and Mauritius in
December 2007 for the Eastern and Southern Africa (ESA) EPA.
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; …

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1.5.4 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.
 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 that trade diversion.
1.5.5 Challenges of Trade agreement
Several trade issues have emerged as important to developing countries. Expanding access to
developing country markets may have adverse consequences for some, especially the poorest
countries. One concern is that higher and more volatile food prices will reduce real disposable
incomes for many poor households in some developing countries. Another is that poor farmers
could be adversely affected by large imports of relatively low priced foods. Some developing
countries have also objected to policy making being determined in the WTO, arguing that the
process sacrifices national sovereignty, and they have argued for a halt to the WTO process.
Africa already experiences the impact of wholly informal rule-making on agricultural standards
imposed by European super markets, against which there is no appeal. The task is to bring these
under some degree of public control – and to avoid the extent of private rule making spiraling.

41
Africa should challenge the economic justifications given by proponents of the most damaging
changes. These are often justified on the grounds that they are a step towards liberalization which
will, over time, enhance global welfare, and that Africa needs to ‗stop living in the past and
accept change‘.
Africa‘s task is to avoid the twin challenges of inappropriate new public rules (whether
multilateral or regional) and the danger that, in the absence of public regulation, the private
sector determines the rules of the game. In recent years its negotiators have demonstrated to the
rest of the world that the region cannot be taken for granted in international trade negotiations.
The task for the future is to develop capacity to develop more proactive positive rule changes
that would respond more appropriately to Africa‘s particular needs.
1.5.6 International Commercial Terms (INCOTERMS)
A universal term that defines a transaction between importer and exporter, so that both parties
understand the tasks, costs, risks and responsibilities, as well as the logistics and transportation
management from the exit of the product to the reception by the importing country.
INCOTERMS are all the possible ways of distributing responsibilities and obligations between
two parties. It is important for buyer and seller to pre-define the responsibilities and obligations
for transport of the goods.
The main responsibilities and obligations terms describe are: Point of delivery: the
INCOTERMS defines the point of change of hands from seller to buyer. Transportation costs:
the INCOTERMS defines who pays for whichever transportation is required. Export and import
formalities: INCOTERMS defines which party arranges for import and export formalities.
Insurance cost: INCOTERMS define who takes charge of the insurance cost.
Here‘s the well-known terms mostly used in international trade transactions:
CFR – Cost and Freight - the exporter must deliver the goods at the port of destination selected
by the importer. Transport expenses are thus the responsibility of the exporter. The importer

42
bears the expenses of insurance and unloading of the goods. Utilization of this term obliges the
exporter to offload the goods for export, and to use only sea and inland waterway transportation.
CIF – Cost, Insurance and Freight – modality equivalent to CFR, except that the insurance costs
are born by the exporter. The exporter must deliver the goods aboard ship, at the port of
embarkation, with freight and insurance paid. The responsibility of the exporter ceases when the
product is offloaded from the ship at the port of destination. This modality may only be used for
sea and inland waterway transportation.
CIP – Carriage and Insurance Paid to... – adopts a principle similar to CPT. The exporter, aside
from bearing expenses for shipment of the goods and freight to the destination, must also bear
expenses of insurance for transport of the goods to the destination indicated. CIP may be used for
any mode of transportation, including multimodal.
CPT – Carriage paid to... – similarly to CFR, this condition stipulates that the exporter must pay
expenses relating to the shipment of the goods and international freight to the designated
destination. Thus, the risk of loss or damage to the goods, and any increase in costs, are
transferred to the exporter by the importer, when the goods are delivered into custody of the
transporter. This Incoterm may be used for any mode of transportation.
DAF – delivered at Frontier - the exporter must deliver the goods at the designated place and
location on the frontier, prior to crossing over to the country of destination. This term is used
principally in the case of highway or railroad transportation.
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. The exporter is not, however, responsible for unloading the
goods. The exporter is also responsible for domestic freight to the destination designated by the
importer. This term may be used for any mode of transportation. This is the Incoterm that places
the largest degree of responsibility upon the exporter.
DDU – Delivered Duty Unpaid - the exporter must place the goods at the disposal of the
importer at the designated place and location abroad. The exporter assumes all expenses and

43
risks for placement of the goods at the named destination, except expenses relating to customs
duties, taxes, and other import charges. This term may be used for any mode of transportation.
DEQ – delivered Ex Quay - the exporter must place the goods, without importation clearance, at
the disposal of the importer on the dock at the port of destination. This term is used for sea and
inland waterway or multimodal transportation.
DES – Delivered Ex Ship – modality used only for sea and inland waterway transportation. The
exporter bears responsibility for placement of goods at the named destination, on board the ship,
without importation clearance, and must fully assume all risks and expenses up to that point
abroad.
FAS – Free Along Ship - obligations of the exporter cease upon loading of the goods, cleared for
export, on the dock, free, alongside the ship. As of this moment, the importer assumes all risks,
and bears all expenses relating to loading of the goods on board the ship. The term is used for sea
and inland waterway transportation.
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. This may apply to any type of transportation, including multimodal.
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. This modality is used for sea and inland
waterway transportation. All expenses, up until the loading of the goods on the transport vehicle,
are born by of the exporter. The importer is responsible for expenses and risks of loss or damage
to the goods, once delivered on board the ship.
1.6 Trade policy in developing Countries
1.6.1 Overview of Trade policy
Trade can play a significant role in the world‘s quest towards sustainable development. Over the
past decades, an increasing number of developing countries have integrated into the world
economy and in most of the development success stories trade was an important element.

44
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 that -
based on a static interpretation of the concept of comparative cost advantages - state intervention
in national production structures falsifies the "natural" specialization of the economy according
to its factor endowment and should therefore be eschewed: international trade leads to an
alignment of factor rewards between different countries by raising the price of those production
factors which are available in relatively large amounts; state intervention thus has the effect of
hindering the use of resources in accordance with their relative availability.
How a country can actively influence its production structure is of particular significance. Here,
as a rule, the original concept of comparative cost advantages is not challenged as such, but is
subjected to dynamic interpretation: factor combinations and specialization structures change
during the development process; it is not a case of wanting to deny the critical role of
endowments for choosing an appropriate specialization, but to accelerate the process of structural
change by means of an appropriate economic policy.
Consequently, the main aim of trade policy is to shift the national economic activity - bearing in
mind its current strengths and comparative advantages – to sectors for whose products the
income elasticity of demand is high, in which labor productivity growth is fast, and where
perspectives for growth are therefore favorable.
International trade needs to play an enabling role in growth and development, as called for in
Sustainable Development Goals. Proactive, best-fit and coherent policy-mix needs to be
mainstreamed into national policy agendas in support of sustainable development. 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.
1.6.2 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 key to economic development was creation of a strong

45
manufacturing sector. The best way to create a strong manufacturing sector was by protecting
domestic manufacturers from international competition.
The most important economic argument for protecting manufacturing industries is the infant
industry argument. However, the infant industry argument was not as universally valid as many
people assumed.
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, gathered by customs officials at the place of entry. Tariffs fall into two
categories. A specific tariff is a money amount per physical unit of import. For example a $ per
ton of textiles. An ad valorem tariff is a percentage of the estimated market value of the goods
imported. Thus, as a result of a tariff consumers will end up paying higher prices, buying less of
the product or both. A tariff brings gains for domestic producers who face import competition.
The second one is quota; the government gives out a limited number of licenses to import items
legally and prohibits importing without a license. A quota gives government officials greater
administrative flexibility and power. A quota is a shelter against further increases in import
spending when foreign competition is becoming severe.
Moreover, the governments of importing countries levy antidumping tariffs against dumping.
Dumping is a form of international price discrimination in which an exporting firm sells its
product at a lower price in a foreign market than it charges in its home country market.
It implies that it is a good idea to use tariffs or import quotas as temporary measures to get
industrialization started. However, many economists are now harshly critical of the results of
import substitution, arguing that it has fostered high-cost, inefficient production.
Many countries that have pursued import substitution have not shown any signs of catching up
with the advanced countries.

46
Import-substituting industrialization generated:
 High rates of effective protection
 Inefficient scale of production
 Higher income inequality and unemployment
Thus, the post war liberalization of trade was achieved through international negotiation.
Governments agreed to engage in mutual tariff reduction. The Advantages of Negotiation can
easier to lower tariffs as part of a mutual agreement than to do so as a unilateral policy because:
– It helps mobilize exporters to support free trade.
– It can help governments avoid getting caught in destructive trade wars.
1.6.3 Import Liberalization Industrlization
Import protection has fallen continuously, more as a result of the unilateral measures than of
multilateral trade liberalization. As a result 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. Unweight average import duty levels are
currently highest in South Asia at 45% (compared to 60% at the end of the 1980s). In Africa,
average import duty levels are around 25%, while Latin America and East Asia have lowered
average duty levels to approximately 15%.
Moreover, Transforming quantitative import restrictions into import duties, for example, does
not lead to losses of revenue - in contrast to reductions in import duty - but opens up a new
source of income.
The most significant possibilities are largely the result of generally improved access to export
markets for products from developing countries due to a reduction in levels of import duty as
well as in quantitative import restrictions in purchasing countries. The fast-growing sales
markets of the dynamic Asian economies represent an important export potential for less
developed countries.

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The measures to be implemented within the framework of an import liberalization programme
should be those which also have a positive effect on the balance of payments and/or export
developments and the budgetary situation. This means that import liberalization must take the
requirements of the economy's productive and exporting sectors into consideration.
Liberalization of imports, which should be concerned initially with important inputs for the
production of export goods, can ensure that there is an even balance between the foreign
exchange requirements of those sectors which produce goods for the domestic markets and the
export sectors which earn foreign exchange. Such policies confront the danger of the possible
negative effects which trade reforms can have on foreign exchange and tax revenues.
Further liberalization of foreign trade appears to be running into difficulties in many countries. It
is reasonable to assume that major reasons for this are inadequate progress in reducing
macroeconomic deficits and the unsatisfactory development of export business. Successful trade
liberalization requires complementary policies.
1.6.4 Export Promotion Industrialization
The greatest cause for concern is the development imbalances on current foreign account mainly
in developing countries. While there are certainly many roots to this problem, the major one is a
conflict of aims exists between trade policy liberalization and foreign trade stabilization. Thus,
the opportunities of globalization can only be exploited if these countries succeed in
implementing adequate fiscal and export promotion policies.
From the mid-1960s onward, an export of manufactured goods, primarily to advanced nations,
was another possible path to industrialization for the developing countries. The process of
globalization and liberalization presents significant trade opportunities to all the developing
countries including the least developed countries (LDCs). In many countries, especially in
Africa, either improved market opportunities resulting from continuing multilateral liberalization
or unilateral measures aimed at dismantling trade protection have so far led to lasting economic
growth or export success.

48
It is therefore 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 through rectification of
deficiencies noticeable in the scheme and by introducing new incentives having direct or indirect
impact of motivating investors engaged in export trade.
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. This is because food, Non-food agricultural product and raw materials makes up
almost 40% of her total export and for many poor countries, it constitutes their principal source
of foreign exchange earnings. There are many reasons for these countries' poor supply capacity.
The underdeveloped private sector with its lack of technological, organizational and marketing
capabilities, the low levels of worker education and training, and poor infrastructures are not the
only problems.
1.7 International Trade policy In Ethiopia
The Government of Ethiopia started the process of accession to the World Trade Organization
(WTO) in 2003. The Memorandum of the Foreign Trade Regime (MFTR) was prepared and
submitted to the WTO Secretariat in December 2006. The goods offer as well as the various
information documents was submitted to the WTO in 2011 and 2012, and the services offer has
been prepared. Nevertheless, since 2012 no tangible progress has been made, although there are
now indications that the accession process may resume. Concerning preferential trade agreement
Ethiopia is one of the members of COMESA, Common Market for Eastern and Southern Africa.
Some among the potential benefits Ethiopia expecting from WTO accession are: It will serves as
a tool to lock in reforms, It will ensures market access for Ethiopian exports increases the trade
volume due to the tariff reduction, It will provide for a transparent and predictable regulatory
framework, It will prohibits arbitrary and discriminatory restrictions on foreign trade, It increases
Ethiopia‘s opportunity to attract foreign investment due to market access. Ethiopia can utilize the

49
WTO‘s dispute settlement mechanism to settle trade disputes with other WTO members, it
provides a platform to integrate Ethiopia in the multilateral trading system, and GDP might also
grow because of FDI and export.
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 which is essential for importing capital goods, intermediate inputs
and other goods and services that are necessary for the growth and development of the economy.
The third one is improving the efficiency and international competitiveness of domestic
producers through participation in the international market.
Since the implementation of the Plan for Accelerated and Sustained Development to End Poverty
(PASDEP) in 2004/05The performance of foreign trade in Ethiopia has increased significantly.
Available evidences shows that the value of both exports and imports improved tremendously
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.
The export receipt of the country is so small that it cannot finance import payments of the
country. For this reason, trade deficit is widening very much as the export basket and
destinations are limited and the import demand is growing following the growing income of
consumers. It is therefore important to identify the factors that can help to develop the export
receipt.
The trade record in Ethiopia shows that most export destinations are European markets and
imports origin from Asia particularly China and Saudi Arabia as well as United Arab Emirates.
The country needs to maximize its share from the American market (AGO opportunities)
through creating value addition and by working on quality of products to exported. Thus, it is
crucial to do other policy options to expand export receipt and narrow trade deficit.

50
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.
1.7.1 The Export Incentive Promotion in Ethiopia
According to Ethiopia export trade duty incentive schemes proclamation No. 768/2012to ensure
economic development by accelerating industrial growth of the country and to improve the
foreign exchange earning needed for development and investment; to achieve transformation into
industry led economy, it is necessary to establish a system of reinforcing value creation in the
process of production;
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.
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 processed;
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 or bought from bonded input
supplies warehouse, for use in the production of goods for external market by persons availing
themselves of the voucher scheme under this Proclamation.

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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.
Bonded export manufacturing warehouse means a warehouse under joint control of the
Ethiopian Customs Commission and the factory concerned, where raw materials imported free of
duty for use in the production of goods destined exclusively for export as well as goods produced
using such raw materials are stored;
Bonded input supplies warehouse means a warehouse under the joint control of the Ethiopian
Customs Commission and the supplier concerned, where raw materials and accessories imported
free of duty by a licensed supplier are stored until such time as they are sold to producers.
Industrial zone means an area set aside for industry which is equipped with the necessary
infrastructural facilities and enjoys policy incentives.
The following persons or parties shall be eligible for the pre-stated export incentive schemes are;
1/ Producer exporters;
2/ Indirect producer exporters;
3/ Raw material suppliers;
4/ Exporters.
Raw materials imported under the above scheme except for industrial zone shall be used in the
production of export commodity and the commodity so produced shall be exported within one
year from receipt of such raw materials by the beneficiary; provided, however, that the Ethiopian
Customs Commission may extend this period by one additional year taking into consideration
the nature of the raw materials.
A beneficiary of the above schemes who has not secured permission for extension of the period
or to sell raw materials imported under this scheme upon payment of duty chargeable on such

52
raw materials in accordance with Article 25 of this Proclamation shall, in addition to the duty
payable on the unused amount of the raw material, be required to pay 50% of the duty.
1.8 Controversies in Trade policy
Globalization of the world economy also entails big risks, however. As a result of the
globalization process, pressure of competition has also intensified on developing countries'
domestic markets. Trade liberalization heightens the risk of macroeconomic destabilization
mainly in developing Countries. If exports fail to take off while imports increase as trade
restrictions are relaxed, foreign trade imbalances will increase.
General import liberalization which is not combined with a deliberate program of export
promotion can quickly lead to an increase in imports and a shortage of foreign exchange revenue.
The risk of such a development is particularly great in times of high inflation - which is usually
an indication of deficient monetary policy instruments - and over-valued exchange rates. The
longer structural adjustment continues without economic activity and exports taking off, the
more difficult it becomes for governments to subdue domestic political resistance to economic
policy reforms.
It is reasonable to assume that the weak supply response to national trade liberalization programs
is partly due to a lack of an export promotion apparatus. Since no such apparatus exists and
because there is insufficient capacity to deliberately promote competitive export sectors, it has,
as a rule, proven impossible to reduce the foreign trade deficit. This makes it difficult to exploit
the market opportunities sketched out above.
Product diversification that aims at moving away from a limited basket of exports to mitigate the
economic risks of dependence upon few commodity exports is imperative. Market opportunities
should improve for non-traditional agricultural products in particular (tropical fruits, fruit and
vegetables, high-value fish products, etc.) due to changing consumer preferences, income growth
and the liberalization of agricultural trade. Moreover, reducing dependence upon limited number
of geographical destinations for the export sales can also be another way of reducing, if not
avoiding, the economic risks of less diversification.

53
Ethiopian export is dominated by few raw or semi processed agricultural products, Lack of
diversification and value addition; limited by type and volume, i.e., confined to few items of
which one commodity (coffee) accounts for about 60 percent, lack of export marketing skills and
market promotion schemes; inadequate trained manpower in international marketing intelligence
are the main contributors to the country‘s foreign exchange earnings which result for failure in
the overall economic development of the country. This feature is expected to continue without
significant change, in the near future, due to the overall underdevelopment of the country‘s
economy.
The prevailing trade and investment policies and strategies need to be improved to bring about a
sound export growth. More importantly, The Ethiopia government should compare the
anticipated benefits and challenges of acceding to the WTO and of staying outside of the WTO.
Then, Ethiopia should revive the accession process and develop a comprehensive trade policy in
which WTO accession should be a core element.
1.9 Chapter summary
 Mercantilists measure the welfare of a society in terms of the accumulation of precious
metals like gold and silver. Thus, they were against free tree trade in general and favor
exports sol long as they brought in gold but imports were looked with apprehension as
depriving the country of its precious metals.
 According to smith‘s theory of absolute cost advantage, the wealth of a nation is measured
in terms of real goods and services.
 According to the theory of absolute cost advantage, a country has to specialize in the
production and export of the good for which it has an absolute cost advantage over the
other country and import the good for which it has an absolute cost disadvantage over the
other country. This will benefit both countries in terms of production and consumption
gains
 Ricardo‘s theory of comparative advantage states that a country has to specialize in the
production and export of the good for which it has either a larger comparative advantage or
smaller comparative disadvantage over the other country. It has to import the good for

54
which it has either a smaller comparative advantage or a larger comparative disadvantage
over the other country. Such a trade relation will benefit both trading countries.
 The distribution of welfare (consumption) gain from international trade among the trading
countries depends on the international terms of trade. If the terms of trade are closer to the
domestic opportunity cost ratio of one country, most of the welfare gains will be attributed
to the other country and vice versa.
 Both Smith‘s and Ricardo‘s theories of international trade are termed as supply version of
the classical theory of international trade. Both theories paid exclusive attention to
production costs (supply factors) in the determination terms of trade and gains from
international trade.
Questions
(1) What are the causes of international trade?
(2) What are the effects of international trade?
(3) Is government intervention in international trade necessary or beneficial?

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2 International Trade Finance of Banking Principle
Objectives
 To understand about the formalities associated with International trade
 To know about the documentation of International Trade
International trade exposes exporters and importers to substantial risks, especially when the
trading partner is far away or in a country where contracts are hard to enforce. Firms can mitigate
these risks through specialized trade finance products offered by financial intermediaries. Banks
play a critical role in international trade by providing trade finance products that reduce the risk
of exporting.
Trade finance differs from other forms of credit (for example, investment finance and working
capital) in ways that have important economic consequences during periods of financial crisis.
Perhaps its most distinguishing characteristic is that it is offered and obtained not only through
third-party financial institutions, but also through inter firm transactions.
The vast majority of trade finance involves credit extended bilaterally between firms in a supply
chain or between different units of individual firms. According to messaging data from the
Society for Worldwide Interbank Financial Telecommunication (SWIFT), a large share of trade
finance occurs through inter firm, open-account exchange. Banks also play a central role in
facilitating trade, both through the provision of finance and bonding facilities and through the
establishment and management of payment mechanisms such as telegraphic transfers and
documentary letters of credit (LCs). Among the intermediated trade finance products, the most
commonly used for financing transactions is LCs, whereby the importer and exporter entrust the
exchange process to their respective banks to mitigate counterparty risk.
Trade was centered in fairs in medieval times and it was there that money changing type banking
services commenced. Fairs were held at regular intervals and developed as meeting places for
merchants from many regions. They differed from markets as they were held less frequently,
although regularly, and continued for a few weeks. These fairs were often centered on wholesale

56
trade between merchants and developed into financial centers where bankers established
branches.
This is the earliest form of international banking and the trade fairs the earliest form of financial
center. These centers emerged in places that were strategically situated on the main trade routes
and flourished due to their local patronage and to the protection provided for foreigners. Their
emergence was associated with trade, their development associated with innovation and
advances in financial systems and their decline with politics, especially in the pre-modern and
the early modern banking eras.
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. The Bank of Venice long remained without a rival; but about the
beginning of the fifteenth century, similar institutions were established at Genoa and Barcelona,
cities, at that time the pride of Europe, and second only to Venice in extent of trade.
At the beginning of the seventeenth century, the Dutch stood at the head of European commerce;
and Amsterdam, the capital of Holland, was the central point of trade. The currency of
Amsterdam consisted not only of its own coins, but principally of the coins of all the neighboring
countries; and many of the pieces were so worn and mutilated as to fall short several per cent in
point of actual value.
The bank of England, first chartered in 1694, is the prototype and grand exemplar of all our
modern banks; its history, therefore, will deserve the more particular attention. The business
which this new corporation principally intended to do by virtue of its charter, was the purchase
and sale of bills of exchange. But as its whole capital was lent to the government, how was it to
do any business at all? This state of things led to the invention of banknotes. 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.

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2.1.2 Ethiopia Banking History
Ethiopian banking history, in its modern sense, began towards the end of the reign of Emperor
Menilek. This period witnessed the establishment, as most readers will know, of 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.
Ten years later, in 1915, the bank began issuing bank notes. The issue of this paper money was
another notable event in the country‘s history. This institution was engaged in issuing notes as
well as in any kind of commercial banking business. 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. The change was implemented, however, in a soft way, providing
an adequate compensation to shareholders, and in agreement with the main foreign shareholder,
the National Bank of Egypt.
The Bank of Abyssinia went, therefore, into liquidation and a new institution, the Bank of
Ethiopia, was established in 1931. The new bank, although under full Government control,
retained management, staff, premises and clients of the ceased financial institution. Italian
occupation of the country, in 1936, brought the liquidation of the Bank of Ethiopia. In 1931, the
Bank of Abyssinia was replaced by the Bank of Ethiopia which was wholly owned by the
government and members of the Ethiopian aristocracy, becoming the first 100% African-owned
bank on the continent; it was also authorized to issue notes and coins and to act as the
government‘s bank. It operated for only a few years, being closed after the Italian invasion.
During the Italian occupation, several Italian banks opened branches in Ethiopia.
After the liberation in 1942, the State Bank of Ethiopia was established. It became operational in
1943, with 43 employees and two branches, and acted as the country‘s central bank. The first
governor was a Canadian. The Bank also acted as the country‘s main commercial bank, while a
few much smaller foreign banks continued to operate. The country‘s first development bank was
founded in 1951: the World Bank provided $2million towards the founding of the Development
Bank of Ethiopia, and invested a further $2 million in 1960.

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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 Bank of Ethiopia
respectively. Both were government-owned. The 1963 banking law is allowed for other
commercial banks to operate. This included foreign banks provided they were 51% owned by
Ethiopians. The biggest of these was the Addis Ababa Bank. It was 40% owned by Grind lays
Bank (British owned) and had 26 branches by 1975. There were also two foreign commercial
banks: the Banco di Roma and the Banco di Napoli, which had eight branches and one branch
respectively in 1975.
In addition to the commercial banks, the government established two development banks, both
of which were 100% state owned. The Agricultural and Industrial Development Bank (AIDB)
was set up in 1970, taking over two earlier development banks: the Development Bank of
Ethiopia and the Ethiopian Investment Corporation which had been established in 1963 as the
Investment Bank of Ethiopia. AIDB was 100% government towed, and provided short, medium
and long term loans to the agricultural and industrial sectors.1
The Housing and Savings Bank
was created in 1975 out of a merger between two earlier housing finance institutions created in
1962 and 1965, one of them with a grant from the United States government.2
2.2 The role of banks in supporting international trade
What is trade finance? Global and local banks support international trade through a wide range
of products that help 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). As such, a working capital loan not specifically tied to trade is generally not included
in this definition. Trade finance products typically carry short-term maturities, though trade in
capital goods may be supported by longer-term credits. The focus of this report is on short-term
trade finance, both because it funds a much larger volume of trade and because of its interactions
1
Its name was changed to the Development Bank of Ethiopia in 1994.
2
The Housing and Savings Bank became the Construction and Business Bank in 1994

59
with bank funding conditions. 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. For the most part, L/Cs represents off-balance sheet commitments, though they may
at times be associated with an extension of credit. This can occur, for example, if an import L/C
is structured to allow the importer a period of time (known as ―usance‖) before repaying the bank
for the payment it made on the importer‘s behalf. Banks may also help meet working capital
needs by providing trade finance loans to exporters or importers. In this case, the loan
documentation is linked either to an L/C or to other forms of documentation related to the
underlying trade transaction.
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. ―Supply chain finance‖ is another growing area of banks‘ trade finance
activities, where banks automate documentary processing across entire supply chains, often
linked to providing credit (eg through receivables discounting).
Trade finance versus trade credit. The principal alternative to bank trade finance is inter-firm
trade credit between importers and exporters, which is commonly referred to as trade credit. This
includes open account transactions, where goods are shipped in advance of payment, and cash-
in-advance transactions, where payment is made before shipment. Inter-firm trade credit entails
lower fees and more flexibility than trade finance, but leaves firms bearing more payment risk,
and potentially a greater need for working capital. Hence, the reliance on inter-firm trade credit
is more likely among firms that have well established commercial relations, form part of the
same multinational corporation and/or are in jurisdictions that have reliable legal frameworks for
collection of receivables. Firms‘ ability to extend trade credit is supported by possibilities to
discount their receivables, e.g. via factoring, and the availability of financing from banks and

60
capital markets not directly tied to trade transactions. Firms can also mitigate payment risk by
purchasing trade credit insurance.
2.3 International Banking and Financial Institutions
2.3.1 Overview of International Banking
Many international banking activities parallel those conducted in domestic banking operations.
For example, in both international and domestic markets, a bank may extend credit, issue and
confirm letters of credit, maintain cash and collection items, maintain correspondent bank
accounts, accept and place deposits, and borrow funds. Other activities are more closely
associated with international banking, such as creating acceptances and trading foreign
currencies.
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. Despite similarities between domestic and international activities, banks often
conduct international operations in a separate division or department.
Large banks typically operate an independent international division, which may include a
network of foreign branches, subsidiaries, and affiliates. Smaller banks, or banks with limited
international activity, often use a separate section that works with a network of foreign
correspondent banks or representative offices. In either case, international activity is usually
operated by separate management and staff using distinct accounting systems and internal
controls. Given the risks introduced by doing business in a foreign country, particularly in
emerging markets, examiners must review and understand international activities when assessing
a bank‘s overall condition. Furthermore, examiners should coordinate international reviews with
Bank Secrecy Act (BSA), Anti-Money Laundering (AML), and Office of Foreign Assets Control
(OFAC) reviews.

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International activities
International banking embraces a wide spectrum of financial services and products. International
Lending Entities that borrow funds from banks include importers, exporters, multinational
corporations, foreign businesses, governments, consumers, foreign banks, and overseas branches
of banks. International lending is concentrated at the largest global institutions and a number of
smaller institutions in select markets, such as New York City, Miami, and San Francisco. Interest
earned from lending to foreign borrowers, both internationally and domestically, remains a major
source of profit for banks that conduct international activities.
Other international activities, such as fund transfers, are necessary components of international
banking and enhance a bank‘s ability to service correspondent relationships, but do not
necessarily produce significant, if any, income after expenses. The tendency for international
loans to be larger than domestic loans promotes economies of scale by allowing banks to
originate, monitor, and collect the loans more efficiently than smaller loans. However, larger
credits often attract strong price competition from other global lenders, which may result in
lower net interest margins.
All loans involve some degree of default risk, and credit officers must effectively assess the
degree of risk in each credit extension. However, while foreign loans share many of the same
risks of domestic credits, several other risks are unique to international lending. As all
international activities are exposed to country risk international lending is especially exposed, as
problems that may arise in a particular country can lead to default, payment moratoriums, or
forced modifications. Additionally, the amount and mix of international credits can affect
liquidity, capital, and sensitivity to market risk requirements and risk management practices.
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. Evaluation of foreign credit risk is similar to domestic credit analysis and requires the
review of appropriate information, including the amount of credit requested, loan purpose,
collateral, anticipated terms, and repayment source. In addition, reviews should assess standard
credit file information such as financial statements covering several years and the borrower‘s

62
performance history on previous loans. A key problem with assessing international credits is that
applicable information is often less readily available and less detailed than in domestic credit
files. Foreign loans are often extended in foreign currencies, and financial statements are often in
a foreign language and formats that vary from country to country. Moreover, there are often
barriers to acquiring such information from foreign sources. Therefore, when evaluating
international loans, credit decisions are frequently based on information inferior to that available
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. Currency conversion exposure
exists in every international credit extension, and currency risk can affect financial transactions
in several ways. For borrowers, rapid depreciation in the home currency relative to the borrowing
currency can significantly increase debt service requirements. For lenders, rapid appreciation or
depreciation in currencies can substantially affect profit or loss depending on how the institution
finances the assets. If a U.S. bank lends in a foreign currency, it must acquire that currency by
either borrowing or exchanging dollars for the new currency. In the latter situation, a bank might
find itself effectively financing its cross-border lending with domestic liabilities, exposing itself
to currency risk. If the foreign currency assets depreciate, a bank might suffer economic or
accounting losses even without a default because the foreign currency assets must be translated
back into dollars for financial statement purposes. In this capacity, currency risk is a sub-set of
market risk, and institutions should apply appropriate techniques to monitor and manage this
risk.
Forms of International Lending
The most common function of international banking is the financing of trade. Generally, several
types of trade credit facilities are used by banks, with the most common types being letters of
credit and banker‘s acceptance financing. Exporters may be willing to ship goods on open
account (self-financed) to credit-worthy customers in developed countries, but are often
unwilling to accept the risk of shipping goods without established bank financing when dealing
with an importer in a high-risk, or developing country. Other types of trade finance instruments

63
and methods, such as discounting of trade acceptances and direct trade advances, are also
available.
2.3.2 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. Unlike the name ―commercial‖, commercial banks expanded their services to
consumers and Government units to be a financial department store of the financial system.
Commercial Banks manage the customers' current and savings accounts, pay out checks that
have been drawn on the bank by account holders, and also perform the collection of checks
deposited in their customers' accounts. Banks implement a number of other procedures for
payments to customers, such as: ATM's (Automated Teller Machines), telegraphic transfer, and
EFTPOS (Electronic Funds Transfer at the Point of Sale), or Debit Cards.
The borrowing process of banks is carried out by receiving funds in savings accounts and current
accounts and receiving term deposits, as well as through issuance of debt securities, such as
bonds and banknotes. Banks also provide loans to customers that are repayable in installments as
well as lending through investments in tradable debt securities and other types of lending. Banks
offer a comprehensive variety of payment facilities, and a bank account is regarded as
indispensable by the majority of Governments, business enterprises, and individuals.
1. Functions of Commercial Banks
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:
 They process payments with the help of online banking, telegraphic transfer, debit
card, and other methods;
 They issue banknotes, such as promissory notes;
 Acceptance of funds on term deposits;
 Issuance of bank checks and bank drafts;

64
 Offering performance bonds, guarantees, letters of credit, and other types of
documents related to underwriting commitments for securities;
 Safe custody of important documents and other valuable items in safe deposit vaults or
safe deposit boxes;
 Providing loans through installment loans, overdrafts, and others; and
 Selling and brokerage services related to unit trust and insurance products and
 Foreign exchange services.
Correspondingly, commercial banks are business corporations that accept deposits, make loans,
and sell other financial services, especially to other business firms, to households and
Governments. They are the largest and most important depository institutions. They have the
largest and most diverse collection of assets of all depository institutions. Their main source of
funds is demand deposits (i.e., checking account deposits) and various types of savings deposits
(including time deposits and certificates of deposit).
The major use of funds by commercial banks is making loans. They are assets of the commercial
bank. These loans could include real estate loans and loans to businesses & automobile loans.
The remaining commercial banks' assets include securities (primarily federal government bonds),
vault cash, and deposits at the central bank. Commercial banks also allow for a diversity of
deposit accounts, such as checking, savings, and time deposit. These institutions are run to make
a profit and owned by a group of individuals.
2. Importance of Commercial Banks
 Banks are principal means of making payments.
 Create money from excess reserves of public deposits.
 Use excess cash reserves to make loans and investments.
 They are principal channel for government monetary policy.
3. Classification of Commercial Banks
While commercial banks offer services to individuals they are primarily concerned with receiving
deposits and lending to businesses

65
Commercial banks can be classified in different types depending on their activities or as per their
functions in the economy. The following classification is the common one.
I. Unit Banking
A banking business operating a single banking office
All operations housed in a single office
II. Branch Banking
A single bank that offers a full-fledged services in two or more offices across
the country, including offices abroad
Home office is the largest branch in the system
III. Correspondent Banking
An arrangement whereby a bank maintains deposit balance with other banks at
a distant place for a variety of services and assistance
The practice can take place within the local environment among local banks or
overseas
4. 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.
 Types of Credit Facilities
The main forms of credit facilities issued by the Commercial Banks are:
1. Term Loan
A term loan is a loan granted to customers to be repaid with interest within a specific period of
time. The loan can be repaid in periodic installments or in a lump sum on the due date of the

66
loan, as the case may be. 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. The purpose of the loan is to finance the working capital needs and/or
to meet other short-term financial constraints of customers. Short-term loan may be repaid
monthly, quarterly, semi-annually or annually in a lump sum upon maturity, depending on the
nature of the business and cash-flow statement. The periodic repayment amount incorporates
both principal and interest.
 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. A long-term loan is a loan that has a
maturity period of five to fifteen years. The purpose of these loans is to finance new projects,
support the expansion of existing projects, investments and meet working capital needs.
Applicants can be either new or existing customers. Loans provided by commercial banks may
also be classified into various categories, according to the purpose for which they are granted.
The major classifications are: Agricultural loan Manufacturing loans, Banks avail loan,
Transport loans, Merchandise loan, Import and Exports Loan, Trade and service loans, and the
likes.
a. Agricultural Loans
Agricultural loan is a loan granted to customers who are engaged in a production business.
Agricultural loan is intended to finance working capital needs and investments of customers
involved in the sector.
Any individuals, enterprises and associations involved in the agricultural sector can apply for this
loan. Agricultural loan may be repaid monthly, quarterly, semi-annually or annually. The Bank
provides a grace period for investment-related agricultural loans. Agricultural loans include
loans granted for purchase of agricultural inputs like selected seeds, fertilizers, agro-chemicals,
rental or purchase of agricultural machinery and equipment; for crop collection, processing and
marketing of agricultural products, projects aiming at producing exportable products like

67
flowers, fruits, and vegetable and agro-industry developments like diary, farming, cattle fattening
etc.
b. Manufacturing loans
Manufacturing loans are loans availed to facilitate the manufacturing activities of small, medium
and large-scale industries.
c. Trade and Service loans
Trade and service loans include wholesale trade, retail trade, services other than transport such as
hotels, schools, hospitals, tour agencies, etc. Financing trade and services helps in the smooth
flow of goods and services in the economy and serve as an intermediary between producers and
consumers. Therefore, trade in essential goods whether imported or locally produced is to be
encouraged through working capital financing. Among others, goods traded include outputs of
manufacturing industries, cottage and handicraft, mining activities and agricultural products.
d. Building and construction loan
Banks avail loan to this category for building contractors, investors engaged on road and water
projects under construction, civil workers and business persons who seek financial assistance to
construct commercial or residential buildings. Loans can be provided to license building
contractors to cover working capital shortages i.e. to mobilize materials required to construct
buildings, roads, dams etc. based on contracts concluded with employers.
e. Transport loans
All loans to be availed for the purchase of transport vehicles like trucks, tankers and public
transport buses to licensed transport operators are to be classified here. Additionally, loans
availed to facilitate smooth operation of trucking companies or loans to cover custom duty
charges or modification costs are also included.
f. Merchandise Loan
Merchandise loan is a credit facility provided by the Bank against which the merchandise is held
as collateral for the loan. The purpose of the loan is to overcome the cash-flow problem of
customers when money is tied up in merchandise. The loan is usually approved for a period of
three months (90 days) or it may be approved on a renewal basis.
g. Import and Exports Loan

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Foreign Trade plays a key role in the development of an economy and has always been the major
force behind the economic relations among nations. In view of its paramount importance, the
bank‘s role is to promote the growth of the country’s economy. International trade financing in
the form of import and export transactions is one of the priority areas of commercial banks.
 Import Letter of Credit Facility
A letter of credit (L/C) is an instrument issued by a bank whereby payments in international trade
are effected by banks through documents. It is issued by the Bank at the request of a buyer
(importer) to pay a seller (exporter) upon presentation of import documents specified in the
instrument. A letter of credit facility is a type of credit that a bank avails to importers (applicants)
to pay a certain percentage of the value of the L/C while opening L/C by setting a limit to the
total value of the L/C to be opened. The facility is secured against valid import documents and
has a tenor of six months and, in exceptional cases, one year. It alleviates temporary working
capital needs of customers while importing goods.
 Export Credit Facility
Export credit facility may take various forms. Some of them are discussed below:
i) 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. The availability period is
determined with the consideration of the validity dates of the sales contracts, but it must be
shorter than the validity date of banks guarantee. The pre-shipment export credit may be settled
from the export proceeds of the goods for which the loan is advanced.
ii) 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. The facility has tenure of six months or one year. The facility is availed to
finance the temporary working capital requirement of customers when the goods are in transit for
shipment. A revolving export credit will be settled from the export proceeds when all relevant

69
export documents are presented to the Bank. The facility has to be renewed every six months or
every year.
iii) Advance On Export Bills
Advance on export bills is a post-shipment export credit provided to exporters with a certain
margin against presentation of all the necessary export documents. This credit is advanced for a
period of fifteen days, and interest is charged if the loan is not settled within this period. An
advance on export bills is intended to bridge the financial gap between the shipment of the goods
and the realization of the proceeds. This export credit will be advanced to all exporters who
could present the following complete export documents, including a bill of lading, as per the
terms and conditions of the letter of credit.
B. Overdraft
An overdraft (O/D) is a credit facility by which a customer can withdraw in excess of her/his/its
current account balance up to the limit approved by the Bank. The purpose of the loan is to
finance the day-to-day operational needs of a viable business. In order to use O/D facility,
applicants have to open a current account. The O/D account should have a proper turnover by
way of withdrawals and deposits. However, an O/D account should not be overdrawn.
An O/D facility is approved only for a period of six months and, in some cases, for a year.
Therefore, it has to be renewed every six months or year. The request for renewal is usually
presented to the Bank some months before the expiry date of the facility. Overdrafts can be
considered for manufacturing, trading and service-giving enterprises.
An O/D facility can be approved against any collateral acceptable by the Bank, except motor
vehicles and machinery. As far as repayment on over draft facility is concerned, interest is
calculated on the amount used by the customers. Customers have to pay the accrued interest
regularly so that the facility will not be overdrawn. At the time of the request for renewal, the
outstanding overdraft balances have to be fully settled. The Bank can claim the outstanding
balance of the O/D facility at any time.
C. Deposits Services

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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. The main features of this account are (1) Non-interest-
bearing deposit account (2) The initial deposit for opening a Special Demand Deposit Account is
Birr 50. It is a deposit account service for those customers demanding non-interest bearing
saving deposit account.
Who is eligible?
Individuals, Trade operators, Organizations, Cooperatives and associations, Domestic banks,
financial institutions, Government Local/Central, Private sector, and Public Agencies and
Enterprises are all eligible to open and operate Special Demand Deposit Account.
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. Saving account is maintained for
various reasons.
 Saving accounts may be classified in to various categories. The major ones are discussed
below:
a. Private saving account: Such account is opened by individual Person
b. Joint Accounts:
 And Account
 And/or Accounts.
c. Company Accounts
d. Accounts of Churches, Mosques, Missions, etc.
e. Earmarked Accounts: This includes Club Accounts, Private Accounts, and the like.
f. Special Accounts
 Tutor account: Tutor accounts are opened in the name or names of minors followed
by the word ―minor‖ or ―minors.‖
 Liquidator account: Liquidators‘ account is opened in the name of a person or
company but appointed by court as liquidator in bankruptcy.

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 Interdicted accounts: Interdicted accounts are saving accounts opened in the name of
the interdicted person.
 Staff accounts: Staff accounts are saving accounts like the individual accounts opened
for the employee of the Bank.
g. Non-Private Accounts. It can be for thrift and credit co-operatives society. Mandate file is a
must to open such an account. The opening of such accounts must first be approved by a regional
organization of the co-operatives, and the approval letter, indicating the names of the persons
authorized to operate the account, must be submitted to the Bank.
3. Fixed (time) Deposit
A time-deposit account is a deposit account that bears interest based on the duration of the
deposit. Parties who can open such account include individuals, sole-proprietorship, and
partnership.
4. Current Account
Current account, also called demand deposit or checking account, is a non-interest-bearing
deposit account that is operated by checks. The unique features of current account are:A non-
interest-bearing deposit account with a check book facility and Overdraft facility permitted in
connection with checking account. Current account may be opened by individuals and
organizations, resident and non-resident, and Non-literates and minors. Current or Demand
Deposits may be classified under the following categories:
i) Demand Deposit Non-resident: This account includes correspondents‘ accounts, Non-
Resident Foreign Currency Account (NRFCY), Non-Resident Non-Transferable Birr
Account (NRNT), and Non-Resident Transferable Birr Account (NRT).
ii) Demand Deposit Resident :
 Cooperatives and Associations: accounts opened for mass organizations such as Kebeles,
Farmers Association, Trade Unions, Savings and Credit Associations, etc. are classified
under the above categories.
 Domestic Banks: accounts of local banks are included in this category. A license from the
National Bank of Ethiopia should be obtained to open accounts for commercial banks.

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 Financial Institutions: These are accounts of insurance companies.
 Government Accounts: (Local and Central) all accounts opened in the names of Ministries
(Offices, Bureaus) budgetary and town developments of municipalities are classified under
this account. The authority to open these accounts emanates from either the local or the
central Finance Bureau and local or central urban development and housing offices.
 Private Sector: the following demand deposit accounts are subsumed under this
account:
 Private individuals,
 Private companies, and
 Ikubs, Edirs, Religious Private and International Organizations.
 Public Agencies and Public Enterprises: The chairman of the Board of the enterprise should
produce a letter of appointment from the Public Enterprises Supervising Authority.
5. Diaspora Account
These types of accounts are opened for people living abroad (who live more than one year
abroad) and citizens by origin but with different nationalities that are referred as eligible citizen.
D. Money Transfers
It is a means of transferring funds through banks to individuals or organizations. Users of money
transfer include individuals, workers, students, members, travelers, organizations, private
organizations, cooperatives, public enterprises, and government.
The main features of money transfers include:
 Transfers are made between branches of the bank
 Transfers are made between branches of different cities or towns.
 Availability of telecommunication and local post offices enhances the smooth flow of
transfers between branches.
Some of the major benefits include:
 It facilitates the operations of trade and other economic sectors and helps to accomplish
their organizational objective as a whole.
 It is an easy and convenient way for both the sender and the receiver.

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 Transfer of money can be done with a minimum cost, time, and energy.
 It reduces the risk of losing money.
 Types of Local Transfer
1. Telegraphic Transfer (TT): Transfers are made through telephone, telegram, telex or
radio. It is relatively the fastest means, and is usually preferred by most transfer users.
2. Mail Transfer (MT): Transfers are made through post offices. It is considered to be an
ordinary type and takes a longer time to reach the paying branch.
3. Demand Draft (DD): Transfers are made with the use of a special bank instrument
called ―draft‖. Drafts are usually called ―demand drafts‖ or ―sight drafts‖ because they are paid
immediately, on demand or on sight. They are negotiable within twelve months from the date of
issue after which the drawer's confirmation is required for payment.
4. Cashier‘s Payment Order: It is a special bank instrument negotiable within six months
from the date of the issue. They are issued to Finance Bureaus, Land Revenue Office, Customs
Authority, Maritime and Transit Service Corp., and to secure bids only.
E. Foreign Currency
It involves buying and selling foreign currency, cash notes, traveler's checks, and drafts for the
following purposes:
 holiday travel expenses,
 Business travel allowances,
 medical expenses,
 Educational expenses, and
 seminars, workshops, symposium, conference, and training fees, etc
F. Guarantee Services

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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. Primary liability for the debt is incurred
by the principal debtor. The guarantor incurs secondary liabilities (becomes liable if the principal
debtor fails to pay or perform). A guarantee is evidenced by a written document signed by the
guarantor. There are various types of guarantees.
Some of them are discussed below:
1.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 in case the bidder
withdraws from the bid during the bid period or fails to accept the award when s/he
becomes a winner.
2. Performance bond guarantee It is issued by the bank in favor of a bid organizer
(beneficiary) at the request of the bid winner to meet any claims to be made by the
beneficiary in case the bid winner fails to deliver the goods or perform the service as
per their agreement.
3.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, representing the bank's commitment to repay the sum in the event that the
seller fails to honor the contract terms in their entirety or in part.
4. Suppliers credit guarantee: It is issued by the bank to meet any claims to be made by
the local or foreign supplier (beneficiary) in case the debtor (buyer) fails to repay in
accordance with the terms and conditions of the contract.
5.Customer’s duty guarantee: It is issued by the bank to meet the requests of the
beneficiary in respect of customs duties in circumstances where the goods imported
without payment of customs duties are not re-exported and the respective customs
duties have not been paid.
G. Information & Advisory services

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 information on foreign trade through periodic publications
 special reports on commodities and markets
 Information to foreign investors about:
 Business climate
 legal requirements
 Banking and insurance
 Foreign exchange
 tax laws etc
 Advisory services on:
 working capital management
 project studies and financing
2.4 Exchange Rates and the Foreign Exchange Market:
 Money
 Interest Rates
 Price Levels and the Exchange Rate
 Fixed Exchange Rates and
 Floating Exchange Rates
 Foreign Exchange Intervention
2.4.1 Foreign exchange
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. This section provides examiners with
basic information regarding foreign exchange activities. While banks of any size can engage in
foreign exchange transactions on behalf of their customers, generally only the largest institutions
specializing in international business or international capital markets enter into material foreign
exchange transactions for their own account.

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An exchange rate is the number of units of a given currency that can be purchased for one unit of
another currency. It is a common practice in world currency markets to use the indirect
quotation, that is, quoting all exchange rates (except for the British pound) per U.S. dollar. The
Financial Times foreign exchange data for September 16, 2006, for example, shows the
quotation for the Canadian dollar as being 1.1218 per one U.S. dollar.
Direct quotation is the expression of the number of U.S. dollars required to buy one unit of
foreign currency. The direct U.S. dollar quotation on September 16, 2006, for the Canadian
dollar was U.S. $0.89. Although it is common for foreign currency markets around the world to
quote rates in U.S. dollars, some traders state the price of other currencies in terms of the dealer‘s
home currency (cross rates), for example, Swiss francs against Japanese yen, Hong Kong dollar
against Colombian pesos, and so on. Strictly speaking, it is reasonable to state that the rate of the
foreign currency against the dollar is a cross rate to dealers in third countries.
2.4.2 The Foreign Currency Exchange Market
Foreign exchange transactions can be conducted between any business entity, government, or
individual. Financial institutions are ideal foreign exchange intermediaries due to their
knowledge of financial markets and experience providing financial services. Banks are involved
in a majority of worldwide, foreign exchange transactions with the volume of an activity largely
dictated by customer demand. 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. Instead, it is a loose
collection of entities (commercial banks, central banks, brokers, and private investors) joined by
near instantaneous communications links.
The foreign exchange market meets the definition given by most economists of perfect
competition, as there are large numbers of buyers and sellers with equal access to price
information who are trading a homogeneous product with few transportation costs. Foreign
exchange is generally traded in an interbank/dealer network, or organized exchanges such as the

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London International Financial Futures and Options Exchange or the Chicago Mercantile
Exchange. The interbank market, which is by far the largest market, is housed in the foreign
exchange departments of larger banks around the world. It is an over-the-counter (OTC) market
because it has no single location or fixed listing of products. It provides opportunities for
customers to buy and sell currencies in virtually any amount, for immediate or forward delivery,
through contracts to exchange one currency for another at a specified exchange rate (price).
Delivery of currencies may be spot (short-term contracts of two business days or less) or forward
(more than two business days).
In either case, the rate of exchange may be established prior to the finalization of the transaction
with all related costs calculated and often passed on to the customers. 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. In general, exchange rates vary depending on the
agreed payment date (value date) of the transaction, i.e., overnight, one week, one month, etc.
Also, dealers may quote a different exchange rate for a given transaction depending on whether
they are buyers or sellers of currency. This applies to both spot and forward transactions and the
two rates are usually referred to as the bid (buy) or offer (sell) price. The spread between the bid
and offered rates represents the dealer‘s profit. The system for establishing currency prices is
virtually unregulated with exchange rates determined by supply and demand. Exchange rates for
most major currencies are free to float to whatever level the market is willing to support, a level
that often fluctuates significantly over short periods.
2.4.3 Foreign Exchange Trading
As a result of modern communication systems and rapid price movements, opportunities have
soared for speculative trading in the exchange markets. In addition to serving the financial needs
of importers and exporters, foreign exchange markets support speculation, arbitrage, and
sophisticated hedging strategies, which can create profitable opportunities for banks that have the
resources and managerial capabilities to participate in the interbank markets as market makers.

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While the volume of foreign exchange activity varies widely among banks, transaction volumes
are increasingly being driven by interbank trading for banks‘ own accounts. Banks trading for
their own account or as a business line present complex risks.
Banks specializing in this complex and specialized field, particularly those banks that trade
foreign exchange for their own account, typically maintain a foreign exchange department with
qualified dealers. Banks that only execute their customers‘ instructions and do no business for
their own account (essentially maintaining a matched book) generally use the services of another
bank or foreign exchange intermediary to place customer transactions. While trading in foreign
exchange is usually encountered only in large global institutions, examiners should be familiar
with the fundamental risks inherent in foreign exchange trading.
2.4.4 Determinants of Exchange Rates
Exchange Rate
The following theories explain the fluctuations in exchange rates in a floating exchange rate
regime (In a fixed exchange rate regime, rates are decided by its government):
1. International parity conditions: Relative Purchasing Power Parity, interest rate parity,
Domestic Fisher effect, International Fisher effect. Though to some extent the above theories
provide logical explanation for the fluctuations in exchange rates, yet these theories falter as
they are based on challengeable assumptions [e.g., free flow of goods, services and capital]
which seldom hold true in the real world.
2. Balance of payments model: This model, however, focuses largely on tradable goods and
services, ignoring the increasing role of global capital flows. It failed to provide any
explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face
of soaring US current account deficit.
3. Asset market model: views currencies as an important asset class for constructing
investment portfolios. Assets prices are influenced mostly by people‘s willingness to hold the
existing quantities of assets, which in turn depends on their expectations on the future worth
of these assets. The asset market model of exchange rate determination states that ―the

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exchange rate between two currencies represents the price that just balances the relative
supplies of, and demand for, assets denominated in those currencies.‖ None of the models
developed so far succeed to explain exchange rates and volatility in the longer time frames.
For shorter time frames (less than a few days) algorithms can be devised to predict prices. It
is understood from the above models that many macroeconomic factors affect the exchange
rates and in the end currency prices are a result of dual forces of demand and supply. The
world‘s currency markets can be viewed as a huge melting pot: in a large and ever-changing
mix of current events, supply and demand factors are constantly shifting, and the price of one
currency in relation to another shifts accordingly. No other market encompasses (and distills)
as much of what is going on in the world at any given time as foreign exchange. Supply and
demand for any given currency, and thus its value, are not influenced by any single element,
but rather by several. These elements generally fall into three categories: economic factors,
political conditions and market psychology.
Economic Factors
These include: (a) economic policy, disseminated by government agencies and central banks,
(b) economic conditions, generally revealed through economic reports, and other economic
indicators.
➢ Economic policy comprises government fiscal policy (budget/spending practices) and
monetary policy (the means by which a government‘s central bank influences the supply
and ―cost‖ of money, which is reflected by the level of interest rates).
➢ Government budget deficits or surpluses: The market usually reacts negatively to
widening government budget deficits, and positively to narrowing budget deficits. The
impact is reflected in the value of a country‘s currency.
➢ Balance of trade levels and trends: The trade flow between countries illustrates the
demand for goods and services, which in turn indicates demand for a country‘s 166
currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the
competitiveness of a nation‘s economy. For example, trade deficits may have a negative
impact on a nation‘s currency.

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➢ Inflation levels and trends: Typically a currency will lose value if there is a high level
of inflation in the country or if inflation levels are perceived to be rising. This is because
inflation erodes purchasing power, thus demand, for that particular currency. However, a
currency may sometimes strengthen when inflation rises because of expectations that the
central bank will raise short-term interest rates to combat rising inflation.
➢ Economic growth and health: Reports such as GDP, employment levels, retail sales,
capacity utilization and others, detail the levels of a country‘s economic growth and
health. Generally, the more healthy and robust a country‘s economy, the better its
currency will perform, and the more demand for it there will be.
➢ Productivity of an economy: Increasing productivity in an economy should positively
influence the value of its currency. Its effects are more prominent if the increase is in the
traded sector.
Political Conditions
Internal, regional, and international political conditions and events can have a profound
effect on currency markets. All exchange rates are susceptible to political instability and
anticipations about the new ruling party. Political upheaval and instability can have a
negative impact on a nation‘s economy. For example, destabilization of coalition
governments in Pakistan and Thailand can negatively affect the value of their currencies.
Similarly, in a country experiencing financial difficulties, the rise of a political faction
that is perceived to be fiscally responsible can have the opposite effect. Also, events in
one country in a region may spur positive/ negative interest in a neighboring country and,
in the process, affect its currency.
Market Psychology
Market psychology and trader perceptions influence the foreign exchange market in a
variety of ways:
➢ Flights to quality: Unsettling international events can lead to a ―flight to quality‖, a
type of capital flight whereby investors move their assets to a perceived ―safe haven‖.
There will be a greater demand, thus a higher price, for currencies perceived as stronger

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over their relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have
been traditional safe havens during times of political or economic uncertainty.
➢ Long-term trends: Currency markets often move in visible long-term trends. Although
currencies do not have an annual growing season like physical commodities, business
cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may
rise from economic or political trends.
➢ ―Buy the rumor, sell the fact‖: This market truism can apply to many currency
situations. It is the tendency for the price of a currency to reflect the impact of a particular
action before it occurs and, when the anticipated event comes to pass, react in exactly the
opposite direction. This may also be referred to as a market being ―oversold‖ or
―overbought‖. To buy the rumor or sell the fact can also be an example of the cognitive
bias known as anchoring, when investors focus too much on the relevance of outside
events to currency prices.
➢ Economic numbers: While economic numbers can certainly reflect economic policy,
some reports and numbers take on a talisman-like effect: the number it-self becomes
important to market psychology and may have an immediate impact on short-term market
moves. ―What to watch‖ can change over time. In recent years, for example, money
supply, employment, trade balance figures and inflation numbers have all taken turns in
the spotlight.
➢ Technical trading considerations: As in other markets, the accumulated price
movements in a currency pair such as EUR/USD can form apparent patterns that traders
may attempt to use. Many traders study price charts in order to identify such patterns.
2.4.5 Foreign Exchange Risks
Trading in foreign currency or holding assets and liabilities denominated in a foreign currency
entail risks that fall into five main categories: exchange rate risk, maturity gap risk, credit risk,
operational risk, and country risk. Exchange rate risk arises when a bank takes an open position
in a currency. An open position occurs when a bank holds or agrees to buy more foreign
currency than it plans to sell, or agrees to sell more foreign currency than it holds or plans to buy.

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Open positions are either long or short. When a bank buys more of a currency, either spot or
forward, than it sells, it has a long position. Conversely, if more currency is sold than bought, a
short position is created. Until an open position is covered by the purchase or sale of an
equivalent amount of the same currency, the bank is exposed to adverse movements in exchange
rates. Banks often hedge open positions with a forward contract, thereby matching a requirement
to deliver with a future contract to receive.
The hedging of open positions can be very complex, sometimes using swaps or options, multiple
contracts, different types of contracts, or even different currencies. It is important to remember
that the level of exchange rate risk is not necessarily dependent on the volume of contracts to
deliver or receive foreign currency, but rather the extent that these contracts are not hedged either
individually or in aggregate. All banks that engage in foreign exchange activity should monitor
their open positions at least daily. Banks that actively trade foreign currencies should monitor
intra-day open positions, closing out or matching exposures at various times during the day.
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 Most export-import
companies do not have the expertise to handle such unanticipated changes in exchange
rates. Banks with international trade capabilities and consultants can help assess
currency risks and advise companies to take appropriate measures.
2.4.6 Protection against exchange rate risks
There are several ways in which export-import companies can protect themselves against
unanticipated changes in exchange rates. The risk associated with such transactions is that the

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exchange rate might change between the date when the export contract was made and the date of
payment (the settlement date), which is often sixty to ninety days after contract or shipment of
the merchandise.
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 theexchange rate
today for receipts or payments in foreign currency that will happen sometime in the future.
Current foreign exchange rates are called spot prices; those occurring at some time in the future
are referred to as forward prices. If the currency in question is more expensive for forward
delivery (for delivery at some future date) than for ordinary spot delivery (i.e., for delivery two
business days following the agreed-upon exchange date), it is said to be at a premium. If it is less
expensive for forward delivery than spot delivery, it is said to be at a discount.
It is pertinent to underscore some salient points about hedging in foreign exchange markets:
 Hedging is not always the most appropriate technique to limit foreign exchange risks: There
are fees associated with hedging, and such costs reduce the expected value from a given
transaction. Export-import firms should seriously consider hedging when a high proportion
of their cash flow is vulnerable to exchange rate fluctuations. This means that firms should
determine the acceptable level of risk that they are willing to take. In contrast, firms with a
small portion of their total cash exposed to foreign exchange rate movements may be better
off playing the law of averages—shortfalls could be eventually offset by windfall gains.
• Hedging does not protect long-term cash flows: Hedging does not insulate firms from
long-term adjustments in currency values (O‘Connor and Bueso, 1990). Thus, it should
not be used to cover anticipated changes in currency values. A U.S. importer of German
goods would have found it difficult to adequately hedge against the predictable fall of the
dollar during the 1973-1980 periods. The impact of such action is felt in terms of higher
dollar prices paid for imports.
• Forward market hedges are available in a very limited number of currencies: Most
currencies are not traded in the forward market. However, many countries peg their
currency to that of a major industrial country whose currency is traded in the forward

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market. Many Latin American countries, for example, peg their currencies to the U.S.
dollar. This insulates U.S. firms from foreign exchange risk in these countries unless the
country changes from the designated (pegged) official rate.
Foreign firms, that is, non–U.S. firms, in these countries can reduce potential risks by
buying or selling dollars (in the event of purchases or sales to these countries) forward as
the case may be.
Example 1. Suppose the Colombian peso is pegged to the U.S. dollar at $1 =
1,000 pesos. A British firm that is to make payment in pesos for its imports from
Colombia, could hedge its position by buying U.S. dollars forward. On the
settlement date, pounds will be converted into dollars, which, in turn, could be
converted into pesos. This assumes that Colombia does not change the pegged
rate during the period.
• Hedging should not be used for individual transactions: Since most export-import firms
engage in transactions that result in inflows and outflows of foreign currencies, the most
appropriate strategy to reduce transaction costs is to hedge the exported net receivable or
payable in foreign currency.
Example 2. Suppose a Canadian firm has receivables from two Japanese buyers
amounting to five million yen and payables to four Japanese suppliers worth nine
million yen. Instead of hedging all six transactions, the Canadian firm should
cover only the net short position (i.e., four million yen) in yen. This reduces the
transaction cost of exchanging currencies for the firm.
Spot and Forward Market Hedge
As previously noted, a spot transaction is one in which foreign currencies are purchased and
sold for immediate delivery, that is, within two business days following the agreed-upon
exchange date. The two-day period is intended to allow the respective commercial banks to make
the necessary transfer. A forward transaction is a contract that provides for two parties to
exchange currencies on a future date at an agreed-upon exchange rate. The forward rate is
usually quoted for one month, three months, four months, six months, or one year. Unlike

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hedging in the spot market, forward market hedging does not require borrowing or tying up a
certain amount of money for a period of time. This is because the firm agrees to buy or sell the
agreed amount of currency at a determinable future date, and actual delivery does not take place
before the stipulated date.
Example 1: Spot market hedge. On September 1, a U.S. importer contracts to buy
German machines for a total cost of 600,000 euros. The payment date is December 1.
When the contract is signed on September 1, the spot exchange rate is $0.5000 per euro
and the December forward rate is $0.5085 per euro. The U.S. importer believes that the
euro is going to appreciate in value in relation to the dollar.
2.5 International trade payment methods
Learning objective
Having completed this lesson,
 You should be able to describe the methods of payment available for international
transactions and the situation when each is appropriate.
 You should understand when payments will be made and the risks associated with each
method of payment both to the buyer and the seller.
 You should know the benefits of agreeing to a particular method of payment and what
kind of financing options it may or may not provide for the buyer and/ or seller.
 You should be able to know about trade finance methods
In any international trade transaction credit is provided by the supplier (ex-porter), the buyer
(importer), one or more financial institution, or any combination of these. The supplier may have
sufficient cash flow to finance the entire trade cycle, beginning with the production of the
product until payment is eventually made by the buyer. This form of credit is known as supplier
credit. In some cases the exporter may require bank financing to augment its cash flow. On the
other hand, the supplier may not desire to provide financing, In which case the buyer will have to
finance the transaction itself, either internally or externally through its bank. Banks on both sides
of the transaction can thus play an integral role in trade financing.
In five basic methods of payment are used to settle international transactions each with a
different degree of risk to the exporter and importer.

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1. Cash in Advance/Prepayment
2. Documentary Collections
3. Letters of Credit
4. Open Account
5. 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.
Risks to Seller *Product is manufactured and never paid for.
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
*When there is no established relationship between the buyer and seller.
*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.
*Seller does not have sufficient liquidity or access to outside financing to
extend deferred payment terms.
Financing *Buyer must have cash or financing available.

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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.
The primary advantage of documentary collections is that a seller who extends credit terms to a
buyer under a D/A collection obtains an enforceable debt instrument in the form of a trade
acceptance. The seller‘s rights to payment are protected under the negotiable instruments law of
that buyer‘s country. In the event this buyer defaults or delays payment at maturity, the
possession of the trade acceptance may put the seller in a stronger position before the court than
if he/she had sold under open account, in which evidence of indebtedness is provided by the
unpaid commercial invoice alone. In addition, a bank presenting a collection on behalf of a seller
may obtain prompt payment from a buyer who might be inclined to delay payment if the seller
were invoicing under open account.
A documentary collection is best used for ocean shipments where original bills of lading are
required. An original bill of lading is a document of title which enables a buyer to gain
possession of the goods. When all the originals of a bill of lading are sent to the collecting bank,
it is in the interest of the buyer to effect payment in order to obtain title to the goods.
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 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.
There are four types of processes available to buyers and sellers:
1. D/P – Documents against Payment

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2. D/A – Documents against Acceptance
3. Clean Collection
4. Cash Against Documents
D/P – Documents against Payment
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.
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.
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. It is,
however, still a collection through the banking system.
Time of Payment
*Either at sight of documents or acceptance as agreed to by the parties (30,
60, 90 days after acceptance).
Goods Available
to Buyer
*Upon arrival of goods after payment or acceptance of draft has been made.
Risks to Seller
*Buyer defaults 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

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method).
*Seller does not ship when requested, either early or late.
When
Appropriate to
Quote or Use
*Seller and buyer have done some business together and are transitioning
away from a prepayment policy.
*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.
*Seller has sufficient liquidity or access to outside financing to extend
deferred payment terms.
Financing
*Seller finances buyer through deferred payment terms.
*Seller can use trade acceptances, which are negotiable instruments, to
obtain financing.
*Leverage /or financing comes from domestic/global business.
2.5.3 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. In addition to providing
reduced risk for both a seller and a buyer, there are many variables that can be used with a letter
of credit to reduce the political and commercial risks that may accompany the transaction as well
as provide extended terms to a buyer through the letter of credit instrument.
The terminology that is used when working with letters of credit is very specific and should be
understood.
Involved Parties:
 Applicant = Buyer/ Importer
 Beneficiary = Seller/Exporter

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 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
Activities and Terms:
 Advice – review and approval of L/C
 Amendment – change to L/C
 Confirmed – the commercial, political and economic risk of the transaction absorbed by
the confirming bank
 Discrepancy – mistake in the documentation
 Documentation – documents required within L/C
 Draft – negotiable order to pay
o Sight Draft – payment assured upon shipment and presentation of documents in
compliance with its terms
o 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)
 Irrevocable – cannot be changed without approval from beneficiary or advising bank
 Issuance – opening of L/C
 Negotiation – review of documents
 Revocable – can be changed without approval of beneficiary or advising bank
Types of L/Cs:
 Back-to-Back – credit and terms of a transaction rollover to a new transaction upon
completion, which eliminates the need to apply or issue a new L/C for identical
shipments
 Confirmed – credit risk taken by bank and agreement to pay (fee charged)
 Straight – payable only at paying bank
 Negotiation – payable at negotiating bank
 Sight – payable at acceptance of documents

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 Standby – used by the beneficiary for payment should the applicant not pay the exporter
directly
 Transferable – part or all of the proceeds from the L/C may be transferred to another
party, used by sales brokers or agents to disguise buyers and sellers
 Usance – time draft based on invoice, bill of lading, or documents, up to 180 days
Time of
Payment
•As agreed between the buyer and seller and stipulated in the L/C, at sight of
documents or acceptance of time draft.
Goods Available
to Buyer
•Upon release of documentation and payment or acceptance of time draft.
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.
When
Appropriate to
Quote or Use
A seller should consider a number of factors:
•corporate credit policy and ability to absorb risk
•credit standing of the buyer
•political environment in the importing country
•type of merchandise to be shipped and value of the shipment
•availability of foreign exchange
•buyer and seller are establishing a new relationship
•when buyer and/or seller‘s governments require use of banks to control flow
of currencies and products
•products and/or services comply with quality steps during production and
documentation is presented for payment

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•used less frequently in international transactions because of the high bank
fees and time-consuming process
Financing
•Often a bank will favorably consider a request for an increase in a credit line
to finance production of the goods. This is done with the knowledge that
letters of credit have been opened and advised to an exporter for an export
order. The bank may further require that the beneficiary assign its interest in
the letter of credit to them.
2.5.4 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, net 30,60, 90 day terms, etc.,
from date of invoice or bill of lading date.
Goods Available to
Buyer
•Before payment (depending on how the products are shipped and the
length of payment option).
Risks to Seller
•Buyer defaults 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.
When Appropriate to
Quote or Use
•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.
•Seller has sufficient liquidity or access to outside financing to

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extend deferred payment terms.
•Used more regularly in international transactions to avoid high
banking fees.
Financing
•Seller finances buyer through deferred payment terms.
•Seller may be able to obtain bank financing through pledge of
receivables.
•Selling receivables on a non-recourse basis to a bank.
•Leverage and/or financing from domestic/global business.
2.5.5 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. For example, should
a new customer require custom-made products, but 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.
2.6 Trade Finance Methods
As mentioned in the previous section, banks on both sides of the transaction play a critical role in
financing international trade. The following are some of the more popular methods of financing
international trade:
1. Accounts receivable financing
2. Factoring
3. Letters of credit (L /Cs)
4. Banker’s acceptances
5. Working capital financing
6. Medium-term capital goods financing (forfaiting)
7. Countertrade
Each of these methods is described in turn.

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2.6.1 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. This could take the form of an open account shipment or a
time draft. Prior to shipment, the exporter should have conducted its own credit check on the
importer to determine creditworthiness. If the exporter is willing to wait for payment, it will
extend credit to the buyer. If the exporter needs funds immediately, it may require financing
from a bank. In what is referred to as accounts receivable financing, the bank will provide a loan
to thee exporter secured by an assignment of the account receivable. The bank‘s loan is made to
the exporter based on its creditworthiness. In the event the buyer fails to pay the ex-porter for
whatever reason, the exporter is still responsible for repaying the bank. 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.
2.6.2 Factoring
When an exporter ships goods before receiving payment, the accounts receivable balance
increases. Unless the exporter has received a loan from a bank, it is initially financing the
transaction and must monitor the collections of receivables. 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. The factor then assumes all administrative responsibilities involved in
collecting from the buyer and the associated credit exposure.
The factor performs its own credit approval process on the foreign buyer before purchasing the
receivable. For providing this service, the factor usually purchases the receivable at a discount
and also receives a flat processing fee. Factoring provides several benefits to the exporter. First,
by selling the accounts receivable, the exporter does not have to worry about the administrative
duties involved in maintaining and monitoring an accounts receivable accounting ledger. Second,

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the factor assumes the credit exposure to the buyer, so 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. Since it is the
importer who must be creditworthy from a factor‘s point of view, cross-border factoring is often
used. This involves a network of factors in various countries that assess credit risk.
The exporter‘s factor contacts a correspondent factor in the buyer‘s country to assess the
importer‘s creditworthiness and handle the collection of the receivable. Factoring services are
usually provided by the factoring subsidiaries of commercial banks, commercial finance
companies, and other specialized finance houses. Factors often utilize export credit insurance to
mitigate the additional risk of a foreign receivable.
2.6.3 Letters of Credit (L /C)
Introduced earlier, the letter of credit (L /C) is one of the oldest forms of trade finances still in
existence. Because of the protection and benefits it accords to both exporter and importer, it is a
critical component of many international trade transactions. The L /C is an undertaking by a bank
to make payments on behalf of a specified party to a beneficiary under specified conditions. The
beneficiary (exporter) is paid upon presentation of the required documents in compliance with
the terms of the L /C. The L /C process normally involves two banks, the exporter‘s bank and the
importer‘s bank. The issuing bank is substituting its credit for that of the importer. It has
essentially guaranteed payment to the exporter, provided the exporter complies with the terms
and conditions of the L /C. Sometimes the exporter is uncomfortable with the issuing bank‘s
promise to pay be-cause the bank is located in a foreign country. Even if the issuing bank is well
known worldwide, the exporter may be concerned that the foreign government will impose ex-
change controls or other restrictions that would prevent payment by the issuing bank.
For this reason, 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. Consequently, the con-firming bank is trusting that the foreign

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bank issuing the L /C is sound. The exporter, however, need worry only about the credibility of
the confirming bank. Nike can attribute part of its international business growth in the 1970s to
the use of L /Cs. In 1971, Nike (which was then called BSR) was not well known to businesses
in Japan or anywhere else. Nevertheless, by using L /Cs, it was still able to subcontract the
production of athletic shoes in Japan. The L /Cs assured the Japanese shoe producer that it would
receive payment for the shoes it would send to the United States and thus facilitated the flow of
trade without concern about credit risk. Banks served as the guarantors in the event that the
Japanese shoe company was not paid in full after trans-porting shoes to the United States. Thus,
because of the backing of the banks, the L /Cs allowed the Japanese shoe company to do
international business without having to worry that the counterparty in its agreement would not
fulfill its obligation. Without such agreements, Nike (and many other firms) would not be able to
order shipments of goods.
Types of Letters of Credit
Trade-related letters of credit are known as commercial letters of credit or import /export
letters of credit. There are basically two types: revocable and irrevocable. A revocable letter of
credit can be canceled or revoked at any time with-out prior notification to the beneficiary, and it
is seldom used. An irrevocable letter of credit cannot be canceled or amended without the
beneficiary‘s consent. The bank issuing the L /C is known as the ―issuing‖ bank. The
correspondent bank in the beneficiary‘s country to which the issuing bank sends the L /C is
commonly referred to as the ―advising‖ bank. An irrevocable L /C obligates the issuing bank to
honor all drawings presented in conformity with the terms of the L /C. Letters of credit are
normally issued in accordance with the provisions contained in ―Uniform Customs and Practice
for Documentary Credits,‖ published by the International Chamber of Commerce.
The bank issuing the L /C makes payment once the required documentation has been presented
in accordance with the payment terms. The importer must pay the issuing bank the amount of the
L /C plus accrued fees associated with obtaining the L /C. The importer usually has established
an account at the issuing bank to be drawn up on for payment, so that the issuing bank does not
tie up its own funds. However, if the importer does not have sufficient funds in its account, the
issuing bank is still obligated to honor all valid drawings against the L /C. This is why the bank‘s

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decision to issue an L /Con behalf of an importer involves an analysis of the importer‘s
creditworthiness and is analogous to the decision to make a loan. The documentary credit
procedure is depicted in the flowchart in Exhibit 19.3. In what is commonly referred to as a
refinancing of a sight L /C, the bank arranges to fund a loan to pay out the L /C instead of
charging the importer‘s account immediately. The importer is responsible for repaying the bank
both the principal and interest at maturity. This is just another method of providing extended
payment terms to a buyer when the exporter insists upon payment at sight. The bank issuing the
L /C makes payment to the beneficiary (exporter) upon presentation of documents that meet the
conditions stipulated in the L /C. Letters of credit are payable either at sight (upon presentation
of documents) or at a specified future date.
The typical documentation required under an L /C includes a draft (sight or time), a commercial
invoice, and a bill of lading. Depending upon the agreement, product, or country, other
documents (such as a certificate of origin, inspection certificate, packing list, or insurance
certificate) might be required. The three most common L /C documents are as follows. Draft
Also known as a bill of exchange, a draft (introduced earlier) is an unconditional promise drawn
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. A banker‘s acceptance is a time draft drawn on and
accepted by a bank. When presented under an L /C, the draft represents the exporter‘s formal
demand for payment. The time period, or tenor, of most time drafts is usually anywhere from 30
to 180 days.
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. The carrier presents the bill to the exporter (shipper), who in turn
presents it to the bank along with the other required documents. A significant feature of a B / L is
its negotiability. A straight B / L are consigned directly to the importer. Since it does not

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represent title to the merchandise, the importer does not need it to pick up the merchandise.
When a B / L is made out to order, however, it is said to be in negotiable form. The exporter
normally endorses the B / L to the bank once payment is received from the bank. The bank will
not endorse the B / L over to the importer until payment has been made. The importer needs the
original B / L to pick up the merchandise. With a negotiable B /L, title passes to the holder of the
endorsed B / L. Because a negotiable B / L grants title to the holder, banks can take the
merchandise as collateral. 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
Under an L /C shipment, the description of the merchandise outlined in the invoice must
correspond exactly to that contained in the L /C.
Variations of the L /C: There are several variations of the L /C that are useful in financing
trade. A standby letter of credit can be used to guarantee invoice payments to a supplier. It
promises to pay the beneficiary if the buyer fails to pay as agreed. Internationally, standby L /Cs
often are used with government-related contracts and serve as bid bonds, performance bonds, or
advance payment guarantees. In an international or domestic trade transaction, the seller will

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agree to ship to the buyer on standard open account terms as long as the buyer provides a standby
L /C for a specified amount and term. As long as the buyer pays the seller as agreed, the standby
L /C is never funded. However, if the buyer fails to pay, the exporter may present documents
under the L /C and request payment from the bank. The buyer‘s bank is essentially guaranteeing
that the buyer will make payment to the seller.
A transferable letter of credit is a variation of the standard commercial L /C that al-lows the
first beneficiary to transfer all or a part of the original L /C to a third party. The new beneficiary
has the same rights and protection as the original beneficiary. This type of L /C is used
extensively by brokers, who are not the actual suppliers .The broker asks the foreign buyer to
issue an L /C for $100,000 in his favor. The L /C must contain a clause stating that the L /C is
transferable. The broker has located an end supplier who will provide the product for $80,000,
but requests payment in advance from the broker. With a transferable L /C, the broker can
transfer $80,000 of the original L /C to the end supplier under the same terms and conditions,
except for the amount, the latest shipment date, the invoice, and the period of validity.
When the end supplier ships the product, it presents its documents to the bank. When the bank
pays the L /C, $80,000 is paid to the end supplier and $20,000 goes to the broker. In effect, the
broker has utilized the credit of the buyer to finance the entire transaction. Another type of L /C
is the assignment of proceeds. In this case, the original beneficiary of the L /C pledges (or
assigns) the proceeds under an L /C to the end supplier. The end supplier has assurance from the
bank that if and when documents are presented in compliance with the terms of the L /C, the
bank will pay the end supplier according to the assignment instructions. This assignment is valid
only if the beneficiary presents documents that comply with the L /C. The end supplier must
recognize that the issuing bank is under no obligation to pay the end supplier if the original
beneficiary never ships the goods or fails to comply with the terms of the L /C.
Banker‘s Acceptance Introduced earlier, a banker‘s acceptance is a bill of exchange, or time
draft, drawn on and accepted by a bank. It is the accepting bank‘s obligation to pay the holder of
the draft at maturity. In the first step in creating a banker‘s acceptance, the importer orders goods

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from the exporter. The importer then requests its local bank to issue an L /C on its behalf. The L
/C will allow the exporter to draw a time draft on the bank in payment for the ex-ported goods.
The exporter presents the time draft along with shipping documents to its local bank, and the
exporter‘s bank sends the time draft along with shipping documents to the importer‘s bank. The
importer‘s bank accepts the draft, thereby creating the banker‘s acceptance. If the exporter does
not want to wait until the specified date to receive payment, it can request that the banker‘s
acceptance be sold in the money market. By doing so, the exporter will receive less funds from
the sale of the banker‘s acceptance than if it had waited to receive payment. This discount
reflects the time value of money. A money market investor may be willing to buy the banker‘s
acceptance at a discount and hold it until payment is due. This investor will then receive full
payment because the banker‘s acceptance represents a future claim on funds of the bank
represented by the acceptance.
The bank will make full payment at the date specified because it expects to receive this amount
plus an additional fee from the importer. If the exporter holds the acceptance until maturity, it
provides the financing for the importer as it does with accounts receivable financing. In this case,
the key difference between a banker‘s acceptance and accounts receivable financing is that a
banker‘s acceptance guarantees payment to the exporter by a bank. If the exporter sells the
banker‘s acceptance in the secondary market, however, it is no longer providing the financing for
the importer. The holder of the banker‘s acceptance is financing instead. A banker‘s acceptance
can be beneficial to the exporter, importer, and issuing bank. The exporter does not need to
worry about the credit risk of the importer and can there-fore penetrate new foreign markets
without concern about the credit risk of potential customers. In addition, the exporter faces little
exposure to political risk or to exchange controls imposed by a government because banks
normally are allowed to meet their payment commitments even if controls are imposed. In
contrast, controls could prevent an importer from paying, so without a banker‘s acceptance, an
exporter might not receive payment even though the importer is willing to pay. Finally, the
exporter can sell the banker‘s acceptance at a discount before payment is due and thus obtain
funds upfront from the issuing bank.

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The importer benefits from a banker‘s acceptance by obtaining greater access to foreign markets
when purchasing supplies and other products. Without banker‘s acceptances, exporters may be
unwilling to accept the credit risk of importers. In addition, due to the documents presented
along with the acceptance, the importer is assured that goods have been shipped. Even though
the importer has not paid in advance, this assurance is valuable because it lets the importer know
if and when supplies and other products will arrive.
Finally, because the banker‘s acceptance allows the importer to pay at a later date, the importer‘s
payment is financed until the maturity date of the banker‘s acceptance. Without an acceptance,
the importer would likely be forced to pay in advance, thereby tying up funds. The bank
accepting the drafts benefits in that it earns a commission for creating an acceptance. The
commission that the bank charges the customer reflects the customer‘s perceived
creditworthiness. The interest rate charged the customer, commonly referred to as the all-in-rate,
consists of the discount rate plus the acceptance commission.
In this case, the interest savings for a six-month period is $12,000. Since the banker‘s acceptance
is a marketable instrument with an active secondary market, the rates on acceptances usually fall
between the rates on short-term Treasury bills and the rates on commercial paper. Investors are
usually willing to purchase acceptances as an investment because of their yield, safety, and
liquidity. When a bank creates, accepts, and sells the acceptance, it is actually using the
investor‘s money to finance the bank‘s customer. As a result, the bank has created an asset at one
price, sold it at another, and retained a commission (spread) as its fee. Banker‘s acceptance
financing can also be arranged through the refinancing of a sight letter of credit. In this case, the
beneficiary of the L /C (the exporter) may insist on payment at sight.
The bank arranges to finance the payment of the sight L /C under a separate acceptance-
financing agreement. The importer (borrower) simply draws drafts upon the bank, which in turn
accepts and discounts the drafts. The proceeds are used to pay the exporter. At maturity, the
importer is responsible for repayment to the bank. Acceptance financing can also be arranged
without the use of an L /C under a separate acceptance agreement. Similar to a regular loan

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agreement, it stipulates the terms and conditions under which the bank is prepared to finance the
borrower using acceptances instead of promissory notes. As long as the acceptances meet one of
the underlying transaction requirements, the bank and borrower can utilize banker‘s acceptances
as an alternative financing mechanism.
2.6.4 Working Capital Financing
As just explained, a banker‘s acceptance can allow an exporter to receive funds immediately, yet
allow an importer to delay its payment until a future date. The bank may even provide short-term
loans beyond the banker‘s acceptance period. In the case of an importer, the purchase from
overseas usually represents the acquisition of inventory. 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. For
example, the firm may have imported foreign beer, which it plans to distribute to grocery and
liquor stores. The bank can not only provide a letter of credit for trade finance, but it can also
finance the importer‘s cost from the time of distribution and collection of payment.
2.6.5 Medium-Term Capital Goods Financing (Forfaiting)
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. The
exporter might be able to provide financing for the importer but may not desire to do so, since
the financing may extend over several years. In this case, a type of trade finance known as for
faiting could be used. 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. In a
for fait transaction, the importer issues a promissory note to pay the exporter for the imported
goods over a period that generally ranges from three to seven years. The exporter then sells the
notes, without recourse, to the forfaiting bank.
In some respects, forfaiting is similar to factoring, in that the forfaiter (or factor) assumes
responsibility for the collection of payment from the buyer, the underlying credit risk, and the

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risk pertaining to the countries involved. Since the forfaiting bank assumes the risk of
nonpayment, it should assess the creditworthiness of the importer as if it were extending a
medium-term loan. For fait transactions normally are collateralized by a bank guarantee or letter
of credit issued by the importer‘s bank for the term of the trans-action. Since obtaining financial
information about the importer is usually difficult, the forfaiting bank places a great deal of
reliance on the bank guarantee as the collateral in the event the buyer fails to pay as agreed
It is this guarantee backing the transaction that has fostered the growth of the for fait market,
particularly in Europe, as a practical means of trade finance. Forfaiting transactions are usually in
excess of $500,000 and can be denominated in most currencies. For some larger transactions,
more than one bank may be involved. In this case, a syndicate is formed wherein each participant
assumes a proportionate share of the underlying risk and profit. A forfaiting firm may decide to
sell the promissory notes of the importer to other financial institutions willing to purchase them.
However, the forfaiting firm is still responsible for payment on the notes in the event the
importer is unable to pay.
2.6.6 Counter trade
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 from that same country. Some
types of countertrade, such as barter, have been in existence for thousands of years. Only
recently, however, has countertrade gained popularity and importance. The growth in various
types of countertrade has been fueled by large balance-of-payment dis equilibriums, foreign
currency shortages, the debt problems of less developed countries and stagnant worldwide
demand. As a result, many MNCs have encountered countertrade opportunities, particularly in
Asia, Latin America, and Eastern Europe. The most common types of countertrade include
barter, compensation, and counter purchase. Barter is the exchange of goods between two parties
without the use of any currency as a medium of exchange. Most barter arrangements are one-
time transactions governed by one contract. An example would be the exchange of 100 tons of
wheat from Canada for 20 tons of shrimp from Ecuador.

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In a compensation or clearing-account arrangement, the delivery of goods to one party is
compensated for by the seller‘s buying back a certain amount of the product from that same
party. The transaction is governed by one contract, and the value of the goods is expressed in
monetary terms. The buy-back arrangement could be for a fraction of the original sale (partial
compensation) or more than 100 percent of the original sale (full compensation).
An example of compensation would be the sale of phosphate from Morocco to France in
exchange for purchasing a certain percentage of fertilizer. In some countries, this is also referred
to as an industrial cooperation arrangement. Such arrangements often involve the construction of
large projects, such as power plants, in exchange for the purchase of the project‘s output over an
extended period of time. For example, Brazil sold a hydroelectric plant to Argentina and in
exchange purchased a percentage of the plant‘s output under a long-term contract. The term
counter purchase denotes the exchange of goods between two parties under two distinct contracts
expressed in monetary terms. Delivery and payment of both goods are technically separate
transactions.
Despite the economic inefficiencies of countertrade, it has become much more important in
recent years. The primary participants are governments and MNCs, with assistance provided by
specialists in the field, such as attorneys, financial institutions, and trading companies. The
transactions are usually large and very complex. Many variations of countertrade exist, and the
terminology used by the various market participants is still forming as the countertrade market
continues to develop.
REVIEW QUESTIONS
1. 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?

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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.
2.7 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. Insurance cover is another aspect, but P&I
Clubs (mutual insurance associations for protection and indemnity of marine risks) generally

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issue cover for the electronic bill of lading (eB/L) issued by approved systems operators, even if
they do not cover losses arising from electronic network risks such as viruses, hacking etc.
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, connecting
instantly all counterparties in one transactional unit with the same references and identifications.
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. It would also
generate very low transactional costs, compared with the present situation when up to 7 per cent
of world trade is wasted on paper-based administrative costs, according to the UN.
One of the most difficult parts of the documentation needed in international trade has been how
to deal with the transport document and particularly the bill of lading as a document of title. The
bill of lading is also often the main transport document in a letter of credit, a tool that both
customers and banks know well, considering it has been in use in different forms for hundreds of
years. An electronic bill of lading (eB/L) must clearly replicate the core functions of a paper bill
of lading, namely its functions as a receipt, as evidence of or containing the legal contract of
carriage and, if negotiable, as a document of title, enabling exporters to combine it with other
supporting documentation in electronic form, such as commercial invoice, insurance document
and packing list etc. These documents should then be transferred online between customers
and/or their banks, under L/C transactions or otherwise, eliminating the need for paper-based
documents between parties.
However, until a common international standard has been developed, many larger banks have
developed their own internal technology platforms for dealing with trade and financial services
towards their customers, such as payments, collections and Letters of Credit, thereby reducing
potential demurrage while awaiting documents and allowing for straight-through processing and
quicker and safer payments. But the key hurdle to expand beyond individual solutions in the use
of electronic solutions in international trade is global standardization and here SWIFT (Society
for Worldwide Interbank Financial Communication), used by more than 10,000 banks and
corporations in more than 210 countries, and may have found a solution.

107
SWIFT‘s latest message type MT798, the ‗trade envelope‘, is a special message type for non-
bank corporates for direct connection to SWIFT member banks‘ own systems, for example as
import letters of credit application and amendment requests, receiving export letters of credit
advises and guarantees/standby letters of credit application and amendment requests. This new
industry message standard also acts as a multi-banking portal for the banks‘ individual electronic
platforms, thereby also giving their customers the possibility to deal with all their transactions in
one system, irrespective of which bank they are working with in any particular case.
Most providers of electronic platforms used in international trade concentrate on certain areas of
trade, mainly dry and wet bulk carriage involving standardized cargo, larger volumes and high-
value shipments, such as oil, ore and agri. Such shipments tend to change hands more frequently
during transportation, often with changed final destinations during the voyage, thereby creating a
stronger need for quicker and safer documentation changes and transfers between the parties
involved.
One of these providers is Bolero International Limited (bolero.net), founded in 1998 as a joint
venture between SWIFT and the TT Club (the leading transport and logistics insurer), but which
is now a stand-alone company with a cloud-based platform for its members to run multi-party
electronic trade transactions. Another is ess DOCS Exchange Limited (essdocs.com), with its
system Cargo Docs, providing a range of supporting e-documents such as eB/Ls, commercial
invoice, certificates of origin, quantity, quality etc, packing list and manifests. The documents
are then electronically transmitted to banks through ess DOCS‘s internal system, whereas other
providers may use the SWIFT network under eUCP rules established by the International
Chamber of Commerce.
However, when describing the advantages and the rapid expansion of electronic messaging in
international trade, one has to bear in mind that a considerable part of international trade is not
conducted in areas where electronic messaging has its greatest potential. Other international
trade is in the form of smaller transactions and often with trading partners and/or in emerging

108
countries where electronic documentation is less common, due to security concerns or simply
because paper-based documents with their signatures and stamps are the norm, accepted practice
or legally required. Consequently, and irrespective of the pace of the future development of
electronic trade, the paper-based system will also continue to be widely used in the foreseeable
future.
SOURCE: Kindly supplied by essDOCS Exchange Ltd, the world’s largest electronic bill of lading network.
As can be seen, it has many visual similarities with a paper-based B/L

109
Bibliography
Bishop, E. (2004). Finance of International Trade: Elsevier Science.
Grath, A. (2011). The Handbook of International Trade and Finance: The Complete Guide to
Risk Management, International Payments and Currency Management, Bonds and
Guarantees, Credit Insurance and Trade Finance: Kogan Page.
JOHNSON, T. E., & Bade, D. (2010). Export or Import Procedures and Documentation:
AMACOM.
Luk, K. W. (2011). International Trade Finance: A Practical Guide (2nd Edition): City
University of Hong Kong Press.
Madura, J. (2008). International Financial Management, Abridged Edition: Cengage Learning.
Roy, M., & Roy, S. S. (2016). International Trade and International Finance: Explorations of
Contemporary Issues: Springer India.
Sercu, P. (2009). International Finance: Theory into Practice: Princeton University Press.
Seyoum, B. (2009). Export-import Theory, Practices, and Procedures: Routledge.

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