Free Market Systems - Research Paper Example

?Introduction The advent of free market systems and the opening of the world economy have led to the magnitude of international trade never seen before. None of the economies in the world are isolated and are dependent on other economies for various things such as clothes, textiles, agricultural products and medicines among millions others. One can find juice from Denmark in a supermarket accompanied with spices from India and meat from Australia. But in order to keep up with the pace of globalization and facilitate trade it is vital to have trade financing, without which it would be impossible to import or export any goods at all. As international trade is complex and requires greater documentation and control, international commercial banks are actively involved in facilitating it by providing financial instruments that cater to exporters and importers. The role of commercial banks in international trade is of utmost important as they provide reliability and assurance to their clients, and provide an easy process to finance trade. This report will cover many aspects of international trade finance. It will focus on the financial instruments that are used to make payment in international trade, the parties involved in international trade finance, and trade finance methods. Payment methods in international trade financing METHOD USUAL TIME GOODS AVAILABLE RISK TO RISK TO OF PAYMENT TO exporter IMPORTER Cash in Before After payment None Dependent Advance shipment upon exporter shipping goods Letter After ship- After payment Very little of ment, when or none Relies on Credit documents depending exporter to complying on LC ship goods with LC are terms presented Document- On presenta- After payment If draft un- Relies on ary Col- tion of draft paid, must exporter to lection to buyer dispose of ship goods Sight goods Draft Document- On maturity Before payment Relies on Almost none ary Col- of draft buyer to pay lection draft; no Time Draft control of goods Consignment After sale Before payment High Low Open After ship- Before payment Relies on None Account ment, as buyer to pay agreed his account (Export financing) In international trade financing, credit is provided either by the supplier, buyer or a financial intermediary. The supplier usually finances the trade cycle from the production till the goods are bought by the buyer and may require financing from the bank to support the production process. In most international trade transactions, the buyer and the supplier have separate banks that act as intermediaries to the transaction. Cash-in-advance The prepayment method involves cash in advance paid by the buyer to the seller. It is a risky and expensive method for the buyer but it may occur in cases where the seller is a long time business partner or a trustworthy party and the buyer is new in the market. In this scenario, the buyer will transfer the payment through his bank to the exporter’s bank account. This is the safest method of financing for exporters as they do not ship the goods till the payment is received from the importer. Letter of Credit A letter of credit is one of the most commonly used financial instruments in international trade. The letter of credit is a document that the importers bank issues promising to pay the exporter upon presentation of the relevant shipping documents such as bill of lading or bill of exchange in accordance with the terms agreed. This provides greater guarantee for the exporter as the bank is a more reliable creditor than any importer and it is easier for the importer as the bank will not release payment till the legal documents have been received. Although, this is riskier for the exporter as compared to the prepayment method, it is a secure was of transferring payment. The letter of credit stands even if the importer is unable to make the payment, thus the issuing bank is liable for the payment to the exporter and not the importer under the letter of credit. In cases where the exporter fears that the issuing bank’s guarantee is not sufficient, which could be due to reasons such as government regulations or exchange controls, he may ask his local bank to confirm the letter of credit. This would mean that the confirming bank is now liable to make the payment to the exporter regardless of whether the issuing bank makes the payment or not. The confirming bank then claims the payment from the issuing bank which is supposed to claim it from the importer. There are different types of letters of credit including: Standby letter of credit A standby letter of credit is a document that guarantees payment to the exporter in the case of nonpayment by the importer. These are commonly used in the USA. The standby letter of credit provides payment to the exporter on the claim of default by the importer. An importer wanting to open a standby L/C may have to collateralize the bank 100%. Back to Back letter of credit A Back to back letter of credit is opened by the exporter, who benefits from an export L/C. The back to back L/C is a baby L/C opened by the beneficiary of a master L/C. This letter of credits is opened by middlemen who buy products from suppliers and export them. The amount of the baby letter of credit is smaller than the amount of the master letter of credit. This type of L/C is common due to its confidentiality. The shipping documents used by the middleman are often provided in this case by the supplier, which in turn are provided by the middleman to the bank. Transferable letter of credit A transferable letter of credit can be transferred from the exporter to a second beneficiary. It should state in the letter, that it is transferable. This usually occurs when the exporter is unable to provide the total shipment required by the importer and a third party supplies a part of the shipment or it maybe that the exporter is not the manufacturer and just the middleman. Revocable letter of credit A revocable letter of credit is not common as it can be cancelled at any time without any prior notification to the exporter. Irrevocable letter of credit An irrevocable letter of credit is more common as it entails that amendments to the letter or cancellation cannot be made without the consent of the exporter. THE LETTER OF CREDIT ISSUING CYCLE Contract Authenticates Applies Issues THE PAYMENT CYCLE Provided the exporter has fulfilled the requirements stated within the letter of credit such as delivering the goods ‘on board’ and the delivering the documents to the bank, the payment cycle would look like this: Goods on Board $$$ Documents Documents $$$ Documents $$$ Documentary Collections In a documentary collection or draft, the banks act as intermediaries passing documents and payment rather than acting as guarantors. It is usually drawn up by the exporter, and entails drawing up a bill of exchange instructing the importer to make payment upon presentation of the draft. The draft will be transferred to the importer through the relevant banks. According to the terms of the documentary collection, the exporter may instruct the bank to handover documents to the importer either upon acceptance (signing) the draft or upon payment when the importer pays the draft. The types of documentary collection are also known as sight or time drafts. A sight draft is when the importer to needs to make the payment on the receipt of the draft and a time draft is when the importer needs to sign the draft which specifies a payment date in the future that the importer has to honor. The sight draft gives control of the goods to the exporter as he will not release the documents and thus the goods until the payment is made. However, the time draft releases documents upon acceptance and thus carries greater risk for the exporter as he may or may not receive payment at the agreed time. Consignment The consignment method is a risky method for the exporter as he ships the goods to the importer without transferring title of ownership. The importer has access to the goods but does not have to make payment to the exporter till the goods are sold to the third party. The importer does not have any liability in this method, and the exporter has limited choices available to him if the importer fails to make payment to the exporter. There is no time frame for when the goods will be sold to the third party and if not sold the exporter is responsible for the recovery of goods. Thus consignments are usually used between subsidiary companies or joint ventures. Open Account An open account is usually opened when the buyer and seller have great trust and experience with each other over a long period of time. In an open account the exporter manufactures and delivers the goods before payment is made. The exporter trusts that the buyer will remit his payment according to the agreed upon terms and does not withhold the documents or goods. This is a very risky method for exporters and should only be used when the exporter has utmost trust in the importer. In other cases, open account is an imprudent method of payment for the exporter. This method is still used in the United States, however if the buyer is not creditworthy or the country of the importer is unstable this method is too risky. International trade financing for exporters and importers. Apart from the financial methods involved to make payment, exporters and importers may need financing before the payment is received or the goods are sold. Thus, there are a few common methods of financing in international trade. In cases where the exporter does not have a letter of credit and uses an open account, and needs financing before payment is made, he can get a loan from the bank against his accounts receivable. However, the exporter will be liable for the loan if the importer does not make the payment. This is called accounts receivable financing. The disadvantages of this method include a higher loan rate depending on the credit worthiness of the exporter and importer as well as liability for the exporter. Factoring is similar to accounts receivable financing with the difference that the exporter sells the accounts receivable to a factor, which is responsible for getting the payment from the importer. The factor becomes the beneficiary of the payment and usually purchases the receivables at a discount or small fee. The strengths of factoring are that the exporter receives the funding when he needs it and he does not have to worry about the administrative aspects and credit worthiness of the importer. The drawback is that the exporter receives less than the value of accounts receivable. The letter of credit is a method of financing where the exporter is guaranteed payment by the importer’s bank and even confirmed by his bank if required. The letter of credit gives the exporter the payment when he submits the documents to the bank .The advantages of the letter of credit are many as it affords protection and financing to both parties. The banker’s acceptance is a method of payment involving the time draft drawn by the exporter and signed by the importer. As the exporter in this case provides the documents to the importer before payment is made on an agreed time, the exporter sends the documents and the time draft to the importer through their respective banks. Upon the importer’s banks acceptance of the time draft, it becomes a banker’s acceptance. If the exporter is unwilling to wait for the specified time, he can sell the banker’s acceptance in the market and get the payment. This gives the exporter payment before time but at a discounted rate as the acceptance is sold at a discount. The banker’s acceptance holds benefits for the bank, importer and exporter. The bank earns extra commission, the importer can reach out into diversified markets due to the banks backing and the exporter gets payment when he needs it. BANKER’S ACCEPTANCE Goods on board Documents $$$ Documents+draft signed $$$ Documents +Time draft draft Accepted time draft $$$ $$$ $$$ B/A The arrows in blue show the transactions when the draft has matured. Working capital financing caters to the need of financing by the importer and exporter. An exporter may need financing from the manufacturing of goods to their sale and payment, whereas the importer may require financing for the time from when the goods are bought to when they are sold in the market. This sort of financing is provided by the bank for the short term helping the importer or exporter meet their working capital needs. Countertrade usually occurs between MNC’s and countries. It is a form o trade financing where a company agrees to either barter goods in exchange of other goods from the same company such as apples for oranges or agrees to compensate the other company by purchasing a certain percentage of another product. This is mentioned in one contract only. However, in the case of counter purchase there are two contracts when the companies buy from each other. International Trade Financing Parties In the private sector, the financing sources available to the exporters and importers include commercial banks and factoring houses. Export trading and management companies provide exporters with research, marketing, insurance, legal, transportation, warehousing and other services. Private trade finance companies provide financing and forfeiting houses are similar to factoring houses that provide the exporter with immediate payment. As the private sector is willing to assume only partial risk, there are many government export financing schemes available. In the US, there is US Small Business administration that provides research and financial assistance to small exporters. Regular business loan program involves loans that the SBA guarantees thus helping exporters get easy financing. The Export revolving line of credit provides exporters with a credit line for 36 months. The Export Import Bank is a major supporter of exporters and provides information, insurance and financial services. The EXIM Bank provides guarantees for private loans, loan programs, working capital financing and direct and intermediary loans among others. Financing Resources Private sector Public Sector Commercial Banks Export Import Bank Factoring houses Small Business administration Export trading and management companies Small Business Investment Company Private trade finance companies Commodity Credit Corporation Forfeiting houses State Export Financing Programs Conclusion The international trade financing system is a complex system that works with the intermediation of commercial banks and other financial intermediaries. The instruments involved in international trade aim to provide the exporter and importer with security and support. However, the presence of various private and government financial programs decrease the risk for importers and exporters. It is advisable that the parties involved choose instruments and finance methods that protect them not only from nonpayment but also from country risks such as exchange rate and political instability. References "Export financing." Foreign trade. 26 2 2011 . Madura, Jeff. International Financial Management, 9th Edition . n.d. Platt, Gordon. "Guide to the Finance of International Trade." HSBC Trade Services. 26 2 2011 . Read More