1. Trade Financing Instruments

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1 CHAPTER 8 AN INTRODUCTION TO TRADE FINANCE The absence of an adequate trade finance infrastructure is, in effect, equivalent to a barrier to trade. Limited access to financing, high costs, and lack of insurance or guarantees are likely to hinder the trade and export potential of an economy, and particularly that of small and medium sized enterprises. As explained in Chapter 1, trade facilitation aims at reducing transaction cost and time by streamlining trade procedures and processes. One of the most important challenges for traders involved in a transaction is to secure financing so that the transaction may actually take place. The faster and easier the process of financing an international transaction, the more trade will be facilitated. Traders require working capital (i.e., short-term financing) to support their trading activities. Exporters will usually require financing to process or manufacture products for the export market before receiving payment. Such financing is known as pre-shipping finance. Conversely, importers will need a line of credit to buy goods overseas and sell them in the domestic market before paying for imports. In most cases, foreign buyers expect to pay only when goods arrive, or later still if possible, but certainly not in advance. They prefer an open account, or at least a delayed payment arrangement. Being able to offer attractive payments term to buyers is often crucial in getting a contract and requires access to financing for exporters. Therefore, governments whose economic growth strategy involves trade development should provide assistance and support in terms of export financing and development of an efficient financial infrastructure. There are many types of financial tools and packages designed to facilitate the financing of trade transactions. This Chapter will only introduce three types, namely: Trade Financing Instruments; Export Credit Insurances; and Export Credit Guarantees 1. Trade Financing Instruments The main types of trade financing instruments are as follows: a) Documentary Credit This is the most common form of the commercial letter of credit. The issuing bank will make payment, either immediately or at a prescribed date, upon the presentation of stipulated documents. These documents will include shipping and insurance documents, and commercial invoices. The documentary credit arrangement offers an internationally used method of attaining a commercially acceptable undertaking by providing for payment to be made against presentation of documentation representing the goods, making possible the transfer of title to those goods. A letter of credit is a precise document whereby the importer s bank extends credit to the importer and assumes responsibility in paying the exporter. A common problem faced in emerging economies is that many banks have inadequate capital and foreign exchange, making their ability to back the documentary credits questionable. Exporters may require guarantees from their own local banks as an additional source of security, but this may generate significant additional costs as the banks may be reluctant to assume the risks. Allowing internationally reputable banks to operate in the country and offer documentary credit is one way to effectively solve this problem.

2 60 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE b) Countertrade As mentioned above, most emerging economies face the problem of limited foreign exchange holdings. One way to overcome this constraint is to promote and encourage countertrade. Today s modern counter trade appears in so many forms that it is difficult to devise a definition. It generally encompasses the idea of subjecting the agreement to purchase goods or services to an undertaking by the supplier to take on a compensating obligation. The seller is required to accept goods or other instruments of trade in partial or whole payment for its products. Some of the forms of counter trade include: Barter This traditional type of countertrade involving the exchange of goods and services against other goods and services of equivalent value, with no monetary exchange between exporter and importer. Counterpurchase The exporter undertakes to buy goods from the importer or from a company nominated by the importer, or agrees to arrange for the purchase by a third party. The value of the counterpurchased goods is an agreed percentage of the prices of the goods originally exported. Buy-back The exporter of heavy equipment agrees to accept products manufactured by the importer of the equipment as payment. c) Factoring This involves the sale at a discount of accounts receivable or other debt assets on a daily, weekly or monthly basis in exchange for immediate cash. The debt assets are sold by the exporter at a discount to a factoring house, which will assume all commercial and political risks of the account receivable. In the absence of private sector players, governments can facilitate the establishment of a state-owned factor; or a joint venture set-up with several banks and trading enterprises. d) Pre-Shipping Financing This is financing for the period prior to the shipment of goods, to support pre-export activities like wages and overhead costs. It is especially needed when inputs for production must be imported. It also provides additional working capital for the exporter. Pre-shipment financing is especially important to smaller enterprises because the international sales cycle is usually longer than the domestic sales cycle. Pre-shipment financing can take in the form of shortterm loans, overdrafts and cash credits. e) Post-Shipping Financing Financing for the period following shipment. The ability to be competitive often depends on the trader s credit term offered to buyers. Post-shipment financing ensures adequate liquidity until the purchaser receives the products and the exporter receives payment. Post-shipment financing is usually short-term. f) Buyer s Credit A financial arrangement whereby a financial institution in the exporting country extends a loan directly or indirectly to a foreign buyer to finance the purchase of goods and services from the exporting country. This arrangement enables the buyer to make payments due to the supplier under the contract. g) Supplier s Credit A financing arrangement under which an exporter extends credit to the buyer in the importing country to finance the buyer s purchases. 2. Export Credit Insurance In addition to financing issues, traders are also subject to risks, which can be either commercial or political. Commercial risk arises from factors like the non-acceptance of goods by buyer, the failure of buyer to pay debt, and the failure of foreign banks to honour documentary credits. Political risk arises from factors like war, riots and civil commotion, blockage of foreign exchange transfers and currency devaluation. Export credit insurance involves insuring exporters against such risks. It is commonly used in Europe, and increasing in importance in the United States as well as in developing markets. The types of export credit insurance used vary from country to country and depends on traders perceived needs. The most commonly used are as follows:

3 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE 61 Short-term Export Credit Insurance Covers periods not more than 180 days. Protection includes pre-shipment and post-shipment risks, the former covering the period between the awarding of contract until shipment. Protection can also be covered against commercial and political risks. Medium and Long-term Export Credit Insurance Issued for credits extending longer periods, medium-term (up to three years) or longer. Protection provided for financing exports of capital goods and services. Investment Insurance Insurance offered to exporters investing in foreign countries. Exchange Rate Insurance Covers losses as a result of fluctuations in exchange rates between exporters and importers national currencies over a period of time. The benefits of export credit insurance include: Ability of exporters to offer buyers competitive payment terms. Protection against risks and financial costs of non-payment. Access to working capital. Protection against losses from foreign exchange fluctuations. Reduction of need for tangible security when borrowing from banks. Export credit insurance mitigates the financial impact of the risk. There are specialized financial institutions available that offer insurance cover, with premiums dependent on the risk of the export markets and export products. 3. Export Credit Guarantees Export credit guarantees are instruments to safeguard export-financing banks from losses that may occur from providing funds to exporters. While export credit insurance protects exporters, guarantees protect banks offering the loans. They do not involve the actual provision of funds, but the exporters access to financing is facilitated. An export credit guarantee is issued by a financial institution, or a government agency, set up to promote exports. Such guarantee allows exporters to secure pre-shipment financing or post-shipment financing from a banking institution more easily. Even in situations where trade financing is commercially available, companies without sufficient track records may not be looked upon favourably by banks. Therefore, the provision of financial guarantees to the banking system for purveying export credit is an important element in helping local companies go into exporting. The agency providing this service has to carefully assess the risk associated in supporting the exporter as well as the buyer. 4. The Role of Governments in Trade Financing The role of government in trade financing is crucial in emerging economies. In the presence of underdeveloped financial and money markets, traders have restricted access to financing. Governments can either play a direct role like direct provision of trade finance or credit guarantees; or indirectly by facilitating the formation of trade financing enterprises. Governments could also extend assistance in seeking cheaper credit by offering or supporting the following: Central Bank refinancing schemes; Specialized financing institutes like Export-Import Banks or Factoring Houses; Export credit insurance agencies; Assistance from the Trade Promotion Organisation; and Collaboration with Enterprise Development Corporations (EDC) or State Trading Enterprises (STE). a) Central Bank Refinancing Schemes Under this type of schemes, the Central Bank will rediscount the commercial bills of exporters at preferential rates. This will provide the cheap post-shipment financing necessary for exporters to quickly turn around funds for further export business. Here, the government is subsidizing the cost of funds that exporters have to pay if they rediscount their bills with commercial banks.

4 62 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE In a similar scheme, government could also offer factoring services at subsidized rates. b) Export-Import Bank (EXIM Bank) The Export-Import Bank (EXIM Bank) specifically caters to the needs of exporters and importers and those of investors in foreign markets. It offers various services, including long-term direct loans to foreign buyers for loans and equipment sales of sufficient sizes. Several countries, including developed nations, have EXIM banks. For example, the United States EXIM Bank was created in 1934 and established under its present law in Its primary role is to aid in financing US exports, and for medium-term (181 days to 5 years) transactions, it co-operates with US commercial banks by providing export credit guarantees. In setting up the EXIM Bank, the US recognized that job creation is a consequence of exports. Its main customers are SMEs in the United States. c) Export Credit Insurance Agencies Export credit insurance agencies act as bridges between banks and exporters. In emerging economies where the financial sector is yet to be developed, governments often take over the role of the export credit insurance agent. Governments traditionally assume this role because they are deemed to be the only institutions in a position to bear political risks. Several countries in Asia and Africa have such an organization. However, the viability of such an organization depend on the volume of business and income from insurance premium. In that context, credit insurance policies vary according to the type of exports. For example, short term policies on the sale of raw materials on 180 days terms are covered up to 95 per cent for commercial risk and 100 per cent for political risk. Such trades are considered relatively secure. Nonetheless, it is good practice to get the exporter to bear a certain portion of the risk. d) Support from Trade Promotion Organisations (TPOs) As explained earlier, banks are often reluctant to lend to exporters because of their lack of knowledge about the creditworthiness of the traders, and as a result may raise interest to compensate for the risks taken. TPOs are in a position to know the strengths and weaknesses of the individual trading houses and exporters, and could share information with financial institutions to facilitate access to financial services. TPOs are the government agencies that are most directly involved with the trading community, often supporting promising trading and exporting enterprises. The support and assistance given by the TPOs could act as a signal to banks as to which companies are creditworthy companies. In addition, TPOs could establish network of financial institutions, identify their credit requirement, and match trading enterprises and financial institutions based on these requirements. e) Export Development Corporation and State Owned Enterprises In most emerging economies, there are a few key conglomerates with a diverse range of products, substantial export capacity and sustainable financial resources. They could be private sector export development corporations (EDCs) or state-owned enterprises (SOEs). Governments could harness these enterprises as mechanisms to assist other local firms, especially SMEs, to export their products or import goods. Unlike the SMEs, the EDCs and the SOEs have the financial resources and trade expertise needed to participate in trading activities. Smaller exporters could sell their products to the EDCs and SOEs and receive payment earlier than if they exported directly by themselves. Small importers could also purchase goods from the EDCs and SOEs, which have the financial strength to bulk purchase from abroad.

5 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE 63 Box 8.1 Trade Finance Trends in Asia The recent economic slowdown is making the need for sound trade finance policies and strong financial systems more acute. Many companies are trying to preserve cash by delaying payment and the number of SMEs in emerging Asian economies with high credit risk is growing. This is partly the result of a regional trend toward unsecured, open-account type transactions. Large Western buyers are asking that their Asian suppliers sell goods on open-accounts terms, instead of using guarantees like letters of credit (LCs). These buyers simply do not want to bear the extra cost of payment guarantees and will source their goods from somewhere else if they are not given open-accounts. These open-accounts allow the buyers to delay payments as needed, rising the need for credit for Asian companies who choose to supply them. The economic slowdown also has made many companies rethink their commitment to electronic trading and payment systems. While these systems may cut significant costs out of the labor-intensive trade finance process, they also make payment delays more difficult to justify. Large Western buyers are not the only ones delaying payments. In fact, many companies prefer dealing with these buyers than with the thinly capitalized buyers commonly found in many emerging Asian economies, mainly because these large buyers remain relatively punctual and have very low credit risk (i.e., even if they delay payment a little, they will pay). With the internationalization of supply chains, a Hong-Kong, China based transformer manufacturer may sell its products to Chinese buyers sub-contracted by Dell or IBM to manufacture PCs. The Chinese sub-contractor may ask to buy from the manufacturer on open-account terms on the basis that payment from Dell or IBM is a sure thing. This kind of arrangement increases the financial risk exposure of the transformer manufacturer, and typically results in payment delays measured in weeks and sometime months. Because LCs or factoring in China and many other countries in Asia are not yet commonly used or available, Asian suppliers can often do very little to protect themselves in regional cross-border transaction, increasing the cost of regional trade transactions relative to that of direct transactions with Western companies. Source: Moiseiwitsch, J., CFO Asia, Trade Finance Time Bandits, November 2001, 5. Conclusion This Chapter has explained the need for trade finance and introduced some of the most common trade finance tools and practices. A proactive role of governments in trade finance may alleviate the lack of trade finance in emerging GMS economies and contribute to trade expansion and facilitation. However, the best long-term solution in resolving the constraints in trade financing is to encourage the growth and development of a vibrant and competitive financial system, comprising mainly private sector players. This point is important as some of the government-supported trade financing schemes may increasingly be challenged by competing countries as unfair export subsidies under existing and future WTO rules. The role of the government and other parties involved in trade finance will need to evolve along with the country s economy. Underlying the functions provided by the different players is the need for a clear and effective legal environment. The commercial legal system must be transparent. Laws of property, contract and arbitration must be clear. The commercial legal environment must be integrated with the financial infrastructure framework in order for it to be effective.

6 64 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE 6. For Further Reading... One illustration of government s proactive role in trade finance in Asia and the Pacific is the creation by the Australian government of the Export Finance and Insurance Corporation (EFIC) in ( A well-developed domestic financial system can go a long way toward facilitating trade by making trade financing easier. The issue of mobilizing domestic finance for development is addressed in the joint ESCAP-ADB report available at: The International Trade Center (ITC), a joint initiative of UNCTAD and the WTO, is a source of practical guides and manuals on international trade finance issues (