Financing Int Trade-1

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Trade Financing

Gargi Sanati

NIBM_PGPBF, 2011


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Why Financing International Trade?

International commercial transaction is similar to the domestic

commercial transaction from the credit aspect, except certain

risks like counter party risk, country risk (exchange rate risk,

political risk and financial risk)

To facilitate the major agents (exporter, importer and bank)

international trade financing has come up with different

payment options along with some structured products

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The challenge associated with itComplicated for a number

of reasons:

the time taken by the voyage,

the hazards of the loss/damage of goods in transit,

customs formalities in both exporters and importers

countries

import/export and exchange control regulations

The major risk associated with it

The time of realization of export proceeds is different than

the contract of sales established between buyer and seller,along with the payment periodexposed to the risk of

Exchange Rate Fluctuation

Possible solutions?

Other risk associatedcounter party risk and country risk


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Regulatory Framework

There are two regulatory bodies of GOI for monitoring

foreign exchange Transactions Ministry of Commerce

Indirectly operates via DGFT

Foreign Trade Policy

Handbook of Rules and Procedures (volume I & II) ITC HS Code ( unique product code No: uniform in the world assigned

to each product, which are traded internationally.)

IEC no (customer code assigned to importer and exporter.)

Ministry of Finance

Monitors the financial/remittance aspect of an international

transaction

Indirectly operates via RBI, Customs, Enforcement Directorate


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Inspection of the Goods before Shipment

Cultural and Language Difference

According to the Contracts for the Sale of International goods (CSIG) theGeneral Rule for the Inspection of the goods before shipment is that

If the parties have agreed that the buyer is entitled to inspect the goodsbefore shipment, the seller must notify the buyer within a reasonable timebefore the shipment that the goods are ready for inspection at the agreed

place.

Case 1: An Australian importer of clothing recounts the following story:

He had ordered custom shipment of 5000 rugby shirts from a foreignsupplier. He requested a sample shirt to test the cotton content in the fabric.

He cut off one of the sleeves of the shirt at the elbow, extracted a few fibres

and tested them. Satisfied, he returned the shirt with the notation: oksend shipment as agreed

Several months later he received an irate call from a major clothingdistributor, to whom the shipment had been sent directly.

The client had received 5000 rugby shirtseach missing one sleeve!

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Parties in International Trade Finance

a) Exporter and Importer

In documentary credit the seller/exporter is alternatively referred to as: Beneficiarybecause it is the seller who receives payment from the

letter of credit.

Shipperbecause the seller ships the goods.

Consignoragain, because the seller ships the goodssometimes

referred to as consignment in international transport

The buyer/importer is alternatively referred to as :

Openerbecause the importer opens the credit to begin the process.

Applicantbecause the importer must begin the process by submittinga credit application to a bank.

Account partybecause the importers application to open a credit

creates an account relationship with the issuing bank, and is

supervised by an account officer.


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Payment Methods

Principal Payment Methods

Advanced Payment

Open Account and Consignment sale

Documentary Collection/Bills for collection

Documentary Credit/ Letters of Credit (LCs)

With each of these methods, risk and security levels of both importer and

exporter vary.

Depending upon the bargaining power of buyers and sellers, their

convenience, requirements, conventions, regulatory framework and

sophistication, many forms of payment settlement have emerged.

Maximum transactions of international trade do not happen through

L/C transactions. Why?


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Prepayment or Advance Payment

Under the prepayment method, the exporter will not ship the goods

until the buyer has remitted payment to the exporter. Riskiest proposal for the importer

Credit rating of the seller may be called for ?

Exporter insists for advance payment If he is the only sellermonopoly situation

is doubtful about the importer who is the first time buyer whosecreditworthiness is unknown.

or whose countries are in financial difficulty because of financial,economical and political risk.

This method affords the supplier the greatest degree of protection. Most buyers, however, are not willing to bear all the risk by

prepaying an order.

Many a times the advance is paid partly.


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Open Account

Buyers market

Exporter dispatches goods directly to importer on an agreement of

payment on later date. Payment made after the goods are sold by the buyer

Risk of non payment fully lies with exporter

Legal remedies to enforce payment is very difficult

No bank finance involved

Cheapest method of payment receiving

Take place usually among subsidiary-parent companies, Creditworthy

buyers or buyers with long standing trade relationship.

Also, when buyer has the monopsony power and would like to execute it.

Despite the risks involved, open account transactions are widely utilized,

particularly among the industrialized countries in North America and

Europe.


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Documentary Collection It is an operation in which a bank channelizes documents between

exporter and importer.

Most trade transactions handled on a draft basis are processedthrough banking channels. In banking terminology, they are knownas documentary collections.

Two types of collection

Collection under Documents against Payment Collection under Documents against Acceptance

Advantage Over Open Account

Sellers bank acts as sellers agent

Buyers bank/subsidiary of sellers bank acts as buyers agent

Governed by the ICC Uniform Rules for Collections

From the sellers point of view if the seller needs to take action against non-paymentthey can take legal action

From the buyers point of view payment is made only after the goods have beenreceived


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Draft

A draft (or bill of exchange) is a promise drawn by the exporter,

instructing the buyer to pay the face amount of the draft upon

presentation.

The draft represents the exporters formal demand for payment from

the buyer. A draft affords the exporter less protection than an L/C, since the

banks are not obligated to honor payments on the buyers behalf.

In a documentary collection transaction, banks on both ends act as

intermediaries in the processing of shipping documents and the

collection of payment. They do not give any guarantee of payment

or of performance on the part of the seller or the buyer.


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Documents against Payment (D/P)

Documents against Payment (D/P) - If shipment is made under a sight

draft, the collecting bank is instructed to deliver documents only against

the payment for the goods.

It is a practice that provides the exporter with some protection, since the

banks will release the shipping documents only according to theexporters instructions.

The buyer needs the shipping documents to pick up merchandise.

If the goods are not at per the ordered quality importer would lose as

payment is already made. If for any reason, the collecting bank overlooks these instructions and

delivers documents before getting paid it faces the risk of having to

recompense the seller for loss.


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Document against Acceptance (D/A) If a shipment is made under a time draft, the exporter provides instructions

to the buyers bank to release shipping documents against acceptance(signing) of the draft. This method of payment is sometimes referred to as

documents against acceptance. By accepting the draft, the buyer is promising to pay the exporter at the

specified future date. In this type of transaction, the buyer is able to obtainthe merchandise prior to paying for it.

It is the buyers responsibility to honor the draft at maturity. In this case,

the exporter is providing the financing and is dependent upon the buyersfinancial integrity to pay the draft at maturity.

Shipping on a time draft basis provides some added comfort in that banksat both ends are used as collection agents.

The added risk is that the buyer fails to pay the draft at maturity; the bank isnot obligated to honor payment. The exporter is assuming all the risk andmust analyze the buyer accordingly.

Sometimes after checking goods importer refuses to pay, so seller may haveto arrange some other customer in the same country or in different country.


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Consignment

Under a consignment arrangement, the exporter ships the goods to

the importer while still retaining actual title to the merchandise.

The importer has access to the inventory but does not have to payfor the goods until they have been sold to a third party. The exporter

is trusting the importer to remit payment for the goods sold at that

time.

If the importer fails to pay, the exporter has limited recourse since

there is no draft involved and the goods have already been sold. As

a result of the high risk, the consignment method is seldom used

except affiliated and subsidiary companies trading with the parent

company. Some equipment suppliers allow importers to hold some

equipment on the sales floor as demonstrator models. Once themodels are sold or after a specified period, payment is sent to the

supplier.


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Letter of Credit

A letter of Credit (L/C) is an instrument issued by a bank on behalfof the importer (buyer) promising to pay the exporter (beneficiary)

upon presentation of shipping documents in compliance with theterms stipulated therein. In effect, the bank is substituting its creditfor that of the buyer.

The exporter is assured of receiving payment from the issuingbank as long as it presents documents in accordance with the

L/C. It is important to point out that the issuing bank is obligated to

honor drawings under the L/C regardless of thebuyers ability orwillingness to pay.

On the other hand, the importer does not have to pay for thegoods until shipment has been made and documents are

presented in good order. However, the importer must still relyupon the exporter to ship the goods as described in thedocuments, since the L/C does not guarantee that the goods

purchased will be those invoiced and shipped.

A C i


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A ComparisonMethod Risk to Exporter Risk to importer

Prepayment None Relies completely on exporter to

ship goods as ordered

Letter of credit Very little or none,

depending on credit terms

Assured shipment made, but

relies on exporter to ship goods

described in documents

Sight draft; documents

against payment

If draft unpaid, must dispose

of goods

Same as above unless importer

can inspect goods before payment

Time draft; documents

against acceptance

Relies on buyer to pay drafts Same as above

Consignment Allows importer to sell

inventory before paying

exporter

None; improves cash flow of

buyer

Open account Relies completely on buyer to

pay account as agreed

None


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Basic Terminology: International Chamber of Commerces

(ICC) Uniform Custom Practice (UCP)

PaymentWith and Without Recourse

Without RecoursePayment represents a cessation

of legal obligations, means transaction ends when

goods are exchanged for money. Without recourse

means without the right to go back to the other party(seller) for the money.

Buyer ADrawee

Seller BDrawer

Goods

Sight

Act of Payment

(Without Recourse)


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Role of Banks

Issuing (or opening) bank The bank which receives theimporters application and agrees to issue the credit. The issuing

bank is commonly, but not necessarily, located in the importerscountry.

By issuing the credit, the bank is making an irrevocableundertaking to pay the beneficiary the value of the draft and/orother documents, provided that the terms and conditions of the

credit are complied with.

Nominated bankThe bank which is stipulated in a credit asauthorized to honour (pay, issue a deferred payment undertaking oraccept drafts) or negotiate.

Unless a credit expressly states that it is available only with theissuing bank, it should nominate some other bank.

If the credit is of the freely available variety, any bank qualifiesas a nominated bank. A nominated bank is not normally bound to

pay under the credit, unless it has added its confirmation to the

credit and become a confirming bank


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Role of Banks

Advising bankThe bank which notifies or advises the exporter

that a credit has been opened in the exporters favour. By advising a

credit, the bank is only acting as a outlet for the issuing bank; theadvising bank does not take any further risk, and only has the

responsibility of satisfying itself as to the apparent authenticity of

the credit and ensuring that the advice of the credit (to the

beneficiary) accurately reflects the terms and conditions of the credit

received. The advising bank is commonly, but not necessarily,located in the exporters country.

Confirming Bank - The bank (normally also the advising bank)

which adds its own irrevocable undertaking (known as

confirmation) in addition to that given by the issuing bank. Theconfirmation allows the exporters own country, or by a bank which

the exporter otherwise trusts. The confirming bank irrevocably

commits itself to paying the exporter upon presentation of

conforming documents.

R l f B k


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Role of Banks

Negotiating bankthe bank which examines the documents presented by

the exporter, then negotiates the credit (i.e., in the case usance draft,

either advances or agrees to advance funds to the beneficiary on or beforethe maturity date of the draft).

Difference between Confirming bank and Negotiating bank.

This negotiation is usually done withrecourse, which means that if

the issuing bank fails to reimburse the negotiating bank, the

negotiating bank will recover the funds advanced to the exporter.

When confirming bank negotiates, it is withoutrecourse.


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Types of Letter of Credit (L/C)

Irrevocable and Revocable

An irrevocable letter of credit can not be amended or cancelledwithout the consent of the issuing bank, confirming bank (if any)and the exporter. This allows the exporter to procure the goodsor prepare them for shipment with the assurance that paymentwill be received if the stipulated documents are presented andcomply with the terms and condition of the credit.

A credit issued, subject to The Uniform Customs and Practicesof Documentary Credits, 2007 Revision, ICC Publication No.600 (UCP), is irrevocable credit, even if there is no indication tothat effect

A revocable letter of credit allows importer to amend or evencancel the LC and it provides no security to the exporter and it ishardly practiced.


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Letter of Credit

Flowchart of Shotz trading L/C to Kazakhstan

Steel Basherov

(Kazakhstan)

Beneficiary/Exporter

Shotz Trading Ltd

(UK)

Applicant/Buyer

Bank of Global

Ttrade (UK)

Issuing Bank

ABC Bank (Kazakhstan)

Advising/Negotiating

Bank

1.L/Cissued

2. L/C Sent

7. Telex of Documentary

compliance

3.L/Cadvised

5.Document

Presented

8.Processof

Negotiationin

US$

4. Goods Exported

9. US$ Reimbursement

6. Documents Checked7/29/2013 Gargi Sanati_NIBM_Financing InternationalTrade

Sales Order


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Bill of Lading

A document issued when goods are entrusted to a shipping companyfor carriage.

It can be used for the following functions Formal receipt for the goods by the shipowner: evidence of the

delivery of the goods

An evidence of the contract of carriage: contains the terms of thecontract carriage

Documentary evidence of control over the goods: represents theright to delivery of the goods

The holder or the consignee of the bill has the right to claim deliveryof the goods from the shipping company when they arrive at the portof destination

Bill of lading may be negotiable (order bill of lading) or non-negotiable (straight bill of lading)

May be distinguished by the mode of transport of shipment


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Bill of Lading

Order bill of ladingshould be endorsed by the exporter andtransferable by delivery.

Negotiable instrument means transferring control over thegoods. But not fully negotiable.

Once the goods arrive at their destination, they will be releasedto the bearer of one original bill of lading

As an alternative to order B/L, the name and the address of theimporter may appear as the consignee. In such case only theimporter can obtain the goods, once the goods have arrived intheir destination, by presenting the original B/L, together withidentification. This bill of lading is known as the straight B/L

Normally B/L are made out to order and endorsed by theexporter

Financing Int Trade-1

Documents

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