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International Trade And Trade Financing?

International Trade as defined by the 2009 International Monetary Fund, is the exchange of goods, services and capital between trading partner countries and regions. International trade allows local producers to
31 Mar 2018 10:00
International Trade And Trade Financing?
Shoran Devi

International Trade as defined by the 2009 International Monetary Fund, is the exchange of goods, services and capital between trading partner countries and regions.

International trade allows local producers to efficiently utilise certain resources that can produce goods worth exporting and it also brings in varieties of goods and services in which consumers have a wide range of choices.

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  withassistance 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 specialised 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 receive 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.

The two most common and safest 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 even 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 transfers 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 goods are delivered.

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

Beside 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 the exporters benefit to accelerate the receivables.

On the other hand, the 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.

 

Structure of International Trade Transactions

International trade transactions can be structured in number of ways.

Prepayments (eliminates all risks to the seller) – the seller may require prepayments in the following circumstances (1) the buyer has not been long established, (2)the buyer has a poor credit history or (3) the product is in high demand  and the seller does not have to accommodate  a buyer’s refinancing request in order to sell the merchandise.

Open account (this option place all risks on the seller) – open account shipment are made when the buyer has a strong credit history and is well known to the seller. The buyer may also be able to demand open account sales when there are several sources from which to obtain the sellers product or when the open account is the norm in the buyers’ market

The Banks role in a prepaid or open account transactions may be only to transfer funds or receive funds at the order of the buyer or the seller.

Trade Collections – in trade collections, the bank acts as an intermediary to facilitate the flow of documents and payments. There is no commitment or guarantee of payment from the bank. There are two types of collections: clean (financial document alone) and documentary (commercial documents with or without a financial document). A financial document is a draft or a check, while a commercial document is a bill of lading or other shipping document. Most trade collections are documentary.

In documentary trade collections, the payment can be settled in one of two ways:

  • Documents against payment (D/P): The collecting bank releases documents to the importer only after the importer has fully paid for the underlying goods.
  • Documents against acceptance (D/A): The exporter permits documents (and therefore the goods) to be released to an importer with the promise of payment at a fixed future date.

The collecting bank presents the term to the importer for acceptance. The credit term is stipulated in the exporter’s collection instructions. Having obtained the importer’s acceptance, the collecting bank releases the documents to the importer, who can then clear the goods.

D/A collection is more risky for the exporter than D/P collection because the exporter runs the risk that the importer might refuse to pay on the due date.

For example, the importer might find that the goods are not what he ordered, might have been unable to sell the goods, might be prepared to default on the transaction, or might have filed for bankruptcy.

In contrast, under D/P collection the exporter retains control of the relevant goods (via the presenting bank) until the importer pays. The exporter may choose D/A over D/P when the long-term business relationship with the importer is stable, there is no doubt about the importer’s ability to meet its payment obligations, the political and economic situation in the importer’s country is stable, and there are no foreign exchange restrictions in the importer’s country.

Documentary collection is more secure than open account but less secure than a letter of credit.

An important advantage over open account is that the exporter’s collection documentation, which effectively controls title to the goods, is not released to the importer until the importer makes the payment, accepts the draft, or issues a promise of payment or obligation to pay later.

 

Letters of Credits – A letter of credit gives the beneficiary increased assurance that promised payments or performance will be fulfilled. In essence, the bank issuing the letter of credit (issuing bank) is substituting its creditworthiness for that of its client.

There are two broad types of letters of credit that banks use to facilitate trade finance: commercial documentary letters of credit and standby letters of credit.

 

Commercial Documentary Letters of Credit

The commercial documentary letter of credit is commonly used to finance a commercial contract for the shipment of goods from seller to buyer. This versatile instrument may be used in nearly every type of trade finance transaction and provides for prompt payment to the exporter when the goods are shipped and conforming documents are presented to the bank.  All letters of credit must be issued

  • in favor of a specific beneficiary (the exporter);
  • for a specific amount of money;
  • in a form clearly stating how payment to the beneficiary is to be made and under what conditions;
  • with a specific expiration date.

 

Terms such as “import letter of credit” and “export letter of credit,” are not separate products. They reflect the different positions of an importer and exporter in the use of the same letter of credit for a transaction.

To the importer, the letter of credit allows the issuing bank to substitute its creditworthiness for that of its client, the importer. At a client’s request, the issuing bank pays stated sums of money to the exporters against stipulated documents transferring ownership of the goods. A letter of credit does not eliminate the risk of fraud or deception by an unscrupulous exporter against an importer, because the bank deals only in documents and does not inspect the goods themselves.

If the issuing bank is not local to the exporter or otherwise acceptable to the exporter, the exporter may insist that the issuing bank obtain confirmation of credit from a bank local to or acceptable to the exporter.

The confirming bank then becomes directly obligated to the exporter as if it were an issuing bank and has rights, obligations, and risks (for example, country) with respect to the issuing bank as if the issuing bank were a letter of credit applicant.

A letter of credit is useful when reliable credit information about a foreign buyer is difficult to obtain, but you are satisfied with the creditworthiness of your buyer’s foreign bank.

A letter of credit also protects the buyer since no payment obligation arises until the goods have been shipped or delivered as promised.

The bank prearranges with the client the method by which the letter of credit will be funded, normally by a debit to an existing bank account or by using a preapproved credit facility.

 

Standby Letters of Credit

Standby letters of credit are common bank instruments that also may be used in trade finance. For example, a bank issues a standby letter of credit on behalf of a client involved in a long term project. Normally that project stipulates that the client adhere to certain performance measures. The standby letter of credit is used to ensure payment to the beneficiary if the bank’s client fails to perform as contractually agreed. A standby is not used to finance the purchase or shipment of goods.

 

Other Particular Types of Letters of Credit in Use

  • Irrevocable – Irrevocable Letters of Credit cannot be amended or cancelled without the agreement of the credit parties. Unconfirmed irrevocable letters of credit cannot be modified without the written consent of both the issuing bank and the beneficiary. Confirmed irrevocable letters of credit need also confirming bank’s written consent in order any modification or cancellation to be effective.
  • Confirmed – If a letter of credit’s payment undertaking is guaranteed by a second bank, in addition to the bank originally issuing the credit this kind of credit is called confirmed letter of credit. The confirming bank agrees to pay or accept drafts against the credit even if the issuer refuses to do so. Only irrevocable credits can be confirmed.
  • Revolving /current at any one time (CAOT) – Single letter of credit that covers multiple-shipments over a long period. Instead of arranging a new letter of credit for each separate shipment, the buyer establishes a letter of credit that revolves either in value (a fixed amount is available which is replenished when exhausted) or in time (an amount is available in fixed installments over a period such as week, month, or year). Letters of credit revolving in time are of two types: in the cumulative type, the sum unutilized in a period is carried over to be utilized in the next period; whereas in the non-cumulative type, it is not carried over
  • Transferable – has the option to allow a trader to transfer its rights and obligations to the supplier. In other words beneficiary has the right to give instructions to the bank called upon to effect payment or acceptance to make the credit available in whole or in part to one or more third parties. This can be done only if the letter of credit is expressly designated as transferable by the issuing bank.
  • Back to back/reciprocal – arrangement in which one irrevocable letter of credit serves as the collateral for another; the advising bank of the first letter of credit becomes the issuing bank of the second letter of credit. Unlike transferable letters of credit, there are two separate letter of credits exist in back-to-back letter of credit transactions. This type is appropriate when the exporter acting as an agent or intermediary does not have the funds to pay the manufacturer and does not want the manufacturer to know the name of the importer.

Trade between Fiji and its major trading partners has increased steadily in the last five years, indicative of the rise in domestic demand for foreign goods and services and vice versa. Fiji’s growing trade flows have an important impact on foreign reserves levels, inflation and more broadly consumption, investment and growth in the economy.

Fiji has gained a lot from international trade including accessing a wider range of goods and services and allowing local producers to tap into global markets. Other benefits include the expansion of local industries and the resulting increase in employment and economic activity, and encouraging innovation. Looking ahead, there are still a number of untapped markets and products that Fiji could explore in order to expand international trade and in turn grow the economy.

Feedback:  maraia.vula@fijisun.com.fj

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