Methods of Export Finance

Methods of Export FinanceExport FinanceExport financing enables businesses to sell their foreign invoices all over the world. Export financing releases working capital that has been tied up in foreign invoices allowing business to grow overseas. Export credit can be broadly classified into pre-shipment finance and post shipment finance. Pre-shipment finance refers to finance extended to purchase, processing or packing of goods meant for exports.Financial assistance extended after the shipment of exports falls within the scope of post shipment finance.

EXPORT FINANCE3Concession for exporters Some of the concessions include:Cheap credit to exporters. Minimum of 12% of net credit should go to exports.Refinance to Banks on eligible portion of export credit outstanding.ECGC guarantee for export creditsNo margin requirements for advance against export receivables.

The Trade RelationshipCopyright 2004 Pearson Addison-Wesley. All rights reserved.23-5The 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 unknownUnaffiliated knownAffiliated (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.23-6Exhibit 23.1 Alternative International Trade RelationshipsUnaffiliatedKnown PartyA long-term customerwith which there is an established relationship oftrust and performance UnaffiliatedUnknown PartyA new customer which with exporter hasno historical business relationshipAffiliatedPartyA foreign subsidiaryor affiliateof exporterRequires:1. A contract2. Protection against non-paymentRequires:1. No contract2. No protection against non-paymentRequires:1. A contract2. Possibly some protection against non-paymentExporterImporter is .Sources of Exporter Financing Financing exporter credit to the importer:

Letter of CreditBankers acceptance (of the draft)FactoringForfaitingEXIM loans Letter of Credit (L/C)Copyright 2004 Pearson Addison-Wesley. All rights reserved.23-8A letter of credit (L/C) is a banks 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.23-9Exhibit 23.5 Parties to a Letter of Credit (L/C)Issuing BankBeneficiary(exporter)Applicant(importer)The relationship between the importer and theexporter is governed by the sales contract.The relationship between theimporter and the issuing bank isgoverned by the terms of theapplication and agreementfor the letter of credit (L/C).The relationship between theissuing bank and the exporteris governed by the terms of theletter of credit, as issued bythat bank.Letter of Credit (L/C)Copyright 2004 Pearson Addison-Wesley. All rights reserved.23-10The essence of the L/C is the promise of the issuing bank to pay against specified documents, which must accompany any draft drawn against the credit.To constitute a true L/C transaction, all of the following five elements must be present with respect to the issuing bank:Must receive a fee or other valid business consideration for issuing the L/CThe L/C must contain a specified expiration date or definite maturityThe banks commitment must have a stated maximum amount of moneyThe banks obligation to pay must arise only on the presentation of specific documentsThe banks customer must have an unqualified obligation to reimburse the bank on the same condition as the bank has paidLetter of Credit (L/C)Copyright 2004 Pearson Addison-Wesley. All rights reserved.23-11Commercial letters of credit are also classified:Irrevocable versus revocableConfirmed versus unconfirmedThe primary advantage of an L/C is that it reduces risk the exporter can sell against a banks 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.DraftCopyright 2004 Pearson Addison-Wesley. All rights reserved.23-12A 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.DraftCopyright 2004 Pearson Addison-Wesley. All rights reserved.23-13If 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 drawerIt must contain an unconditional promise or order to pay a definite sum of moneyIt must be payable on demand or at a fixed or determinable future dateIt must be payable to order or to bearerThere are time drafts and sight drafts.Copyright 2004 Pearson Addison-Wesley. All rights reserved.23-14 Essence of a Time DraftName of ExporterDate: October 10, 2003Draft number 7890Ninety (90) days after sight of this First of Exchange, pay to the order of Bankof the West [name of exporters bank] the sum of Five-hundred thousand U.S.dollars for value received under Bank of the East, Ltd. letter of credit number 123456.Signature of ExporterBill of Exchange The most common versions of a bill of exchange are:A) Sight Draft When the drawer (exporter) expects the drawee (importer) to make payment immediately upon the draft being presented to him.

Unless and until the Draft is received, the Negotiating/ Collecting Bank does not hand over the Shipping documents and the buyer cannot take delivery of goods. Bill of Exchange B) Usance Draft When draft is drawn for payment at a date later than the date of presentation. It may be a fixed future (specific) date or determinable date according to the period of credit viz. 30 days, 60 days or 90 days etc. It is presented to the drawee (importer) who will retire the documents by accepting the draft by putting his signature and date.

Advance PaymentSeller may insist for advance payment :When he is not confident on the buyers financial position When the buyers Country is not stable.

Under this method seller is able to secure his commercial risk on the buyer by receiving the advance payment for his supply.

While agreeing for advance payment buyer is exposed to a risk on the seller and his capacity to supply the materials.

In a competitive buyers market seller may not be able to receive advance payment.

If it is the sellers market and if the seller has monopoly in certain items, seller can insist for advance payment. Open account It is an arrangement between the buyer and the seller that seller delivers the goods to the buyer directly or to his order and the buyer agrees to pay on an agreed date.

Under this method, the goods are with the buyer on trust and the buyer is expected to pay the seller on the due date.

Seller is exposed to a high degree of risk since the goods are under the control of the buyer.

This type of trading requires a high degree of trust between buyer and seller and this method is more advantageous to the buyer.

This method is also known as consignment sale or on account sales.Documents against payment It is an arrangement by which the seller after shipping the goods submits the documents to his bank with a request for collecting the payment from the buyer. Sellers bank forwards the document to the buyers bank with a request to collect the payment from the buyer against the documents. Documents are presented to the buyer and if the buyer makes payment, buyers bank collects the payment and remits to the sellers bank, which in turn will transfer the payment to the seller. Under this method sellers bank does not undertake any responsibility for payment. It acts as agent for collection. If the payment is not received the documents are returned to the seller. Payment risk is with the seller. If the payment is not forthcoming, seller has to recall the documents or direct it to a new buyer. Documents against acceptance Under this arrangement all the commercial documents are forwarded by the sellers bank to the buyers bank. Sellers bank specifically instructs the buyers bank to deliver all the commercial documents to the buyer only on acceptance of the payment liability by the buyer on the bill of exchange. Bill of exchange is drawn on the buyer demanding payment on the due date. Buyer accepts his payment liability by signing on the bill of exchange and collects all the original documents. With the original shipping document he is able to take delivery of the consignment. Buyer goes to the bank on the due date and pays the dues with or without interest as per the arrangement.Bill of Lading (B/L)Copyright 2004 Pearson Addison-Wesley. All rights reserved.23-21Another 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.Documentation in a Typical Trade TransactionCopyright 2004 Pearson Addison-Wesley. All rights reserved.23-22A 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 importers bank.The following exhibit illustrates such a transaction.23-23Exhibit 23.8 Steps in a Typical Trade TransactionExporterBank XBank IImporterPublicInvestor1. Importer orders goods2. Exporter agrees to fill order6. Exporter ships goods to Importer4. Bank I sends L/C to Bank X9. Bank I accepts draft, promising to pay in 60 days, and returns accepted draft to Bank X7. Exporter presents draft and documents to its bank, Bank X12. Bank I obtains importers note and releases shipment3. Importer arranges L/C with its bank13. Importer pays its bank8. Bank X presents draft and documents to Bank I5. Bank X advises exporter of L/C10. Bank X sells acceptance to investor14. Investor presents acceptance and is paid by Bank I11. Bank X pays exporterGovernment Programs to Help Finance ExportsCopyright 2004 Pearson Addison-Wesley. All rights reserved.23-24Governments 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.Trade Financing AlternativesCopyright 2004 Pearson Addison-Wesley. All rights reserved.23-25In 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.ForfaitingCopyright 2004 Pearson Addison-Wesley. All rights reserved.23-26Forfaiting 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.Forfaiting is a practice that allows exporters to sell their receivables to a third party known as a forfaiter. The exporter receives immediate funds to cover transactions, which limits risk and cleans up its account books. The importer can enter a credit agreement with the forfaiter to get goods on credit and repay it over terms varying from 180 days to five years or more. This allows goods and services to move freely through the international supply chain.23-28Exhibit 23.10 Typical Forfaiting TransactionExporter(private industrial firm)

Importer(private firm or governmentpurchaser in emerging market)FORFAITER

Importers Bank(usually a private bank inthe importers country Investor(institutional or individual)

Step 1Step 3Step 2Step 7Step 5Step 4Step 6CountertradeCopyright 2004 Pearson Addison-Wesley. All rights reserved.23-29The word countertrade refers to a variety of international trade arrangements in which goods and services are exported by a manufacturer with compensation linked to that manufacturer accepting imports of other goods and services.In other words, an export sale is tied by contract to an import.The countertrade may take place at the same time as the original export, in which case credit is not an issue; or the countertrade may take place later, in which case financing becomes important.CountertradeStructures an international sale when means of payment are difficult, costly, or non-existentNo currency convertibilityWeak reserves prohibit access to hard currencyBarter-like agreementsTrade goods and services for other goods and servicesCountertradeMain attraction: way to finance an export deal meet requirement of local government to support exportsMain drawback: risk of disposal / sale of goods at less than full value disposal of imports may require resources other than those that the firm possessesTypes of CountertradeBarterCounterpurchaseOffsetSwitch TradingCompensation or BuybackBarterIt is the exchange of goods and services for goods and services without any use of money. Like the trade relationship between China and Thailand where fruit has been traded by Thailand for buses made by China.International Reciprocal Trade Association (IRTA) the industry trade organization - almost a half a million small businesses use commercial barter exchanges every year. Counter PurchaseIn this, a foreign company, or country, trades with a nation with the promise that in the future they will make purchase of a specific product from the nation. Seller agrees to buy products/services unrelated to its businessSeller then sells products to third partiesA recent example of this is the ongoing trade between Congo and China where infrastructure is being traded for a supply of metals.

Offset PurchaseUsually large projects, often involving expenditure of buying governments moneyA % of the selling price is required to be purchased or sourced from the buying countryCompensationBarter with a combination of goods and convertible currencyLess risk than in straight barter

BuybackIn this type of counter trade, a company builds a plant, supplies technology, training, etc. In exchange they take a part of output of the plant. For example, a company based in the USA sets up a lets say an automobile factory in X country. They take a part of the total produce as their own but they have setup the industry, provided the technology and the training to X country.Switch TradingIn this method one company trades products and services or, in some cases, builds infrastructure like roads, railway lines, hospitals with another nation and, in turn, are obligated to make a purchase from that nation. One such example is a deal proposed by the Philippine Government where they offer to trade Philippine coffee for essential products.Export FactoringFactoring is a continuous arrangement between a factoring concern and the seller of goods and services (on credit) whereby the factor i.e. a commercial bank or a specialized financial firm purchases the accounts receivable for immediate cash and also provides other services such as sales ledger maintenance, collection and credit protection.The factor also assumes the risk on the ability of the foreign buyer to pay, and handles collections on the receivables. Thus, by virtually eliminating the risk of non-payment by foreign buyers, factoring allows the exporter to offer open account terms, improves liquidity position, and boosts competitiveness in the global marketplace.

Contd..Factoring is suited for continuous short-term export sales of consumer goods on open account terms.It offers 100 percent protection against the foreign buyers inability to pay no deductible or risk sharing. It is an option for small and medium-sized exporters, particularly during periods of rapid growth, because cash flow is preserved and the risk of non-payment is virtually eliminated.

Export CreditExport credit: Loan facilityextended to an exporter by abankin theexporter'scountry.

Working capital finance Export Credit Performance Indicator for Banks :Banks are required to reach a level of outstanding export credit equivalent of 12% of each bank's Adjusted Net Bank Credit.Project SME Gyanshala Capsule Training Programme for Officials handling SME Credit 9.1EXPORT FINANCEPre-Shipment Finance, also referred to as EPC(EXPORT PACKING CREDIT), is extended as WC for purchase of RM, processing, packing, transportation, warehousing, etc., of goods meant for exports.

Post-Shipment Finance is extended after shipment to bridge the time lag between the shipment of goods and the realisation of proceeds.41Project SME Gyanshala Capsule Training Programme for Officials handling SME Credit 9.1PRE-SHIPMENT CREDITExport Finance is by and large governed by RBI directives / guidelines.

Pre-Shipment Credit can be classified as:Packing Credit Advances (PCA) in RupeesAdvance against Duty Drawback entitlementsPre-Shipment Credit in Foreign Currency (PCFC)42Project SME Gyanshala Capsule Training Programme for Officials handling SME Credit 9.1PACKING CREDIT This advance is granted to the exporter (and in some cases even to the sub-suppliers who are not exporters) for procuring the goods from the market may be of a clean nature at initial stage, It should be converted into secured advance as soon as the goods are procured by the exporter and are undergoing further processing/manufacturing, by hypothecating the goods in the name of the Bank. The security offered may further be perfected by pledging the goods to the Bank when the physical / constructive custody of the goods remains with the Bank or Banks approved clearing agent. However, this stage will arise when the goods are ready for shipment and do not require further processing.

Project SME Gyanshala Capsule Training Programme for Officials handling SME Credit 9.1PACKING CREDIT ADVANCEPacking credit advance - available to the eligible exporter against lodgement of irrevocable LC established/transferred in his favour by the foreign buyer through the medium of a First Class bank or confirmed order/contract placed by the buyer for export of goods from India. However, branches may grant advances without insisting on lodgement of LC or confirmed order/contract at initial stage, In case of exporters with good track record and if the reasons for delayed submission of LC/orders are genuine

Project SME Gyanshala Capsule Training Programme for Officials handling SME Credit 9.1POST-SHIPMENT CREDITPost-Shipment Credit means any loan or advance granted or any other credit provided by the Bank to an exporter of goods from India from the date of extending the credit after shipment of the goods to the date of realisation of the sale proceeds.

Standing of L/C Opening Bank is vital.

The period prescribed for realization of export proceeds is 12 months from the date of shipment

46Project SME Gyanshala Capsule Training Programme for Officials handling SME Credit 9.1POST-SHIPMENT CREDITPost-Shipment Credit can be classified as follows:

Negotiation / Payment / Acceptance of export documents under L/C.Purchase / Discount of export documents under confirmed orders / export contracts.Advances against bills sent on collection basis.Advances against exports on consignment basis.Advances against Duty Drawback Entitlements.Advances against undrawn balances / retention money.Re-discounting of Export Bills abroad (EBR).

47Project SME Gyanshala Capsule Training Programme for Officials handling SME Credit 9.1Post-shipment advance can mainly take the form of - (i) Export bills purchased/discounted/negotiated. (ii) Advances against bills for collection. (iii) Advances against duty drawback receivable from Government.

Project SME Gyanshala Capsule Training Programme for Officials handling SME Credit 9.1Export of ServicesPre-shipment and post-shipment finance may be provided to exporters of all the 161 tradable services covered under the General Agreement on Trade in Services where payment for such services is received in free foreign exchange as stated at Chapter 3 of the Foreign Trade Policy 2009-14. A list of services is given in Appendix 36 of Handbook (Vol.1) of the Foreign Trade Policy 2009-2014.. The financing bank should ensure that there is no double financing and the export credit is liquidated with remittances from abroad. Banks may take into account the track record of the exporter/overseas counter party while sanctioning the export credit. Exporters of services qualify for working capital export credit (pre and post shipment) for consumables, wages, supplies etc

Export Credit Insurance

Risks such as non-payment, country, geographical, loss in transit and war are inherent in foreign trade. Export Credit Guarantee Corporation of India Ltd (ECGC) offers policies to protect exporters from non-payment risks of buyer/country and guarantees to banks against non-payment by the borrower. Export credit insurance assesses the buyer and the country risks, enabling it to devise various insurance schemes.