Working capital finance requirements for overseas trade are likely to be greater than for solely domestic trade because of transport time, administrative delays and perhaps longer credit terms (90 days from shipment or 60 days from receipt).Before considering financing methods themselves, it will be useful to briefly review the terms under which international trade transactions conducted.
Terms and Methods of Payment
The most common form of settlement for the cost of a trading transaction is means of a bill of exchange (also called trade bills). This occurs when the seller draws a bill on the buyer asking them to pay, on a certain future date, the price of the goods supplied, which is then accepted the purchaser (signing and returning it to the seller). The purchaser is thus formally acknowledging his debt to the seller. The seller can then use the bill of exchange as security in order to obtain money from the seller’s bank. A bank may also agree to accept a bill from its customer in exchange for an agreement that the customer will repay the bank. The cost for arranging this finance is the discount (i.e. the full amount of the bill is not advanced). The more secure the bill (e.g. from a bank as compared to a trader) the “finer” or lower the discount. Note that a bill of exchange is a method of facilitating payment and could therefore be used in several of the terms of payment we consider below. A bill of exchange may also be termed a draft. There are a number of different ways in which payment for transactions may be effected.
- Open account: The exporter ships the goods and any documents of title direct to the importer. Payment is made the importer in accordance with invoice terms, the exporter bearing the risk of non-payment.
- Documentary collection: The exporter ships the goods and sends the documents of title through the banking system. There is a collection order which instructs the overseas bank regarding release of documents to the buyer. The exporter can instruct that the documents are either released against payment or against acceptance. Open account trading status reports should be taken on the buyer, and insurance can also be taken out, if required.
- Documentary letters of credit: A documentary credit is a guarantee the buyer’s bank (the issuing bank) that bills of exchange drawn the exporter will be honored, provided the credit terms have been fulfilled. If the credit is irrevocable, it can only be modified or cancelled with the agreement of all parties. Confirmed credits are ones which contain the additional guarantee of a bank in the exporter’s country to honor them, should the issuing bank default. Documentary credits have an additional security over documentary collections. Banks deal in documents not in goods and, as the seller must comply with the instructions issued the buyer’s bank, the seller will check those instructions before shipping the goods and, if he can comply with the instructions, he will get his money. Failure to comply with the instructions as detailed will mean that the seller’s bank must refer to the buyer’s bank and get permission to effect payment.
- Advance payment terms: The most advantageous method of payment from an exporter’s point of view is to receive cash for his goods before shipment. This method affords the greatest protection and allows the exporter to avoid tying up his own funds. Although less common than in the past, cash payment upon presentation of documents is still widespread. Cash terms are used where there is political instability in the importing country or where the buyer’s credit is doubtful. In addition, where goods are made to order, prepayment is usually demanded, both to finance production and to reduce marketing risks
Finance for Exporters
Delays in receipt of payment for goods sold overseas can seriously affect a company’s cash flow, eventually reducing profitability. Banks and other organizations have therefore developed a wide range of finance facilities to assist exporters in financing their international business. Export credit can be split into two categories:
Supplier credit -where the exporter sells goods to an overseas buyer on credit terms (for example, 30 days) and then obtains finance from a bank to cover the period of time between shipping the goods and receiving payment.
Buyer credit -where the bank provides finance directly to the overseas buyer and the exporter receives payment upon shipment of the goods. Payments made banks in respect of various export finance schemes are paid either:
- With recourse -where the bank has the right to claim reimbursement for sums advanced to the exporter, in the event that the buyer does not pay.
- Without recourse -where the exporter is not liable to repay finance received from a bank, if the buyer defaults.
If the exporter is cash-rich, he may be able to finance export sales from his existing bank balances. However, outlay can be considerable and, if credit terms are allowed to the buyer, the cost of raw materials, manufacturing and shipping will not be recouped in the form of the buyer’s payment for some time, and additional funding may be required. The following are the normal method of obtaining such funding.
Probably the easiest way of financing export sales is use of an overdraft facility agreed with the exporter’s bankers, though exporting companies are unlikely to use this method to finance all their exports, since other forms of finance which are specifically designed for export credit are available at lower cost.
b)Advance against bills
This is short-term, with-recourse, finance obtained an exporter who draws a bill of exchange, under the terms of the export contract, on the overseas buyer. The exporter presents the bill of exchange to the bank, which advances an agreed percentage of the face amount of the bill to the exporter and undertakes to present it to the buyer for collection. The bank charges a fee for this service, together with interest at a variable rate for the period of the advance.
c)Negotiation of bills
This means that the bank buys the bill from the customer. The customer receives the face amount of the bill immediately. The bank sends the bill of exchange and the related shipping documents to the buyer’s bankers for collection and reimburses itself upon receipt of the proceeds, at the same time recovering its collection charges and interest for the period involved. A negotiation facility must be specifically agreed with the exporter’s bankers, and funds made under this facility are on a with-recourse basis. Recourse is available to the banker upon dishonor of the bill, the charges and interest for this being fixed at the time of negotiation.
d)Discount of a bill
Banks are prepared to discount bills of exchange which can be either: Drawn an exporter on a buyer and accepted that buyer; or Drawn an exporter on a bank, under a letter of credit, and bearing a bank acceptance. Bills are discounted with recourse to the customer and the discounting bank pays the face value of the bill less the discount charge which depends partly on the length of time the bill has to run to maturity and partly on the rate of discount which is usual for that type of bill. Finer rates are available for bills bearing a bank acceptance than for those accepted an unknown or doubtful buyer.
e)Acceptance credit facility
This is a facility offered banks for large companies with a good reputation. The company draws bills of exchange on the banks, generally for 60, 90 or 180 days, denominated in whichever currency most matches the needs of the company. The bills can be drawn on, as and when required, throughout the length of the agreement, which can be up to five years, provided the credit limit is not exceeded. The bill is then sold in the discount market and the proceeds passed to the company (less the bank’s commission). At maturity, the company reimburses the bank the full value of the bill, and the bank pays the holder of the bill.A major advantage of acceptance credits is that they can be sold at a lower discount than trade bills. The cost is also fixed, allowing for easier budgeting and may be lower in times of rising interest rates than that of an overdraft. The credit is also guaranteed for the length of the agreement, which is not the case with an overdraft. Where goods are involved, the bank generally has control over the documents and the goods.Be careful not to confuse acceptance credits with documentary acceptance credits.
f)Documentary acceptance credit
When an exporter presents documents under a confirmed irrevocable letter of credit to the confirming bank, he can obtain immediate finance, provided the documents comply with the terms of the letter of credit. The confirming bank will accept a term bill of exchange which can be discounted the confirming bank, or the exporter can regain possession of the accepted bill and discount it with any bank for cash.
Discount fees are paid the exporter unless, under the terms of the letter of credit, the applicant/overseas buyer is responsible for such costs.
g)Merchant bank finance
A merchant bank can provide most of the facilities already mentioned but, in addition, it may offer an accepting house acceptance facility. The exporter again hands over the documents as collateral security and draws a second bill on the accepting house for up to, say, 75% of the collection value and with a tenure slightly longer than the export bill, to allow receipt of proceeds before the accommodation bill matures. The merchant bank accepts the accommodation bill and discounts it in the market. For protection against risks, the merchant bank would expect not only to have control of the bill and the documents it is handling for collection, but also additional safeguards such as insurance cover.
- Credit risk is eliminated under the non-recourse agreement and there are, therefore, no losses through bad debt.
- There is no need for credit and political risk insurance, nor any need to take out forward exchange cover.
- Immediate financing is available on approved invoices, if required.
- There is a reduced staffing requirement, since accounting, debt collection and the sales ledger are handled the factor.
- It gives the exporter the opportunity of trading on “open account” terms, but with the security of also using more traditional instruments, such as letters of credit and bills of exchange.
- Experienced credit managers are on hand, whose knowledge of language, local laws and trading customs are invaluable. A factor with established contacts is able to assess foreign buyer’s creditworthiness more easily and thoroughly than the exporter can from his own sources. There is, then, no need for any other source of status reports and credit information.
- Costs -these vary, depending upon the extent of the service required the exporter, but may include administration of the exporter’s exports sales ledger, credit protection and financing.
- A factor is selective in choosing clients and debts.
- A factor may set an overall turnover limit for the exporter.
- A factor may set a limit on the amount owing at anyone time anyone buyer.
- Terms may be limited to 120 days.
- Factors lend or provide finance against debts which are already approved on the strength of the creditworthiness of the overseas buyer. The exporters own bankers may be prepared to effect an introduction to a factoring subsidiary of the bank. An exporter considering employing the services of a factor should always consult his bankers, since factoring can affect the value of a lending banker’s security.
- Export merchants: These buy goods in their own right from suppliers and export them to their own buyers abroad for cash -usually within seven days. A merchant can therefore eliminate credit risk for the exporter, and transform the deal into the equivalent of a domestic cash sale.
- Export agent: An export agent acts as agent for the exporter, and the contract relationship between the buyer and seller is maintained. The exporter receives payment from the export agent upon shipment of the goods, and the overseas buyer is allowed a period of credit the agent, which is provided from the agent’s own resources.
- Confirming house: A confirming house acts as agent for the overseas buyer, places an order with the exporter, and accepts a usance bill from the buyer which can be discounted at a fine trade bill rate. The buyer therefore receives a period of short-term credit, and the exporter need not be concerned with credit risk, since this is the equivalent of a domestic sale.
- Export finance house: This will provide non-recourse finance to the exporter under the terms of the export contract and agree credit terms to the buyer. Like the factoring company, it will deal with obtaining a credit assessment of the buyer and will relieve the exporter of the need for credit/risk insurance but it can arrange such, if required, or accept an assignment of a policy, as the banks do.
Some finance houses can arrange hire-purchase finance, covering a wide range of consumer and capital goods, through a network or credit union of associates in both buyers’ and sellers’ countries. The exporter will gain satisfaction from the arrangement (which is without recourse to himself), as he receives immediate payment, while the buyer receives deferred terms under a hire-purchase agreement. It is a relatively costly plan, and it may not work where there are exchange control restrictions or other monetary regulations.
An exporter sells the equipment to a leasing company, which then leases it to an overseas hirer. The exporter receives payment without recourse from the leasing company -usually after the equipment has been shipped and installed at the hirer’s premises. There are two main types of lease seen in the international context:
- Cross-border leases, which are made directly from the leasing institution (often subsidiaries of major banks) in the exporter’s country to the overseas buyer.
- Local leasing facilities, which may be available, perhaps, through overseas branches or international leasing associations.
Both types of arrangement may be eligible for insurance cover. Where contracts are arranged between the leasing company and the foreign buyer, the insurance will be undertaken the lessor. Here the exporter will have no risk, having sold the goods direct to the leasing company. In those cases where the exporter arranges his own leasing deals direct with the foreign buyer, he will himself be able to obtain cover.
Forfaiting is a means of providing exporting companies with trade finance on a without recourse basis, while their overseas buyer acquires a period of credit of up to seven years. When forfaiting an exporter is giving up the right to claim payment for goods delivered to an overseas buyer. These rights are surrendered to the forfeiter (normally a bank, finance house or discount house) in return for cash payment at an agreed rate of discount.Any type of trade debt can be forfeited and these debts can be in any form but they are usually either:
- A bill of exchange accepted the buyer, or
- A promissory note issued the buyer.
The forfeiter will calculate the discount rate, taking into account:
- The currency used
- The buyer’s credit rating
- The credit-risk factor for the buyer’s country
The discount rate is calculated as a margin above prevailing eurocurrency market rates for the period of credit and it varies in line with those rates, since this is the main source of funds which forfeiters tap to provide finance to exporters. Trade paper is discounted in any fully convertible currency, although US dollars, Swiss francs and Euros are usual, since these are the main eurocurrency market currencies. A forfeiter will not finance a trade debt without the guarantee of a known international bank, although finance will be considered in respect of bills of exchange accepted, or promissory notes issued, a first-class buyer, such as a government agency or a major multinational company. There are two main forms in which the debt instrument may be secured:
This is an irrevocable and unconditional guarantee to pay on the due date. The words “pour avaf’,together with the bank’s signature, are written directly onto the bill or the promissory note and thus the bank becomes the debtor as far as the forfeiter is concerned. The aval is not legally recognized in some countries, including England. However, this does not appear to have caused practical difficulties and, in fact, most forfeiters, including those in the UK, prefer the aval toa separate letter of guarantee.
This is a separate document wherethe guarantor undertakes to pay bills of exchange or promissory notes on their due dates. The guarantee must not, of course, refer to the underlying commercial transaction, since the forfeiter, having bought the debt instrument without recourse, will not wish to find payment is withheld because of a dispute between exporter and importer as to the goods or services supplied. The aval or the guarantee is the forfeiter’s security which effectively eliminates any commercial risk. The forfeiter may hold the bill or note until the maturity date, which is known as primary forfaiting, or sell it to another institution in what is known as the secondary forfaiting market. A separate guarantee is generally less favored than an aval, since it involves more work for the forfeiter and its transferability can cause problems.
Advantages of forfaiting for the exporter include:
- Forfaiting offers 100% finance on a without recourse basis and at a fixed rate, thereenabling the exporter to build finance costs into the contract price. Finance is off-balance sheet, thus preserving existing bank credit facilities.
- In addition to removing interest risk, forfaiting also eliminates exchange, credit, political and transfer risks.
- Forfaiting is flexible, there being no distinction between types of goods and services and no constraints on origin.
- Forfaiting finance can be arranged very quickly, and documentation is brief and relatively simple.
- Forfaiting transactions are rarely published, and this aspect of confidentiality is often attractive to exporters.
- The ability to offer forfaiting in a tender may be necessary in order to remain competitive.
Disadvantages of forfaiting for the exporter include:
Despite the greater degree of competition among financial institutions for forfaiting business, which has brought interest margins down, forfaiting tends to be relatively expensive.
Forfaiting is generally limited to the major currencies, and forfeiters will not accept countries where too great a risk is perceived. Similarly, the forfaiting institutions will only accept the aval of a limited number of banks considered suitable.
The exporter normally has a responsibility to ensure that the debt instruments are validly prepared and guaranteed.
Finance for Importers
The importer must also have adequate finance available to enable him to purchase goods either for immediate resale or for processing prior to resale. Banks and other financial institutions have developed various products to make sterling and foreign currency financing available to importers. These are similar in nature to the methods available to exporters and include the following.
In most cases an importer would not be able to finance all his purchases from an overdraft facility, since this is an expensive source of finance. Overdraft facilities may be secured or unsecured, depending on the financial standing of the importer.
Bank loans are available to companies in both sterling and foreign currency. Some form of security, however, would be called for the bank. Importers may take advantage of favorable interest rates borrowing in foreign currency, especially if they are able to make repayment of the loan from receivables denominated in the same currency. Eurocurrency loans are available for large national or international projects.
c)Term documentary letter of credit
The importer can ask his bank to open a documentary letter of credit in favour of the seller, under which drafts are drawn, payable not at sight but at usance, i.e. 30, 60, 90, 120 or 180 days after sight. The exporter can readily discount such bills and get spot cash because of the standing of the accepting bank. The importer, however, does not have to provide cash until the maturity of the bill. As an alternative, where a documentary letter of credit is not considered appropriate, the importer’s bank may simply add his “pour avaf’ endorsement to the bill. This guarantees to the drawer that the bill will be paid at maturity.
d)Produce loan or merchandise advance
A produce loan is made a bank to an importer to enable him to pay for goods which he has contracted to buy. The goods are the security for the loan, which is repaid from the proceeds of sale. Produce loans are granted for short periods only -long enough for the importer to be able to resell the goods and repay the loan with the proceeds -usually between seven days and three months.
As we considered earlier in the unit.
Export credit agencies have been established in several countries, to encourage the export of goods and services. The exporter can obtain credit facilities from these agencies at fixed and preferential interest rates, which enables credit finance to be made available to importers in other countries.Rates of interest and lengths of credit terms are agreed members of the Organization for Economic Cooperation and Development (OECD) and these terms, which are offered most national credit agencies, are reviewed on a regular basis.
The importer can receive short-term credit from the confirming house, to which he must pay a commission for the service provided. In addition to direct financial assistance, banks also provide a range of further services. The principal service is effecting payment: Where open account or payment in advance terms are used, banks will effect payment means of money transfers, telegraphic transfers, the SWIFT system, or draft. Opening of documentary letters of credit, including back-to-back and transferable letters of credit. Selling foreign currency to the importer to settle his purchases, both on the spot and onforward currency markets. In addition, they will also obtain status reports on prospective suppliers, provide advice and practical assistance in complying with exchange control requirements, import licenses, documentation, etc., secure travel facilities for importers seeking to make contacts overseas and assist in finding suppliers via the bank’s correspondent networks, and arranging introductions.
Countertrade can be defined as a trading transaction whereexport sales are dependent on the exporter receiving imports, in one form or another, from the buyer. Countertrade developed rapidly during the 1980s as the international debt crisis worsened and many countries did not have the funds or credit facilities to pay for imports in the normal way. Countertrade has also been used to protect or stimulate the output of domestic industries. It is thought that 30% of world trade is arranged through some form of countertrade agreement, being common in developing countries; centrally-planned economies (as part of their political and economic policies); in those lacking foreign currency; and in buyers’ markets. It is less common between industrial countries, though it is used in high technology areas such as aviation and defense. Types of countertrade transactions are:
This is the most common form of countertrade. As a condition of obtaining a sales order, the exporter agrees to purchase goods and services from the buyer’s country. Two parallel, but separate, contracts are arranged, and the value of the counter purchase varies from 10% to 100% of the export order. The counter-purchase goods will often be unrelated to those exported -and indeed the counter-purchase agreement may be between parties not involved in the original transaction (although normally there will be recourse to the exporter if the counter- purchase obligations are not fulfilled).
This is a direct exchange of goods for goods, and only one contract is involved. Such deals are rare, although they are still sought several African and Latin American countries, or for large contracts involving oil.
Here, exporters of capital equipment agree to be repaid from the future output of the equipment supplied; such deals tend to be for large amounts and for long periods. They are sometimes referred to as “compensation” deals.
Because of imbalances in trading agreements, one country may accumulate large surpluses owed another country, e.g. Brazil may have a large surplus with Poland. These surpluses could be used by, for example, UK exports to Brazil being financed the sale of Polish goods to the UK. Such “switch” or “swap” deals can be very complex and specialist intermediary organizations are often involved in arranging such transactions.
This type of countertrade is most commonly used in connection with high technology products, and involves an agreement an exporter of such products to use materials and components produced in the importing country in his final product. Alternatively, an offset agreement may incorporate a requirement that bidders establish local production capacity.
In some countries there is a requirement for goods imported to be matched an equivalent amount of goods exported from that country, and where such trade is of a continuing nature it may be impractical to balance the business on an item-by-item basis. In these cases, a record of the balance of this trade may be kept means of evidence accounts, such accounts being kept in balance on a year-by-year basis. Countertrade is expensive, administratively difficult and often collapses -thus smaller and medium-sized companies tend to avoid it. One party may receive goods it is unable to trade in, or receive them at too high a price; or there may be too many parties involved to ensure the contract goes ahead.
The costs of countertrade include:
- Insurance costs.
- Advice fees, e.g. from banks, specialist consultants or third-party trading houses or brokers who may take up obligations of countertrade.
- The discount needed to dispose of goods can be up to 50% of low quality goods; this is known as disagio.
Countertrade transactions are fraught with danger, and the number of successful transactions form a relatively small percentage of those negotiated. However, the ability of an exporter to quote countertrade terms, even if the particular exporting transaction does not eventually result in countertrade, may mean the difference between success and failure in tendering for business. It can therefore be an important marketing tool.
Among the many dangers associated with countertrade are:
- Inability to dispose of large quantities of unmarketable goods taken as part of a countertrade deal.
- Loss of profits on the main exports because the costs of countertrade have not been fully considered.
- Cancellation of export orders because of the failure of other parties to meet countertrade obligations.
There are a number of specialists who can assist in countertrade, such as traders, brokers and banks.
End of topic Review questions
- Discuss some of the reasons why international trade is more difficult and risky from the exporter’s perspective than is domestic trade.
- What three basic documents are necessary to conduct a typical foreign commerce trade? Briefly discuss the purpose of each.
- Discuss the various ways the exporter can receive payment in a foreign trade transaction after the importer’s bank accepts the exporter’s time draft and it becomes a banker’s acceptance.
- Briefly discuss the various types of countertrade.
- The time from acceptance to maturity on a $1,000,000 banker’s acceptance is 120 days. The importer’s bank’s acceptance commission is 1.75 percent and the market rate for l20-day B/As is 5.75 percent. What amount will the exporter receive if he holds the B/ A until maturity? If he discounts the B/A with the importer’s bank? Also determine the bond equivalent yield the importer’s bank will earn from discounting the B/A with the exporter. If the exporter’s opportunity cost of capital is II percent, should he discount the B/A or hold it to maturity?