1. Copyright © 2010 Pearson Prentice Hall. All rights reserved. Chapter 22 International Trade Finance

2. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-2 The Trade Relationship Trade financing shares a number of common characteristics with the traditional value chain activities conducted by all firms. All companies must search out suppliers for the many goods and services required as inputs to their own goods production or service provision processes. Issues to consider in this process include the capability of suppliers to produce the product to adequate specifications, deliver said products in a timely fashion, and to work in conjunction on product enhancements and continuous process improvement. All of the above must also be at an acceptable price and payment terms.

3. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-3 The Trade Relationship The nature of the relationship between the exporter and the importer is critical to understanding the methods for import- export financing utilized in industry. There are three categories of relationships (see next exhibit): –Unaffiliated unknown –Unaffiliated known –Affiliated (sometimes referred to as intra-firm trade) The composition of global trade has changed dramatically over the past few decades, moving from transactions between unaffiliated parties to affiliated transactions.

4. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-4 Exhibit 22.1 Financing Trade: The Flow of Goods and Funds

5. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-5 Exhibit 22.2 Alternative International Trade Relationships

6. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-6 The Trade Dilemma International trade (i.e. between and importer and exporter) must work around a fundamental dilemma: –They live far apart –They speak different languages –They operate in different political environments –They have different religions –They have different standards for honoring obligations In essence, there could be distrust, and clearly the importer and exporter would prefer two different arrangements for payment/goods transfer (next exhibit)

7. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-7 Exhibit 22.3 The Mechanics of Import and Export

8. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-8 The Trade Dilemma The fundamental dilemma of being unwilling to trust a stranger in a foreign land is solved by using a highly respected bank as an intermediary. The following exhibit is a simplified view involving a letter of credit (a bank’s promise to pay) on behalf of the importer. Two other significant documents are an order bill of lading and a sight draft.

9. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-9 Exhibit 22.4 The Bank as the Import-Export Intermediary

10. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-10 Benefits of the System The system (including the three documents discussed) has been developed and modified over centuries to protect both importer and exporter from: –The risk of noncompletion –Foreign exchange risk –To provide a means of financing

11. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-11 International Trade Risks The following exhibit illustrates the sequence of events in a single export transaction. From a financial management perspective, the two primary risks associated with an international trade transaction are currency risk (currency denomination of payment) and risk of non- completion (timely and complete payment). The risk of default on the part of the importer is present as soon as the financing period begins.

12. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-12 Exhibit 22.5 The Trade Transaction Timeline and Structure

13. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-13 Key Documents: Letter of Credit (L/C) A letter of credit (L/C) is a bank’s conditional promise to pay issued by a bank at the request of an importer, in which the bank promises to pay an exporter upon presentation of documents specified in the L/C. An L/C reduces the risk of noncompletion because the bank agrees to pay against documents rather than actual merchandise. The following exhibit shows the relationship between the three parties.

14. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-14 Exhibit 22.6 Parties to a Letter of Credit (L/C)

15. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-15 Key Documents: Letter of Credit (L/C) A letter of credit (L/C) is a bank’s promise to pay issued by a bank at the request of an importer (the applicant/buyer), in which the bank promises to pay an exporter (the beneficiary of the letter) upon presentation of the documents specified in the L/C. An L/C reduces the risk of noncompletion because the bank agrees to pay against documents rather than actual merchandise. The essence of an L/C is the promise of the issuing bank to pay against specified documents, which must accompany any draft drawn against the credit. The L/C is not a guarantee of the underlying commercial transaction, but rather a separate transaction from any sales or other contracts on which it might be based.

16. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-16 Key Documents: Letter of Credit (L/C) Commercial letters of credit are also classified: –Irrevocable versus revocable –Confirmed versus unconfirmed The primary advantage of an L/C is that it reduces risk – the exporter can sell against a bank’s promise to pay rather than against the promise of a commercial firm. The major advantage of an L/C to an importer is that the importer need not pay out funds until the documents have arrived at the bank that issued the L/C and after all conditions stated in the credit have been fulfilled.

17. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-17 Exhibit 22.7 Essence of a Letter of Credit (L/C)

18. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-18 Key Documents: Draft A draft, sometimes called a bill of exchange (B/E), is the instrument normally used in international commerce to effect payment. A draft is simply an order written by an exporter (seller) instructing and importer (buyer) or its agent to pay a specified amount of money at a specified time. The person or business initiating the draft is known as the maker, drawer, or originator. Normally this is the exporter who sells and ships the merchandise. The party to whom the draft is addressed is the drawee.

19. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-19 Key Documents: Draft If properly drawn, drafts can become negotiable instruments. As such, they provide a convenient instrument for financing the international movement of merchandise (freely bought and sold). To become a negotiable instrument, a draft must conform to the following four requirements: –It must be in writing and signed by the maker or drawer –It must contain an unconditional promise or order to pay a definite sum of money –It must be payable on demand or at a fixed or determinable future date –It must be payable to order or to bearer There are time drafts and sight drafts.

20. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-20 Key Documents: Bill of Lading (B/L) The third key document for financing international trade is the bill of lading or B/L. The bill of lading is issued to the exporter by a common carrier transporting the merchandise. It serves three purposes: a receipt, a contract, and a document of title. Bills of lading are either straight or to order.

21. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-21 Documentation in a Typical Trade Transaction A trade transaction could conceivably be handled in many ways. The transaction that would best illustrate the interactions of the various documents would be an export financed under a documentary commercial letter of credit, requiring an order bill of lading, with the exporter collecting via a time draft accepted by the importer’s bank. The following exhibit illustrates such a transaction.

22. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-22 Exhibit 22.8 Steps in a Typical Trade Transaction

23. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-23 Government Programs to Help Finance Exports Governments of most export-oriented industrialized countries have special financial institutions that provide some form of subsidized credit to their own national exporters. These export finance institutions offer terms that are better than those generally available from the competitive private sector. Thus domestic taxpayers are subsidizing lower financial costs for foreign buyers in order to create employment and maintain a technological edge. The most important institutions usually offer export credit insurance and a government-supported bank for export financing.

24. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-24 Government Programs to Help Finance Exports The exporter who insists on cash or L/C payment for foreign shipments is likely to lose orders to competitors from other countries that provide more favorable credit terms. Competition between nations to increase exports by lengthening the period for which credit transactions can be insured my lead to a credit war and to unsound credit decisions. In the United States, export credit insurance is provided by the Foreign Credit Insurance Association (FCIA), an unincorporated association of private commercial insurance companies operating in cooperation with the Export-Import Bank. The Export-Import Bank of the U.S. (Eximbank) is another important agency of the U.S. Government established to facilitate the foreign trade of the United States.

25. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-25 Trade Financing Alternatives In order to finance international trade receivables, firms use the same financing instruments as they use for domestic trade receivables, plus a few specialized instruments that are only available for financing international trade. There are short-term financing instruments and longer-term instruments in addition to the use of various types of barter to substitute for these instruments.

26. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-26 Trade Financing Alternatives Some of the shorter term financing instruments include: –Bankers Acceptances –Trade Acceptances –Factoring –Securitization –Bank Credit Lines Covered by Export Credit Insurance –Commercial Paper

27. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-27 Forfaiting Forfaiting is a longer term financing instrument. Forfaiting is a specialized technique to eliminate the risk of nonpayment by importers in instances where the importing firm and/or its government is perceived by the exporter to be too risky for open account credit. The following exhibit illustrates a typical forfaiting transaction (involving five parties – importer, exporter, forfaiter, investor and the importers bank). The essence of forfaiting is the non-recourse sale by an exporter of bank-guaranteed promissory notes, bills of exchange, or similar documents received from an importer in another country.

28. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-28 Exhibit 22.10 Typical Forfaiting Transaction

29. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-29 Mini-Case Questions: Crosswell How are pricing, currency of denomination, and financing interrelated in the value chain for Crossewll’s penetration of the Brazilian market? Can you summarize them using Exhibit B? How important is Sousa to the value chain of Crosswell? What worries might Crosswell have regarding Sousa’s ability to fulfill his obligations? If Crosswell is to penetrate the market, some way of reducing its prices will be required. What do you suggest?

30. Copyright © 2010 Pearson Prentice Hall. All rights reserved. Additional Chapter Exhibits Chapter 22

31. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-31 Exhibit 22.9 Instruments for Financing Short- Term Domestic and International Trade Receivables

32. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-32 Exhibit 1 Export Pricing for the Precious Diaper Line to Brazil

33. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-33 Exhibit 2 Export Payment Terms on Crosswell’s Export to Brazil

34. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 22-34 Exhibit 3 Competitive Diaper Prices in the Brazilian Market (in Brazilian Reais)