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Research Paper

Benefit of Trade Finance Loan to Exporter and Importer


LONG KimKhorn, PUC, MA. IRs, ID: 61283

Date: September 11th, 2012

Content

Overview of Trade Finances and Loans Definition of Trade Finance Trade Financing Instruments The Processes of Trade Finance Loan .

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The Roles of Government in Trade Financing Benefits of Trade Finance Risks of Trade Finance Loans Risk Management Conclusion Reference

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I.

Overview of Trade Finances and Loans a. Trade Finance Trend U.S. and Asia According to Comptroller, 1998, Governments around the world are supporting cross-border trade bycoordinating the rules that govern it. In 1993, the United States and 116other nations concluded the Uruguay Round negotiations of the GeneralAgreement on Tariffs and Trade (GATT), a major multilateral trade agreement. The GATT establishes free trade principles and expands worldwide trade byreducing tariffs and other trade barriers, including export subsidies andregulations. Also in 1993, the United States, Mexico, and Canada completedthe North American Free Trade Agreement (NAFTA). By integrating 370million consumers and an approximately $6.5 trillion economy, NAFTAcreated one of the worlds largest trading markets. Several other significantregional trade blocs have developed

recently e.g., the European Union.

As international trade increases, so does the importance of trade finance? Thesuccess of a nations export program depends on the availability of tradefinance, which facilitates the transfer of commodities and manufacturedgoods between countries. Trade finance, an

important business for U.S.banks, generates more than $1 billion in revenue annually. Banks canparticipate in trade financing by providing pre-export financing, helping inthe collection process, confirming or issuing letters of credit, discountingdrafts and acceptances, and offering fee-based services such as providingcredit and country information on buyers. Although most trade financing isshort-term, medium-term loans (one to five years) and long-term loans (morethan five years) finance the import and export of capital goods such asmachinery and equipment.

In Time Bandits, November 2001 by Moiseiwitsch, J., CFO Asia, Trade Finance the recent economic slowdown is making the need for sound trade finance policies and strong financialsystems more acute. Many companies are trying to preserve cash by delaying payment and the number ofSMEs in emerging Asian economies with high credit risk is growing.This is partly the result of a regional trend toward unsecured, open-account type transactions. LargeWestern buyers are asking that their Asian suppliers sell goods on openaccounts terms, instead of usingguarantees like letters of credit (LCs). These buyers simply do not want to bear the extra cost of paymentguarantees and will source their goods from somewhere else if they are not given open-accounts. Theseopen-accounts allow the buyers to delay payments as needed, rising the need for credit for Asian companieswho choose to supply them.

The economic slowdown also has made many companies rethink their commitment to electronic tradingand payment systems. While these systems may cut significant costs out of the labor-intensive trade financeprocess, they also make payment delays more difficult to justify.Large Western buyers are not the only ones delaying payments. In fact, many companies prefer dealingwith these buyers than with the thinly capitalized buyers commonly found in many emerging Asianeconomies, mainly because these large buyers remain relatively punctual and have very low credit risk(i.e., even if they delay payment a little, they will pay).With the internationalization of supply chains, a Hong-Kong, China based transformer manufacturer maysell its products to Chinese buyers sub-contracted by Dell or IBM to manufacture PCs. The Chinesesub-contractor may ask to buy from the manufacturer on open-account terms on the basis that paymentfrom Dell or IBM is a sure thing. This kind of arrangement increases the financial risk exposure of the transformer manufacturer, and typically results in payment delays measured in weeks and sometime months.Because LCs or factoring in China and many other countries in Asia are not yet commonly used or available,Asian suppliers can often do very little to protect themselves in regional cross-border transaction, increasingthe cost of regional trade transactions relative to that of direct transactions with Western companies.

II.

Definition of Trade Finance According to Trade Finance Magazine Trade, finance has been reviewing the global trade market since 1983. The remit of what we cover is somewhat broad, and as the market evolves to meet the requirements of financing global trade, so our content has changed. The following is a guide for those of you new to the market, those looking for clarification, and those of you who have bluffed your way through up to this point. There are various definitions to be found online as to what trade finance is, and the choice of words used is interesting. It is described both as a science and as an imprecise term covering a number of different activities. As is the nature of these things, both are accurate. In one form it is quite a precise science managing the capital required for international trade to flow. Yet within this science there are a wide range of tools at the financiers disposal, all of which determine how cash, credit, investments and other assets can be utilized for trade.

In its simplest form, an exporter requires an importer to prepay for goods shipped. The importer naturally wants to reduce risk by asking the exporter to document that the goods have been shipped. The importers bank assists by providing a letter of credit to the exporter (or the

exporter's bank) providing for payment upon presentation of certain documents, such as a bill of lading. The exporter's bank may make a loan to the exporter on the basis of the export contract. III. Trade Financing Instruments a. Documentary Credit, According to TRADE FACILITATION HANDBOOK FOR THE GREATER MEKONG SUBREGIONT, 2001, this is the most common form of the commercialletter of credit. The issuing bank will make payment,either immediately or at a prescribed date, upon thepresentation of stipulated documents. Thesedocuments will include shipping and

insurancedocuments, and commercial invoices. Thedocumentary credit arrangement used method of attaining acommercially acceptable undertaking by providing forpayment to be made against presentation ofdocumentation representing the goods, makingpossible the transfer of title to those goods. A letterof credit is a precise document whereby the

importersbank extends credit to the importer and assumesresponsibility in paying the exporter.

b. Countertrade, As mentioned above, most emerging economies facethe problem of limited foreign exchange holdings.One way to overcome this constraint is to promoteand encourage countertrade. Todays modern countertrade appears in so many forms that it is difficult todevise a definition. It generally encompasses the ideaof subjecting the agreement to purchase goods orservices to an undertaking by the supplier to take ona compensating obligation. The seller is required toaccept goods or other instruments of trade in partialor whole payment for its products. Barter This traditional type ofcountertrade involving the exchange ofgoods and services against other goods andservices of equivalent value, with nomonetary exchange between exporter andimporter. Counter-purchase The exporter undertakesto buy goods from the importer or from acompany nominated by the importer, oragrees to arrange for the purchase by a thirdparty. The value of the counter-purchasedgoods is an agreed percentage of the pricesof the goods originally exported. Buy-back The exporter of heavyequipment agrees to accept

productsmanufactured by the importer of theequipment as payment.

c. factoring,

This involves the sale at a discount of accountsreceivable or other debt assets on a daily, weekly ormonthly basis in exchange for immediate cash. Thedebt assets are sold by the exporter at a discount to afactoring house, which will assume all commercial andpolitical risks of the account receivable. In theabsence of private sector players, governments

canfacilitate the establishment of a state-owned factor;or a joint venture set-up with several banks andtrading enterprises.

d. Post-Shipping Financing, This is financing for the period prior to the shipmentof goods, to support pre-export activities like wagesand overhead costs. It is especially needed wheninputs for production must be imported. It alsoprovides additional working capital for the exporter.Pre-shipment financing is especially important tosmaller enterprises because the international sales cycleis usually longer than the domestic sales cycle.Pre-shipment financing can take in the form of short-term loans, overdrafts and cash credits.

e. Post-Shipping Financing Financing for the period following shipment, theability to be competitive often depends on the traderscredit term offered to buyers. Post-shipmentfinancing ensures adequate liquidity until thepurchaser receives the products and the exporterreceives payment. financing is usuallyshort-term. Post-shipment

f. Buyers Credit, A financial arrangement whereby a financialinstitution in the exporting country extends a loandirectly or indirectly to a foreign buyer to finance thepurchase of goods and services from the exportingcountry. This arrangement enables the buyer to makepayments due to the supplier under the contract.

g. Suppliers Credit, A financing arrangement under which an exporterextends credit to the buyer in the importing countryto finance the buyers purchases.

IV.

The Processes of Trade Finance Loan Figure 1: Stage of Trade Financing

According to Comptroller, 1998, p 7-8, Trade finance transactions can be structured in a number of ways. Thestructure used in a specific transaction reflects how well the participantsknow each other, the countries involved, and the competition in the market. Sales can involve prepayments, shipments by open account, collections, andletters of credit. All of these structures are likely to be encountered in tradetransactions with most countries. However, open account sales prevail inEurope, whereas letter of credit transactions are the norm in sales to emergingmarket countries.

The seller may require prepayment in the following circumstances: (1) thebuyer has not been long established, (2) the buyer has a poor credit history,or (3) the product is in heavy demand and the seller does not have toaccommodate a buyers financing request in order to sell the merchandise. Prepayment eliminates all risks to the seller.Open account (unsecured) shipments are made when the buyer has a strongcredit history and is well-known to the seller. The buyer may also be able todemand open account sales when there are several sources from which toobtain the sellers product or when open account is the norm in the buyersmarket. This option places all risks on the seller.Letters of credit allow the issuing banks to substitute their creditworthiness forthat of their customers. At a customers request, the issuing bank pays statedsums of money to sellers of goods against stipulated documents transferringownership of the goods.Collections are of two types: clean (financial document alone) anddocumentary (commercial documents with or without a financial document). A financial document is a check or a draft; a commercial document is a bill oflading or other shipping document.A clean

collection involves dollar-denominated drafts and checks presentedfor collection to U.S. banks by their foreign correspondents.

In adocumentary collection, the exporter draws a draft or bill of exchangedirectly on the importer and presents this draft, with shipping documentsattached, to the bank for collection.The banks role in a prepaid or open account transaction may be to transferfunds at the order of the buyer to the seller or to provide credit informationon either party. In collection and letter of credit transactions, the bank takesa very active role in the exchange of documents between buyer and seller.The documents are the means by which the banker participates in the tradetransaction, either as agent for the seller or financier for the buyer. The bankmay also extend credit to the seller in anticipation of the incoming payment.

V.

The Roles of Government in Trade Financing The role of government in trade financing is crucialin emerging economies. In the presence ofunderdeveloped financial and money markets, tradershave restricted access to financing.

Governments caneither play a direct role like direct provision of tradefinance or credit guarantees; or indirectly by facilitating the formation of trade financingenterprises. Governments could also extend assistancein seeking cheaper credit by offering or supportingthe following: Central Bank refinancing schemes; Specialized financing institutes likeExport-Import Banks or Factoring Houses; Export credit insurance agencies; Assistance from the Trade PromotionOrganization; and Collaboration with Enterprise DevelopmentCorporations (EDC) or State TradingEnterprises (STE).

a. Central Bank Refinancing Schemes Under this type of schemes, the Central Bank willrediscount the commercial bills of exporters atpreferential rates. This will provide the cheappost-shipment financing necessary for exporters toquickly turn around funds for further export business.Here, the government is subsidizing the cost of fundsthat exporters have to pay if they rediscount their billswith commercial banks.

b. Export-Import Bank (EXIM Bank)

The Export-Import Bank (EXIM Bank) specificallycaters to the needs of exporters and importers andthose of investors in foreign markets. It offers variousservices, including long-term direct loans to foreignbuyers for loans and equipment sales of sufficientsizes.

c. Export Credit Insurance Agencies Export credit insurance agencies act as bridgesbetween banks and exporters. In emerging

economieswhere the financial sector is yet to be developed,governments often take over the role of the exportcredit insurance agent. Governments traditionallyassume this role because they are

deemed to be theonly institutions in a position to bear political risks.

d. Support from Trade Promotion Organizations (TPOs) As explained earlier, banks are often reluctant to lendto exporters because of their lack of knowledge aboutthe creditworthiness of the traders, and as a result mayraise interest to compensate for the risks taken. TPOsare in a position to know the strengths and weaknessesof the individual trading houses and exporters, andcould share information with financial institutions tofacilitate access to financial services.

e. Export Development Corporation and StateOwned Enterprises In most emerging economies, there are a few keyconglomerates with a diverse range of products,substantial export capacity and sustainable financialresources. They could be private sector exportdevelopment corporations (EDCs) or state-ownedenterprises (SOEs).

VI.

Benefits of Trade Finance According to U.S. Department of Commerce, 2008, p. 1, Benefits of Exporting: The United States is the worlds largest exporter, with $1.5 trillion in goods and services exported annually. In 2006, the United States was the top exporter of services and second largest exporter of goods, behind only Germany. However, 95 percent of the worlds consumers live outside of the United States. So if you are selling only domestically, you are reaching just a small share of potential customers. Exporting enables SMEs to diversify their portfolios and insulates them against periods of slower growth in the domestic economy. Free trade agreements have opened in numerous markets including Australia, Canada, Chile, Israel, Jordan, Mexico, and Singapore, as well as Central America. Free trade agreements create more opportunities for U.S. businesses. The Trade Finance Guide is designed to provide U.S. SMEs with the knowledge necessary to grow and become competitive in foreign markets.

VII.

Risks of Trade Finance Loans For purposes of the OCCs discussion of risk, the OCC can be said to assessbanking risk relative to its impact on capital and earnings. From asupervisory perspective, risk is the potential that events, expected orunanticipated, may have an adverse impact on the banks capital or earnings. The OCC has defined nine categories of risk for bank supervision purposes. These risks are: credit, interest rate, liquidity, price, foreign currencytranslation, transaction, compliance, strategic, and reputation. Thesecategories are not mutually exclusive; any product or service may expose thebank to multiple risks. For analysis and discussion purposes,

however, theOCC identifies and assesses the risks separately.

a. Credit Risk Credit risk is the current and prospective risk to earnings or capital arisingfrom an obligors failure to meet the terms of any contract with the bank orotherwise to perform as agreed. Credit risk is found in all activities in wheresuccess depends on counterparty, issuer, or borrower performance. It arisesany time bank funds are extended, committed, invested, or otherwiseexposed through actual or implied contractual agreements, whether reflectedon or off the balance sheet.

In trade finance, many transactions are self-liquidating or supported by lettersof credit and guarantees, and the examiner must review each transactionindividually to properly identify and evaluate the sources of repayment. The low default risk is due, in part, to the

importance that countries assign tomaintaining access to trade credits. In a currency crisis, central banks mayrequire all foreign currency inflows to be turned over to the central bank. The central bank would then prioritize foreign currency payments. Tradeliabilities would be more likely to be designated for repayment than mostother types of credits. For this reason, trade finance is viewed as having lesstransfer risk than other types of debt.

b. Foreign Currency Translation Risk Foreign currency translation risk is the current and prospective risk toearnings or capital arising from the conversion of a banks financialstatements from one currency into another. It refers to the variability inaccounting values for a banks equity accounts that result from variations inexchange rates which are used in translating carrying values and incomestreams in foreign currencies to U.S. dollars. Market-making and position-taking in foreign

currencies should be captured under price risk. In a trade transaction, foreign currency translation risk arises from theexposure to fluctuations in exchange rates whenever

payments involveforeign currencies. The level of risk depends on the currency involved in thetransaction, whether the bank creates an open position, the size of anymaturity gap, and settlement uncertainties.

c. Transaction Risk Transaction risk is the current and prospective risk to earnings or capitalarising from fraud, error, and the inability to deliver products or services,maintain a competitive position, and manage information. Risk is inherent inefforts to gain strategic advantage, and in the failure to keep pace withchanges in the financial services marketplace. Transaction risk is evident ineach product and service offered.

Transaction risk encompasses: productdevelopment and delivery, transaction processing, systems development,computing systems, complexity of products and services, and the internalcontrol environment.Transaction risk is also referred to as operating or operational risk. This risk isparticularly high in trade transactions because of the high level

ofdocumentation required in letter of credit operations. Many transactionsevolve readily from letters of credit to sight drafts or acceptances or to notesand advances, collateralized by trust or warehouse receipts. Repaymentoften depends on the eventual sale of goods and the accuracy ofdocumentation. Thus, the documents required to secure payment under theletter of credit should be properly handled.

d. Compliance Risk Compliance risk is the current and prospective risk to earnings or capitalarising from violations of, or nonconformance with, laws, rules, regulations,prescribed practices, internal policies and procedures, or ethical standards. Compliance risk also arises in situations where the laws or rules governingcertain bank products or activities of the banks clients may be ambiguous oruntested. Compliance risk exposes the institution to fines, civil

moneypenalties, payment of damages, and the voiding of contracts. Compliancerisk can lead to a diminished reputation, reduced franchise value, limitedbusiness opportunities, reduced expansion potential, and an inability toenforce contracts.

e. Strategic Risk Strategic risk is the current and prospective risk on earnings or capital arisingfrom adverse business decisions, improper implementation of decisions, orlack of responsiveness to industry changes. This risk is a function of thecompatibility of an organizations strategic

goals, the business strategiesdeveloped to achieve those goals, the resources deployed against these goals,and the quality of implementation. outbusiness strategies are both tangible and intangible. The resources needed to carry They includecommunication

channels, operating systems, delivery networks, andmanagerial capacities and capabilities. The organizations internalcharacteristics must be evaluated against the impact of economic,technological, competitive, regulatory, and other environmental changes.

f. Reputation Risk Reputation risk is the current and prospective impact on earnings and capitalarising from negative public opinion. This affects the institutions ability toestablish new relationships or services or to continue servicing existingrelationships. This risk may expose the institution to litigation, financial loss,or a decline in its customer base. Reputation risk exposure is presentthroughout the organization and includes the responsibility to exercise anabundance of caution in dealing with its customers and community.

VIII.

Risk Management

In reviewing risk, examiners should determine that a bank has adequatesafeguards in place to identify, measure, monitor, and control risks inherentin the trade finance area. Such safeguards include policies, procedures,internal controls, and management information systems governing tradefinance activities. The importance of strong internal controls in this areacannot be

overemphasized. There is a growing incidence of counterfeitletters of credit, totaling millions of dollars. Often, these counterfeitinstruments are not identified in a timely manner. significant amount offunds can be released before the schemes are detected. A

Bankers

shouldclosely monitor every detail of a letter of credit transaction.Examiners should also assess the capabilities of the trade finance staff and theadequacy of their training.

A banks trade finance policy should identify thetarget market, prospective customers, and desirable countries, and it shouldset country limits and minimum standards for documentation. The bankstrade credit administration system should be documented in a complete andconcise manner and should include, when appropriate, narrativedescriptions, flowcharts, copies of forms, and other pertinent information. Adequate documentation is the principal means available to reduce oreliminate risks inherent in international trade. Therefore, operating

policiesand procedures should address the documentation requirements for eachtransaction, and internal controls should be established to ensure adequatereviews. A well-organized and

efficient backroom operation is essentialbecause of the amount of documentation

involved.There is always the risk that a shipment will be damaged or destroyed, thewrong goods will be shipped, or the quality of goods (especially if the goodsare agricultural) will be lower than stipulated. Insurance coverage is crucial toprotect the buyer, the seller, and the issuing bank from loss. Banks shouldnot issue commercial letters of credit without satisfactory insurance coverage.

IX.

Conclusions This Chapter has explained the need for trade finance and introduced some of the most common tradefinance tools and practices. A proactive role ofgovernments in trade finance may alleviate the lackof trade finance in emerging GMS economies andcontribute to trade expansion and facilitation.However, the best long-term solution in resolving theconstraints in trade financing is to encourage thegrowth and development of a vibrant and competitivefinancial system, comprising mainly private sectorplayers. This point is important as some of thegovernmentsupported trade financing schemes mayincreasingly be challenged by competing countries asunfair export subsidies under existing and futureWTO rules.

The role of the government and other parties involvedin trade finance will need to evolve along with thecountrys economy. Underlying the functionsprovided by the different players is the need for a clearand effective legal environment. The commerciallegal system must be

transparent. Laws of property,contract and arbitration must be clear. Thecommercial legal environment must be integratedwith the financial infrastructure framework in orderfor it to be effective.

References: N/A

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