Import trade finance solves for a number of issues that arise when sending money internationally. In any international trade deal, the interests of the importer and exporter are to some degree opposed. The importer wants the comfort of knowing goods have arrived and are in good shape before paying for them; ideally, the importer would like to sell them on to customers before paying for them. Conversely, the exporter wants to mitigate the risk that the importer will default by receiving payment before shipping. Import trade finance and its cousin, trade credit, balance these conflicting needs so that goods and money can both flow – to mutual benefit.
Types of Trade Credit for Import Trade Finance
For importers, a consignment purchase is the lowest-risk import trade finance option. Here, the importer does not pay until the goods are sold on to the end customer. Unsurprisingly, exporters are often reluctant to agree to consignment purchase terms since it can mean a long delay before receiving payment – or not getting paid in full at all. Consignment purchase arrangements are regarded by exporters as highly risky, and are therefore rare.
At the other extreme, cash-in-advance is the riskiest import trade finance option for importers since it commits funds up front with no guarantee that the goods will be delivered. Exporters like it, though, especially if they are themselves intermediaries who have to pay for goods in advance of receiving payment for their exports. Some exporters offer discounts for cash in advance.
Consignment purchases leave all the risk with the exporter, while cash-in-advance terms leave all the risk with the importer. A reasonable compromise can be a down payment, where the importer makes an up-front non-returnable deposit and the exporter ships the goods on the strength of that deposit. The importer then pays the remainder of the purchase cost when the goods have been received and checked.
Many exporters offer open account purchase terms for import trade finance. In an open account arrangement, the importer initially purchases the goods “on account,” then makes a series of payments to pay down the balance. The exporter may charge interest on the payments.
Open account arrangements can help importers manage their cash flow more efficiently. However, there is risk for the exporter, since the importer might default on the payments. In an open account arrangement, the title of the goods passes from the exporter to the importer when the goods are delivered, and the importer can sell the goods on to customers before making the final payment to the importer. If the importer defaults on the payment, the exporter is unlikely to recover the goods.
Because of this, exporters often prefer to limit open account arrangements to long-standing regular customers who have impeccable payment records. However, with the growing availability of credit insurance in international trade, open account arrangements are becoming more widely used.
These alternatives are all forms of trade credit. But for many importers, particularly smaller businesses and those trading over the internet, trade credit can be severely restricted or very expensive. Sometimes it is not available at all. So, many importers need to use some kind of trade finance to fund their international purchases.
The most widely used forms of trade finance are documentary collections and letters of credit. Both of these rely on banks.
The Role of Banks in Import Trade Finance
A letter of credit is the most widely used form of import trade finance in the world. It is a letter issued by an importer’s bank authorizing the exporter to withdraw funds from the bank under certain conditions. A letter of credit is issued in favor of a named beneficiary, for a stated amount of money and with a hard expiration date. It specifies the terms and conditions under which payment will be made.
In order to claim payment from the importer’s bank, the exporter has to provide documentary evidence that the goods have been supplied in accordance with the terms and conditions specified in the letter of credit. The documents required typically include an invoice or receipt for the goods and a bill of lading confirming that the goods have been shipped; insurance documents, inspection reports and other export documents may be needed as well.
When the exporter presents correct documentation to the importer’s bank, the bank is obliged to pay, whether or not the importer has provided the funds to do so. Depending on the terms specified in the letter of credit, payment can be either a funds transfer (“sight draft”) or a promise to pay (“term draft”). A promise to pay often takes the form of a bill of exchange, which is a non-interest bearing note requiring the issuer to make payment at a specified time in the future. Bills of exchange can themselves be used as a means of payment, since they can be endorsed over to another beneficiary. They can therefore help to ease cash flow pressures for exporters.
Sometimes, a trusted third party – usually a major international bank – acts as guarantor for a letter of credit to protect the exporter in the event the issuing bank defaults on payment. This is known as a “confirmed” letter of credit.
A letter of credit eliminates the obligation on the importer to pay for goods prior to shipping, since the importer’s bank in effect guarantees that payment will be made on receiving documentary evidence that goods have been shipped. It therefore acts as a form of credit.
Letters of credit eliminate much of the risk inherent in international trade. But they can be expensive, and if too tightly specified they can be difficult to enforce, resulting in long and expensive legal battles. A cheaper but slightly riskier form of trade finance is documentary collection.
In a documentary collection, the sale of goods is settled by banks through the exchange of documents. The exporter provides documentary evidence to his bank that the goods have been shipped. Usually this takes the form of a bill of lading. The bank forwards the bill of lading to the importer’s bank and receives in return settlement of the invoice. Settlement can be a funds transfer or a promise to pay, such as a bill of exchange.
The difference between documentary collection and letters of credit is that in documentary collection the importer’s bank does not guarantee payment. If the importer decides not to accept the goods, the bank won’t pay. In a documentary collection, title does not pass to the importer until payment has been made, so the exporter can recover the goods. However, recovering goods from some locations can be difficult and expensive.
For many international trade transactions, some form of trade credit will be sufficient, especially one which creates a reasonable balance between the needs of exporters and importers. But when the exporter and importer have not yet established a relationship of trust, using trusted intermediaries can mitigate cash flow and credit risks on both sides. Identifying the best import trade finance solution for both exporter and importer is a matter for negotiation as part of the trade deal.