Estimated duration: 2hrs
There has been a dramatic increase in the globalisation of trade in recent years with international trade increasing at an ever-accelerating rate. International trade brings with it great opportunities and challenges. One of the challenges is in the area of finance. How can a company generate the finance required to engage in international trade activity, know that it will get paid and how does that same company ensure that the risks associated with such trade are covered?
Trading across borders has always been risky: you may over-trade, you may not get paid. In this course, you will learn about these different types of risks and how to prepare yourself so that you are more likely to be successful.
The issues associated with finance while doing business across borders can be dealt with under 3 headings:
– Financing Production Plan
– Payment Terms
– Offers to New Buyers
Financing Production Plans
You will need to produce more goods for export activity. How will you finance this production? While we talk here about producing goods, remember that if you are a service-based business you will also need to consider how you will “gear-up” to accommodate the extra expected activity. Your financing options may be curtailed in that you may find that you are pushing the limits of your existing credit lines with your current financing arrangements.
There is the matter of deciding how best to get paid so that you will generate a profit and still be able to deliver the product to the chosen market at a competitive price.
Offers to New Buyers
What offers should you/ can you make to your “new buyers” in order to guarantee a mutually satisfying relationship?
Essentially your company will need to see this exporting activity as an opportunity. Coupled with this opportunity comes the need to be rational and aware of the many pitfalls. It takes more than a great product to be successful in an export market- you also need to be able to make the activity commercially viable. Hence the requirement for a strategic approach to export financing.
There is always risk associated with doing any business and doing so on an international/cross-border basis is no different. We will now take a look at some financial areas of importance which you must be aware of when working through your planned export activity.
We will now look at 3 areas:
- International Trade and Documentary Credit/ Letters of Credit
- Export Finance (pre and post shipment)
- Export Credit Insurance
International Trade and Documentary Credit/ Letters of Credit
When you are selling to a buyer in another country especially for the first time, you are correct to be nervous and concerned about whether you will get paid in a timely manner or indeed at all. Perhaps the buyer will default on payment, leaving you with a very big headache. Documentary Credit services/facilities offered by banks help solve these concerns or worries for you.
When the two parties have agreed on the terms of the sale (delivery date and method , quantity, quality, and price et cetera), the buyer instructs his bank to undertake a payment obligation on his behalf in favour of the seller. This is called a Letter of Credit or LC.
The LC is essentially saying to the seller that if every element of the agreed contract is adhered to, then upon submission of a series of agreed documents, the buyer bank guarantees payment by transfer of funds. This will satisfy the seller. Interestingly if the bank deems that the seller has acted in a correct manner and has fulfilled all obligations set out in agreed documentation, it will release the funds. This will happen even if the buyer is unhappy with the situation. The issuing bank is obligated to complete the transfer of funds. The LC is a contract and exists independently of the seller and the buyer. The documents sought by the bank in order to release funds will typically be:
Commercial Invoice, Bill of Lading or Airway Bill, and Insurance Documents. (there may be other documents which the parties require, this will be something that will be agreed during negotiations).
The LC works for both parties and reassures everyone that all must be in order for funds and products to transfer to the other side. Having paid the seller the issuing bank ( the one that drew up the LC) will collect payment from the buyer. It is worth noting that there may also be an Advising Bank and a Confirming Bank.
Advising Bank: this is a bank in the country of the seller or beneficiary of the LC. The role here is to advise and assist the seller in preparing the LC to send to the issuing bank. The Advisory Bank does not normally have a financial obligation in the process, it is there to simply “advise”.
Confirming Bank: is a correspondent bank of the bank issuing the LC. Similar to the Advising Bank, however, this bank is in the country of the buyer. It will confirm that all is in order and make this known to the issuing bank.
Types of Letter of Credit (LC)
All LCs require the seller (beneficiary) to present a draft and specified documents in order to receive payments from the issuing bank. A draft is a written order, whereby the buyer orders the LC issuing bank to pay money to the seller. This draft is known as a “bill of exchange”. The bill of exchange can be of sight or time in nature. In a sight bill of exchange, the seller receives payment from the issuing bank, as soon as it is presented for payment. The bank reviews documents within a given number of days and then makes payment.
As we have seen above, an LC is a very important document in the context of alleviating the pain and frustration associated with doing business across borders, because it guarantees payment subject to all conditions being met. There are several types/variations of LC. Let us take a look at these.
Ten Types of LCs
- Irrevocable LC. This LC cannot be cancelled or modified without consent of the beneficiary (Seller). This LC reflects absolute liability of the Bank (issuer) to the other party.
- Revocable LC. This LC type can be cancelled or modified by the Bank (issuer) at the customer’s instructions without prior agreement of the beneficiary (Seller). The Bank will not have any liabilities to the beneficiary after revocation of the LC. It would be unusual for parties to agree to an LC of this type, given that either party could back-away from the agreement within telling the other!
- Stand-by LC. This LC is closer to the bank guarantee and gives more flexible collaboration opportunity to Seller and Buyer. The Bank will honour the LC when the Buyer fails to fulfil payment liabilities to the Seller.
- Confirmed LC. In addition to the Bank guarantee of the LC issuer, this LC type is confirmed by the Seller’s bank or any other bank. Irrespective to the payment by the Bank issuing the LC (issuer), the Bank confirming the LC is liable for performance of obligations.
- Unconfirmed LC. Only the Bank issuing the LC will be liable for payment of this LC.
- Transferable LC. This LC enables the Seller to assign part of the letter of credit to other parties). This LC is especially beneficial in those cases when the Seller is not a sole manufacturer of the goods and purchases some parts from other parties, as it eliminates the necessity of opening several LC’s for other parties.
- Back-to-Back LC. This LC type considers issuing the second LC on the basis of the first letter of credit. This LC is opened in favour of intermediary as per the Buyer’s instructions and on the basis of this LC and instructions of the intermediary a new LC is opened in favour of the Seller of the goods.
- Payment at Sight LC. According to this LC, payment is made to the seller immediately (maximum within 7 days) after the required documents have been submitted.
- Deferred Payment LC. According to this LC the payment to the seller is not made when the documents are submitted, but instead at a later period defined in the letter of credit. In most cases the payment in favour of Seller under this LC is made upon receipt of goods by the Buyer.
- Red Clause LC. The seller can request an advance for an agreed amount of the LC before shipment of goods and submittal of required documents. This red clause is so termed because it is usually printed in red on the document to draw attention to the “advance payment” term of the credit.
Taking out an LC
If you wish to take out an LC here are the steps that you should follow:
- The seller and buyer negotiate the terms of sale.
- The seller deposits the goods at the carrier or ships it.
- The seller collects the necessary document indicating that the goods have been shipped.
- The seller presents a “bill of exchange” which the buyer ratifies.
- The seller presents the bill of exchange and other supporting documents to a local bank or a correspondent bank. The correspondent bank in turn forwards these documents to the issuing bank.
- Once the issuing bank checks the document, the correspondent bank releases money to the seller.
- The correspondent bank then reimburses the payment from the issuing bank.
- The issuing bank contacts the buyer and the buyer pays the due amount to the issuing bank.
- The issuing bank, then releases the original document to the buyer.
- Using the original document, the buyer releases the goods from the carrier.
The rules pertaining to the letter of credit are governed by the “International Chamber of Commerce (ICC)”. ICC has a standard set of rules known as “The uniform Customs and Practice (UCP) for Documentary Credit”. From time to time ICC revises UCP rules.
Export Finance (pre and post shipment)
In order to support and encourage export activity, given its value to an economy, most countries have export finance facilities available. These facilities are broadly known as Export Credit. They are designed to cover the gap or lag between the costs associated with producing the product for export and getting paid by the buyer. Without a means to “cover” this gap or lag, it would often be impossible and/or impractical for a seller to engage in export activity. Financial institutions step in to provide finance.
There are 2 types of export finance:
1. Pre-Shipment Export Finance
2. Post-Shipment Export Finance
Pre-Shipment Export Finance
Pre-shipment finance includes any finance that an exporter needs before goods are sent to a buyer. Once the exporter has a confirmed order from a buyer, which is sometimes backed by a Letter of Credit, working capital finance is often required to fund wages, production costs and buying raw materials. Exporters can access receivables backed financing, inventory/ warehouse financing and pre-payment financing. This means that the finance is secured against the monies due when the goods are eventually paid for. What we have here is a loan where the goods exported are the security, so in the case of defaulting, the lender can seize the goods.
Lenders can often fund up to 80% of the total value of the goods, but this can vary depending on the risk of exporting the goods and the lender. The goods being exported are also an important consideration for export finance lenders: if there is little demand for the goods (customised items, or very specific items), a lender may not be able to resell in the case of seizing the goods. Therefore, the risk is higher, and they may be unwilling to finance the transaction, or may charge a higher rate, which may not be acceptable to the seller as it would/might render the transaction unprofitable.
Lenders can put conditions on the export finance arrangements such as having the goods kept in a particular location. Warehouse or inventory financing is often favourable to borrowers for short term working capital or loans (especially if they have used up existing credit lines or bank overdraft facilities), and the inventory can be used as collateral or more flexible terms.
Another form of financing is Pre-payment financing. In this case, the buyer will take out a loan specifically for the purpose of paying the seller in advance of shipping the goods, and the borrowing contract states that the buyer pays the loan back to the bank once they have received payment for the goods. This process ensures quick payment and the risks are shared with the buyer and the bank. Whatever method of financing your company engages in, as a seller or as a buyer, the finance available and the terms and conditions will be agreed to between the parties involved and will always take on-board the inherent or perceived risk.
Post-Shipment Export Finance
Once an exporter has shipped goods, a financier can advance the payment so that they have sufficient liquidity between shipping the goods and receiving the payment. Post-shipment finance can operate in a number of ways: through a Letter of Credit, a loan via an accounts receivable document, or via invoice factoring or Receivables Discounting* (selling the invoice or receivables document).
* Receivables discounting (also known as receivables factoring) is a mechanism in which finance is provided against receivables; such as invoices. The typical way this will happen is for 75-90% of funding to be provided against the invoice value.
Export Credit Insurance
Export Credit Insurance protects a seller from the risk of non-payment by a foreign buyer. The insurance usually covers commercial risks such as buyer insolvency, bankruptcy, or default. It usually covers some political risks as well, including war, terrorism, riots, revolution, currency inconvertibility, and changes in import or export regulations. Sellers are thus protected from things both within and outside the buyer’s control. This relieves anxiety and enhances the propensity to do business.
Export Credit Insurance can conveniently be classified as either short term or long term. For example, short-term export credit insurance might offer 90–95% coverage against a buyer’s payment default and would generally cover sales of such items as consumer goods, materials, and services up to 180 days and small capital goods, consumer durables, and bulk commodities up to 360 days. By contrast a medium-term export credit insurance would typically provide somewhat less protection but for a longer period of time – for instance, 85% coverage of the net contract value on sales of large capital equipment, for up to 5 years.
Naturally, securing Export Credit Insurance requires the payment of premiums. Insurance premiums are based on individual risk factors such as (1) buyer’s creditworthiness (as assessed by the entity that provides the insurance coverage) and (2) the countries involved in the transaction. Depending on circumstances, such insurance can often be purchased either on a single-buyer basis or on a ‘portfolio’ multi-buyer basis. Export Credit Insurance is an option for large contracts. The cost typically ranges from 0.2-0.5% of turnover although premiums have increased over the last few years. Risk factors that affect the premium include the political and economic climate of the country you are trading into; the enforceability of legal judgments there; the financial standing of your customer and your terms of payment, as well as previous experience of dealing with you and your business.
Export Credit Insurance is offered by private insurers and by government agencies often referred to as Export Credit Agencies (ECAs). These will exist in most countries especially those that have a track record of export activity. You should check what assistance and support is provided in your country.
Take 30 minutes to address this task and subsequent questions.
List the different types of LC’s that you have encountered in this module.
What is the core advantage of having a LC drawn up?
Why would a buyer not draw up a LC?
Why might an exporter insist on a LC?
What is the purpose of Export Credit Insurance (ECI) , and what determines the premium charged?
What agency in your country provides assistance with Export Credit Insurance?