International trade includes all the exports and imports of goods and services by every type of entity. The purpose of discussing international trade is to find out how a domestic trader, either importer or exporter will deal with all the vacillations in trade.
International trade shares similar value chain activities as any domestic business. They must find an acceptable supplier who can give them quality assurance at a reasonable price.
For making understandability of the international trade easier, let’s discuss international trade relationships.
The international trade relationship consists of the following parties:
1. Unaffiliated Unknown Party
The trade between two parties across borders where both are unknown to each other, they are having a business relationship for the first time. In this case, both have to be very careful in documentation like sale and purchase contracts, the duties and responsibilities of each other, and there must be an intermediary for transaction purposes on which both parties can rely.
2. Unaffiliated Known Party
The trade relationship between two parties across the border where they had any kind of business relationship previously for at least one time. The need for detailed documents depends upon the depth of their business relationship. but still, they need sale/purchase contracts, but with less tight terms and conditions.
3. Affiliated Party
The trade between two companies which already have some relationship, like parent and subsidiary relationship. This type of trade is also known as intra-firm trade. It does not need any legal documentation like contracts or protection against each other for non-payments. The only issue to ponder here are political or state-level issues.
How do transactions occur between exporter and importer?
Doing transactions, especially across the border is a matter of trust. This matter is resolved by banks acting as intermediaries between exporters and importers.
The process starts with a letter of credit, which means that the bank will pay the amount on behalf of the importer who has promised the bank to pay. The bank will be trusted by exporters too. After that, the exporter will ship the order to the importer’s destination. This is known as the bill of lading. Exporter will request the payment from the bank through sight draft. After the payment is made by the bank to the exporter, the bank will now pass the title of goods or services to the importer and then the importer will pay the amount to the bank.
Benefits of the above-mentioned system
- Protection against risk of non-completion
- Protection against foreign exchange risk
- Financing the trade
- Non-completion risk
Protection against risk of non-completion
Once a deal of trading is done between importers and exporters, both face the risk that one might not complete his obligation, importer wants the delivery first, then payment and the exporter wants payment then he agrees to transfer the possession of goods and services. The exporters and importers both are reluctant to bear financial losses if any of them become defaulters. Meanwhile the letter of credit, bill of lading, and sight draft play an important role to decide who will bear the loss if any of them might refuse the completion of their task.
Protection Against Foreign Exchange Risk
Because the transactions made between exporters and importers are across the borders, there must be a foreign exchange risk. The most effective technique for hedging this risk is to predefine the date and amount of payment. The above-mentioned three documents (letter of credit, bill of lading, and credit sight) play an important role in hedging the foreign exchange risk because the date of payment and the amount is already mentioned on them.
Financing the Trade
The time lag is always involved in international trade. When the goods are in transit meanwhile the funds are tied up for the trade. Banks are ready to finance the trade once the non-completion and foreign exchange risks are eliminated. Banks are always willing to finance these trades which are based on the documents: letter of credit, bill of lading, and credit sight.
Non-Completion Risk
Non-completion risk is at the end of the exporter usually, it arises when the exporter ships the good and loses its physical control over the goods. The importer might not pay for the goods shipped pay exporter is the non-completion risk. The importer’s promise (letter of credit) will eliminate this risk.
Details of Three key Documents
What Is a Letter of Credit?
A document issued by a bank as a promise by an importer to pay consideration to the exporter is a letter of credit. The importer’s bank will issue the letter of credit after checking his creditworthiness and going through all the terms and conditions of trade. If the bank is satisfied with the creditworthiness and the terms of trade, it will then issue a letter of credit as protection of payment for the exporter. Bank will pay the exporter after making sure that goods are according to order.
The following conditions must be applied while issuing a letter of credit with respect to issuing bank:
- The issuing bank will charge a fee or any state of consideration for issuing a letter of credit.
- The maturity and expiration date of the letter of credit should be present.
- The maximum amount of money should be stated as the bank’s commitment
- The bank is obliged to pay the exporter only in the presence of specific required documents.
- The importer will reimburse the bank payment on the same conditions on which the bank has paid.
Letter of credits has two classes:
- Irrevocable versus revocable
- Confirmed versus unconfirmed
Irrevocable Versus Revocable
An irrevocable letter of credit is the guarantee of payment, it can neither be canceled nor be changed without the consent of both parties whereas a revocable letter of credit can be canceled or modified at any time before payment occurs. It is not a guarantee but a source of arranging finance.
Confirmed Versus Unconfirmed:
The confirmed letter of credit involves two banks, the bank which issues and the bank which confirms the issuance of the letter of credit. It contains an irrevocable guarantee for payment whereas in the unconfirmed letter of credit, the bank does not involve any other bank and guarantees the irrevocable letter of credit issuance.
| Advantages | Disadvantages |
| Reduces the foreign exchange risk | Fees charged by issuing bank |
| Exporters can get pre-export financing loan | It can affect the credit line of the importer with issuing bank. |
| The importer will not pay anything unless they double-check the goods as required. | A competitive disadvantage for exporters. |
What is a Draft In Export Finance?
It is an order of payment usually by the seller (exporter) to the buyer (importer) for payment at a specified date.
Normally the seller or the exporter in the draft making is known as the drawer, maker, or originator. While the buyer or the importer who will receive the goods is known as the drawee. When the draft is from the buyer’s bank, it is called a trade draft and otherwise, it is called a bank draft.
A draft is a negotiable instrument if it fulfills the following conditions:
- If it is signed by the maker or drawer.
- If it contains an unconditional order or promises to pay the predetermined amount.
- Must be paid to order or bearer
- If it has to be payable on-demand or on a specified date.
Types of drafts
- Sign Draft: a draft in which drawee pay at once or otherwise dishonor it.
- Time Draft: also known as usance draft, it can be delayed. When presented to the drawee, he will stamp it. After the drawee accepted it. It becomes the buyer’s (importer) promise.
Bill of Lading
Bill of lading acts in three ways:
1. A receipt: It acts as a receipt because it tells that goods have been received by the importer.
2. A contract: it acts as a contract because a bill of lading imposes the obligation to career that it must drop the goods at the specified destination, in case, any unpredictable situation occurs, it will drop goods in an alternate destination with the concern of receiving parties otherwise it will return the goods to the exporter at exporter’s cost.
3. A document of title: with a bill of lading, one can obtain payment or promise of payment from importers. The title of goods remains to exporters unless the payment or promise of payment is made.
Government plans to help finance exporters
| Export credit insurance | Competitors are always in the market when an exporter wishes to get cash or a letter of credit straight away, there are many more who are willing to export under more favorable conditions, in this way exporters can lose their market share. To help out in this situation, the government plans to introduce a program “export credit insurance”, which will give surety to the exporter that if the importer becomes a defaulter, the insurance company will on its behalf. Importers give more preference to this scheme than any other protection against payment for the exporter. |
| Export-Import Bank and Export Financing | The export-import bank known as EXIM bank provided loan guarantees and offers many insurance programs to facilitate the US exporters. It ensures medium-term and long-term loans to borrowers outside the US. It has private sources of funds. The interest of the loan is paid to EXIM bank. |
Trade Financing Alternatives
- Banker’s acceptances
- Trade acceptances
- Factoring
- Securitization
- Bank credit lines
- Commercial papers
Banker’s acceptances: bank document which shows the bank’s promise to pay the amount at a specified date. It can be used for both international and domestic trades.
Trade acceptances: it is very much similar to bankers’ acceptances. The only difference is that commercial firms rather than banks are accepting firms.
Factoring: the special firms buy the receivables of companies or banks., they will be responsible for receivables collection.
Factoring is further classified into two types:
- Non-resource: in a non-resource basis, the factoring company considers all risks in receivables like political, foreign exchange, or credit risk.
- Resource: in a resource basis, the factoring company is responsible for all the receivables including unrecoverable ones.
Therefore, the cost of factoring is always more than others.
Securitization
In securitization, a firm can sell its receivable exports to any legal entity, which turns them into marketable securities.
Bank credit lines
It is basically a maximum limit given to a client at which he can borrow money. In financing, the eligibility for inclusion in bank credit lines can be receivables exports. But with foreign customers, it would be difficult for banks to assess the information of borrowers about their creditworthiness and other important information.
Commercial paper
Commercial papers also known as unsecured promissory notes are issued by the firm for its short-term financing needs covering both domestic and export receivables. But the access to domestic and euro commercial papers is only available to large, well-known firms.
Forfeiting
Medium-term and long-term financing: where the importer or the importer’s government is too risky to trust for the payment, a specialized technique is used known as forfeiting.
The following steps are included in forfeiting:
| Step 1: | Agreement | In the first step, both the importer and exporter agree on the amount which will be paid by the importers. |
| Step 2: | Commitment | The forfeiter makes a commitment that he will pay the exporter as the deliveries made by the exporter at a fixed discount rate. The rate could be LIBOR. |
| Step 3: | Aval or Guarantee | At this step, the importer makes promissory notes at every delivery of goods to the bank. Now the importer is obliged to pay the amount. |
| Step 4: | Delivery of notes | In the fourth step, the promissory notes are now delivered to the exporter. |
| Step 5: | Discounting | Now the exporter endorses those promissory notes to the forfeiter at a specified discount rate. The exporter freely endorses those notes and receives the discounted amount and gets rid of all the obligations against that trade. |
| Step 6: | Investment | Now, it’s up to the forfeiter that either it will keep those notes until maturity or rediscount them in the money market. |
| Step 7: | Maturity | At the maturity date, the forfeiter brings notes to the importer’s bank for collection. The value of the document (the promissory note) is because of the promise made by the bank. |
