Financing of Foreign Trade
In international trade, both the suppliers and buyers need short-term credit from financial institutions. For example, an exporter needs bank finance to have sufficient cash flow. In some cases, the exporter (supplier) may finance the entire trade cycle, starting from production to the receipt of the payment from the buyer. This type of credit is called supplier’s credit. In other cases, the exporter may not be willing to finance the entire trade cycle. In such cases, the buyer may need financing from financial institutions.
Table of Content
- 1 Financing of Foreign Trade
- 2 Financing Facilities Availed by Importers and Exporters in International Trade
- 3 Modes of Payments in Foreign Trade
This type of financing is called buyer’s credit. Therefore, you can see that short-term financing plays crucial role in the smooth functioning of international trade. Commercial banks play a very important role in meeting the financial requirements of an exporter as well as an importer. The credit needs of importers and exporters from the time the exporters enter into a contract till they receive the final payment from the importers are taken care of by the commercial banks. Banks extend facilities like pre-shipment and post-shipment finance to exporters. In addition, importers can also avail advances from banks to make payment to the exporter for the imported goods
Financing Facilities Availed by Importers and Exporters in International Trade
Let us study various financing facilities availed by importers and exporters in international trade:
Letter of Credit (LC)
An LC is the most secured and widely used form of international trade transaction method. An LC is a commitment on behalf of the importer by a bank in the importer’s country that the payment will be made to the exporter if he meets the terms and conditions as stated in the LC.
Banker’s acceptance refers to a bill of exchange or a time draft drawn on and accepted by a bank. It is the obligation of the accepting bank to pay the holder at maturity.
The following steps are involved in the creation of banker’s acceptance:
- Step 1: The importer places order for goods to the exporter.
- Step 2: The importer asks its local bank to issue an LC. This LC allows the importer to draw a time draft on the bank to pay for the imported goods.
- Step 3: The exporter presents the time draft along with the relevant shipping documents to its local bank. The exporter’s local bank in turn sends the time draft and the shipping documents to the importer’s local bank.
- Step 4: The importer’s local bank accepts the time draft. The acceptance of the time draft by the importer’s local bank is called ‘banker’s acceptance’.
Banker’s acceptance benefits the importer, exporter and the issuing bank. The exporter does not need to worry about the credit risk. Banker’s acceptance makes it easier for the importer to make payment to the exporter. Lastly, the accepting bank earns commission out of the transaction.
Short-term Working Capital
Maintenance of short-term capital of importers and exporters is an important factor in the success of international trade. For example, an importer may face short-term working capital problem until the imported goods are sold in the market. Similarly, an exporter needs sufficient working capital for smooth function of its manufacturing processes. Short-term working capital needs of firms are fulfilled by shortterm international trade finance.
In case of banker’s acceptance, an exporter can receive funds immediately. Banker’s acceptance also allows the importer to defer payment until a future date. In addition, the accepting bank may also offer short-term loans for a period greater than the banker’s acceptance period. This type of credit finances the short-term working capital needs of the importer and the exporter.
Pre-shipment Finance or Packing-credit
It is the advance given to the exporter to procure, process, manufacture, pack and prepare the goods for the purpose of export. This credit facility is provided to the exporter before and till the goods are exported.
It is the credit facility given to the exporter from the time when the goods are shipped till the export proceeds are realised.
In international trade, buyer refers to the importer whereas supplier refers to the exporter. Buyer’s credit refers to the loans that are taken by a buyer for making payment to the exporter for the imported goods. For availing such loan, the importer’s bank must give an undertaking to the overseas bank. After getting this undertaking, the overseas bank credits the nostro account of the importer’s bank with the required amount of loan. The importer’s bank uses this amount to make payment to the exporter against the import bill.
A supplier’s credit refers to the financing that a supplier (exporter) extends to a foreign importer (buyer) to finance his purchase. The importer usually pays some amount upfront in cash and promise to pay the rest of amount later and issue a promissory note for the same. In this way, the exporter receives a deferred payment from the importer. The supplier can get the promissory note discounted from his bank for cash payment. Here also, the interest rate is quoted in terms of London Inter-Bank Offered Rate (LIBOR).
In international trade, a factor refers to a bank or a financial institution. The factor helps the exporter purchase the invoice or the accounts receivable. Factoring refers to an agreement in which the factor and the exporter agree that the factor will purchase exporter’s foreign currency receivables for cash at a discount from its face value. The discounting may or may not be with recourse. This eliminates the risk of non-payment for the buyer.
Forfaiting is similar to factoring and it eliminates the risk of non-payment by buyer after the goods have been delivered to the importer. Forfaiter is a special department in a bank that conducts the work of forfaiting. Forfaiting is usually non-recourse financing. Factoring is usually provided for short-term receivables; whereas, forfaiting is done for medium-term receivables. The forfaiter usually works with exporters who sell capital goods, commodities, or large projects and they require credit for 180 days to seven years.
Modes of Payments in Foreign Trade
The importer and exporter should agree on the terms of trade and decide how the payment is supposed to be made by the importer to the exporter at the time of entering into a contract for export. Once the terms like bargaining power of parties concerned and exchange control requirements are taken care of, the method in which the payment has to be done should also be decided.
The following are the major modes of payments in international trade:
As the name suggests, in advance remittance, the full payment is made by the importer to the exporter before the receipt of goods. The importer has to trust the exporter and take a risk by making full payment of the goods he wishes to import. The exporter will dispatch goods only after he receives the full payment.
At times, it also happens that the exporter starts manufacturing the goods after receiving payment. Though this mode of payment is advantageous to the exporter, it is not so for the importer. This is because the importer is required to bear additional costs and the risks of not receiving the goods.
Such a method of payment is entirely different and opposite to the advance remittance system. Under open account, the importer or the buyer gets the goods before making any payment. Hence, the entire risk is borne by the exporter who relies on the integrity of the importer. As per the decided terms and conditions, the importer makes payment to the exporter after, say, 2 months after the shipment date.
It is possible where a commodity commands a buyer’s market. Many countries have developed certain credit insurance schemes to safeguard the interests of the exporter. In India too, the Export Credit Guarantee Corporation (ECGC) have placed restrictions on open account business for exports.
In consignment sale, the exporter may have his selling agents abroad to whom the goods are sent. They are not required to make any payment for receiving such goods. These selling agents sell goods to the importer on behalf of the exporter. As the sales proceeds are received, they are further sent to the exporter. The exporter is at risk in consignment sale as the ownership remains with the exporter. The open account method is an absolute sale in which the agent receives goods on behalf of the importer. Few traditional goods are exported from India using this method.
Documents Against Payment (DP)
In all the methods discussed above, the risk is high for either importer or the exporter. Thus, naturally there was a need to safeguard the interests of both the concerned parties in a deal. Hence, in this type of method of payment, the exporter is not required to part away with goods without receiving payment and also the importer is not required to make payment until he gets possession or control over the goods.
It works by the exporter drawing a bill of exchange on the importer for the goods exported. The goods are sent by the exporter to the country of the importer. Then the exporter draws a bill of exchange on the importer. The relative documents are sent by the bank to the importer and the bank ensures that possession of the goods is given only when the importer pays the value of the goods as advised by the exporter.
This method where the payment is made against the documents is called DP or Documents against Payment. Here too, however, the exporter faces a risk of non-payment by the importer. In case of repudiation by the importer, it is the exporter who has to bear additional costs.
Documents Against Acceptance (DA)
In this type of method, along with the documents, a usance bill of exchange for a specific period will be drawn for the importer to make payment. On the acceptance of the bill of exchange by the importer, the export documents will be released by the bank. DA method is used when the exporter wants to give the importer a credit facility. Hence, upon accepting the bill, the importer is not required to pay any amount to the bank. The export documents are used by the importer to get the possession of goods but he will be required to pay the amount to the collecting bank only on the due date.
Letter of Credit (LC)
To avoid the risk of repudiation by the importer when the exporter draws a bill of exchange, another method was devised to ensure that the exporter receives payment of the goods without default, if he enters into a contract. LC is an undertaking by the importer’s bank to make payment to the exporter, if the exporter exports the goods and produces documents as specified in the letter.
The bank is hence required to make payment to the exporter as it is now the bank’s obligation to pay to the exporter for the goods exported by him. Thus, the obligation to pay to the exporter has now shifted from the importer to the bank. This is considered to be the best method of payment in international trade.