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ANALYSIS: International Trade & Trade Financing

ANALYSIS: International Trade & Trade Financing
October 03
09:53 2015

This is an informative publication, sponsored by The Fiji Sun, Fiji Bureau of Statistics and HFC Bank. All views expressed or implied are purely of the Treasurer at the HFC Bank, Peter Fuata.

 

Banks play a critical role as intermediaries in international trade by providing various trade services and trade finance products which reduce the inherent risks in trading across borders for both buyer and the seller.

First and foremost, a bank facilitates the cross border currency translation between the buyer and the seller.

Secondly, a bank sells various products that would mitigate the inherent risks associated with international trade and banks further  provides financing when seller and the buyer require assistance  with trade cycle funding gaps.

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.

When an exporter and an importer trade, they have to decide how to settle the transaction.

Under one option, the exporter produces the good and the importer pays upon receipt (open account).

Under another, the importer pays before the exporter produces the good (cash-in-advance). In each case, one of the trading partners bears substantial risk: With an open account, the exporter may never receive payment.

Under cash-in advance, the importer may never obtain the goods.

To reduce the risk of the transaction for either party, firms can turn to banks, which can act as intermediaries and thereby reduce the need for law enforcement.

 

Trade financial instruments

The two most common trade finance instruments provided by banks are letters of credit and trade collections.

The importer initiates the letter of credit transaction by having its bank issue the instrument to the exporter.

The letter of credit guarantees that the issuing bank will pay the agreed contract amount when the exporter proves that it delivered the goods, typically by providing shipping documents confirming the arrival of the goods in the destination country.

To cover the risk that the issuing bank will not pay, an exporter may have a bank in its own country confirm the letter of credit, in which case the confirming bank agrees to pay the exporter if the issuing bank defaults.

In contrast to a letter of credit, a trade collection does not involve payment guarantees.

Instead, the exporter’s bank forwards ownership documents to the importers bank; the documents, which transfer the legal ownership of the traded goods to the importer, are handed to the importer only upon payment for the goods.

Besides non-delivery and non-payment, there could also be a timing problem.

Eventually, the exporter may deliver and the importer may pay, but a long delay would generate significant costs for the other party.

A letter of credit provides more security to the exporter than does a documentary collection.

With a letter of credit, an exporter is paid by the issuing bank or confirming bank upon proof of delivery regardless of whether the bank received the importers payment.

A trade collection does not offer an exporter this safety since the exporter is paid only if the bank receives the payment from the importer.

If the importer defaults, does not want the goods, or can take possession of the goods and divert them without receiving the export documents, the exporter may not get paid even though it delivered.

Therefore, compared with a letter of credit, a documentary collection leaves the exporter exposed to a great deal more risk.

 

Pre export and import loans

Besides instruments that reduce the risk of a transaction, banks also provide pre-export and pre-import loans to firms.

With a letter of credit, trade collection or an open account, the exporter is paid only after delivering the goods.

Therefore, it has to pre-finance the production of the goods. When trade is settled with cash-in-advance, it is the importer that must pre-finance the transaction and provide the working capital to the exporter.

In both cases, firms may turn to banks to obtain the required funds.

Therefore trade finance help settle the conflicting needs of the exporter and the importer.

An exporter needs to mitigate the payment risk from the exporter and it would be in exporters benefit to accelerate the receivables.

On the other hand importer wants to mitigate the supply risk from the exporter and it would be in their benefit to recover extended credit from the exporter.

The function of trade finance is to act as a third party to remove the payment risk and supply risk while providing the exporter with accelerated receivables and importer with extended credit.

 

Continuation

In next week’s issue, we will look at the structure of international trade transactions.

Feedback: rachnal@fijisun.com.fj

 

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