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CHAPTER 8

AN INTRODUCTION TO TRADE FINANCE

The absence of an adequate trade finance

infrastructure is, in effect, equivalent to a barrier to

trade. Limited access to financing, high costs, and

lack of insurance or guarantees are likely to hinder

the trade and export potential of an economy, and

particularly that of small and medium sized

enterprises.

As explained in Chapter 1, trade facilitation aims at

reducing transaction cost and time by streamlining

trade procedures and processes. One of the most

important challenges for traders involved in a

transaction is to secure financing so that the

transaction may actually take place. The faster and

easier the process of financing an international

transaction, the more trade will be facilitated.

Traders require working capital (i.e., short-term

financing) to support their trading activities.

Exporters will usually require financing to process or

manufacture products for the export market beforereceiving payment. Such financing is known as

pre-shipping finance. Conversely, importers will need

a line of credit to buy goods overseas and sell them

in the domestic market before paying for imports. In

most cases, foreign buyers expect to pay only when

goods arrive, or later still if possible, but certainly not

in advance. They prefer an open account, or at least

a delayed payment arrangement. Being able to offer

attractive payments term to buyers is often crucial in

getting a contract and requires access to financing forexporters.

Therefore, governments whose economic growth

strategy involves trade development should provide

assistance and support in terms of export financing

and development of an efficient financial

infrastructure. There are many types of financial tools

and packages designed to facilitate the financing of

trade transactions. This Chapter will only introduce

three types, namely:

• Trade Financing Instruments;

• Export Credit Insurances; and

• Export Credit Guarantees

1. Trade Financing Instruments

The main types of trade financing instruments are as

follows:

a) Documentary Credit

This is the most common form of the commercial

letter of credit. The issuing bank will make payment,

either immediately or at a prescribed date, upon the

present ation of stipulated documents. These

documents will include shipping and insurance

documents, and commercial invoices. The

documentary credit arrangement offers an

internationally used method of attaining a

commercially acceptable undertaking by providing for

payment to be made against presentation of

documentation representing the goods, making

possible the transfer of title to those goods. A letter

of credit is a precise document whereby the importer’s

bank extends credit to the importer and assumes

responsibility in paying the exporter.

A common problem faced in emerging economies is

that many banks have inadequate capital and foreign

exchange, making their ability to back the

documentary credits questionable. Exporters mayrequire guarantees from their own local banks as an

additional source of security, but this may generate

significant additional costs as the banks may be

reluctant to assume the risks. Allowing internationally

reputable banks to operate in the country and offer

documentary credit is one way to effectively solve this

problem.

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TRADE FACILITATION HANDBOOK FOR THE GREATER MEKONG SUBREGION

60 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE

b) Countertrade

As mentioned above, most emerging economies face

the problem of limited foreign exchange holdings.

One way to overcome this constraint is to promote

and encourage countertrade. Today’s modern counter

trade appears in so many forms that it is difficult todevise a definition. It generally encompasses the idea

of subjecting the agreement to purchase goods or

services to an undertaking by the supplier to take on

a compensating obligation. The seller is required to

accept goods or other instruments of trade in partial

or whole payment for its products.

Some of the forms of counter trade include:

• Barter – This traditional type of

countertrade involving the exchange of goods and services against other goods and

services of equivalent value, with no

monetary exchange between exporter and

importer.

• Counterpurchase – The exporter undertakes

to buy goods from the importer or from a

company nominated by the importer, or

agrees to arrange for the purchase by a third

party. The value of the counterpurchased

goods is an agreed percentage of the prices

of the goods originally exported.

• Buy-back – The exporter of heavy

equipment agrees to accept products

manufactured by the importer of the

equipment as payment.

c) Factoring

This involves the sale at a discount of accounts

receivable or other debt assets on a daily, weekly ormonthly basis in exchange for immediate cash. The

debt assets are sold by the exporter at a discount to a

factoring house, which will assume all commercial and

polit ical risks of the account receivable. In the

absence of private sector players, governments can

facilitate the establishment of a state-owned factor;

or a joint venture set-up with several banks and

trading enterprises.

d) Pre-Shipping Financing

This is financing for the period prior to the shipment

of goods, to support pre-export activities like wages

and overhead costs. It is especially needed when

inputs for production must be imported. It also

provides additional working capital for the exporter.

Pre-shipment financing is especially important to

smaller enterprises because the international sales cycle

is 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. The

ability to be competitive often depends on the trader’s

credit term offered to buyers. Post-shipment

financing ensures adequate liquidity until the

purchaser receives the products and the exporter

receives payment. Post-shipment financing is usuallyshort-term.

f) Buyer’s Credit

A financial arrangement whereby a financial

institution in the exporting country extends a loan

directly or indirectly to a foreign buyer to finance the

purchase of goods and services from the exporting

country. This arrangement enables the buyer to make

payments due to the supplier under the contract.

g) Supplier’s Credit

A financing arrangement under which an exporter

extends credit to the buyer in the importing country

to finance the buyer’s purchases.

2. Export Credit Insurance

In addition to financing issues, traders are also subject

to risks, which can be either commercial or political.

Commercial risk arises from factors like thenon-acceptance of goods by buyer, the failure of buyer

to pay debt, and the failure of foreign banks to

honour documentary credits. Political risk arises from

factors like war, riots and civil commotion, blockage

of foreign exchange transfers and currency

devaluation. Export credit insurance involves insuring

exporters against such risks. It is commonly used in

Europe, and increasing in importance in the United

States as well as in developing markets.

The types of export credit insurance used vary from

country to country and depends on traders’ perceived

needs. The most commonly used are as follows:

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In a similar scheme, government could also offer

factoring services at subsidized rates.

b) Export-Import Bank (EXIM Bank)

The Export-Import Bank (EXIM Bank) specifically

caters to the needs of exporters and importers andthose of investors in foreign markets. It offers various

services, including long-term direct loans to foreign

buyers for loans and equipment sales of sufficient

sizes.

Several countries, including developed nations, have

EXIM banks. For example, the United States EXIM

Bank was created in 1934 and established under its

present law in 1945. Its primary role is to aid in

financing US exports, and for medium-term

(181 days to 5 years) transactions, it co-operates with

US commercial banks by providing export credit

guarantees. In setting up the EXIM Bank, the US

recognized that job creation is a consequence of

exports. Its main customers are SMEs in the United

States.

c) Export Credit Insurance Agencies

Export credit insurance agencies act as bridges

between banks and exporters. In emerging economies

where the financial sector is yet to be developed,

governments often take over the role of the export

credit insurance agent. Governments traditionally

assume this role because they are deemed to be the

only institutions in a position to bear political risks.

Several countries in Asia and Africa have such an

organization. However, the viability of such an

organization depend on the volume of business and

income from insurance premium. In that context,

credit insurance policies vary according to the typeof exports. For example, short term policies on the

sale of raw materials on 180 days terms are covered

up to 95 per cent for commercial risk and 100 per

cent for political risk. Such trades are considered

relatively secure. Nonetheless, it is good practice to

get the exporter to bear a certain portion of the risk.

d) Support from Trade Promotion Organisations

(TPOs)

As explained earlier, banks are often reluctant to lend

to exporters because of their lack of knowledge about

the creditworthiness of the traders, and as a result may

raise interest to compensate for the risks taken. TPOsare in a position to know the strengths and weaknesses

of the individual trading houses and exporters, and

could share information with financial institutions to

facilitate access to financial services.

TPOs are the government agencies that are most

directly involved with the trading community, often

supporting promising trading and exporting

enterprises. The support and assistance given by the

TPOs could act as a signal to banks as to whichcompanies are creditworthy companies. In addition,

TPOs could establish network of financial

institutions, identify their credit requirement, and

match trading enterprises and financial institutions

based on these requirements.

e) Export Development Corporation and State

Owned Enterprises

In most emerging economies, there are a few key

conglomerates with a diverse range of products,substantial export capacity and sustainable financial

resources. They could be private sector export

development corporations (EDCs) or state-owned

enterprises (SOEs).

Governments could harness these enterprises as

mechanisms to assist other local firms, especially

SMEs, to export their products or import goods.

Unlike the SMEs, the EDCs and the SOEs have the

financial resources and trade expertise needed toparticipate in trading activities. Smaller exporters

could sell their products to the EDCs and SOEs and

receive payment earlier than if they exported directly

by themselves. Small importers could also purchase

goods from the EDCs and SOEs, which have the

financial strength to bulk purchase from abroad.

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CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE 63

5. Conclusion

This Chapter has explained the need for trade finance

and introduced some of the most common trade

finance tools and practices. A proactive role of

governments in trade finance may alleviate the lack

of trade finance in emerging GMS economies and

contribute to trade expansion and facilitation.

However, the best long-term solution in resolving the

constraints in trade financing is to encourage the

growth and development of a vibrant and competitive

financial system, comprising mainly private sector

players. This point is important as some of the

government-supported trade financing schemes may

Box 8.1 Trade Finance Trends in Asia

The recent economic slowdown is making the need for sound trade finance policies and strong financial

systems more acute. Many companies are trying to preserve cash by delaying payment and the number of

SMEs 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 open-accounts terms, instead of using

guarantees like letters of credit (LCs). These buyers simply do not want to bear the extra cost of payment

guarantees and will source their goods from somewhere else if they are not given open-accounts. These

open-accounts allow the buyers to delay payments as needed, rising the need for credit for Asian companies

who choose to supply them.

The economic slowdown also has made many companies rethink their commitment to electronic trading

and payment systems. While these systems may cut significant costs out of the labor-intensive trade finance

process, 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 Asian

economies, 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 may

sell its products to Chinese buyers sub-contracted by Dell or IBM to manufacture PCs. The Chinese

sub-contractor may ask to buy from the manufacturer on open-account terms on the basis that payment

from 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.

Source: Moiseiwitsch, J., CFO Asia, Trade Finance – Time Bandits, November 2001, http://www.cfoasia.com/archives/200111-03.htm

increasingly be challenged by competing countries as

unfair export subsidies under existing and future

WTO rules.

The role of the government and other parties involved

in trade finance will need to evolve along with the

count ry’s economy. Underlying the funct ions

provided by the different players is the need for a clear

and effective legal environment. The commercial

legal system must be transparent. Laws of property,

contract and arbit ration must be clear. The

commercial legal environment must be integrated

with the financial infrastructure framework in order

for it to be effective.

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6. For Further Reading...

• One illustration of government’s proactive role

in trade finance in Asia and the Pacific is the

creation by the Australian government of the

Export Finance and Insurance Corporation

(EFIC) in 1991. (http://www.efic.gov.au).

• A well-developed domestic financial system can

go a long way toward facilitating trade by

making trade financing easier. The issue of

mobilizing domestic finance for development is

addressed in the joint ESCAP-ADB report

available at: http:/ /www.un.org/esa/ffd/escap-

rpt2001.pdf.

• The International Trade Center (ITC), a joint

initiative of UNCTAD and the WTO, is asource of practical guides and manuals on

international trade finance issues (http://

www.intracen.org/tfs/docs/overview.htm).

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