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Export and Import Financing Mechanisms for financing exports and imports have evolved over the centuries in response to a problem that can be particularly acute in international trade: the lack of trust that exists when one must put faith in a stranger. In this section, we examine the financial devices that have evolved to cope with this problem in the context of international trade: the letter of credit, the draft (or bill of exchange), and the bill of lading. Then we will trace the 14 steps of a typical export - import transaction. Lack of Trust Firms engaged in international trade have to trust someone they may have never seen, who lives in a different country, who speaks a different language, who abides by (or does not abide by) a different legal system, and who could be very difficult to track down if he or she defaults on an obligation. Consider a US firm exporting to a distributor in France. The US businessman might be concerned that if he ships the products to France before he receives payment for them from the French businesswoman, she might take delivery of the products and not pay him for them. Conversely, the French importer might worry that if she pays for the products before they are shipped, the US firm might keep the money and never ship the products or might ship defective products. Neither party to the exchange completely trusts the other. This lack of trust is exacerbated by the distance between the two parties--in space, language, and culture--and by the problems of using an underdeveloped international legal system to enforce contractual obligations. Due to the (quite reasonable) lack of trust between the two parties, each has his or her own preferences as to how they would like the transaction to be configured. To make sure he is paid, the manager of the US firm would prefer the French distributor to pay for the products before he ships them (see Figure 15.1). Alternatively, to ensure she receives the products, the French distributor would prefer not to pay for them until they arrive (see Figure 15.2). Thus, each party has a different set of preferences. Unless there is some way of establishing trust between the parties, the transaction might never take place. The problem is solved by using a third party trusted by both--normally a reputable bank--to act as an intermediary. What happens can be summarized as follows (see Figure 15.3). First, the French importer obtains the bank's promise to pay on her behalf, knowing the US exporter will trust the bank. This promise is known as a letter of credit. Having seen the letter of credit, the US exporter now ships the products to France. Title to the products is given to the bank in the form of a document called a bill of lading. In return, the US exporter tells the bank to pay for the products, which the bank does. The document for requesting this payment is referred to as a draft. The bank, having paid for the products, now passes the title on to the French importer, whom the bank trusts. At that time or later, depending on their agreement, the importer reimburses the bank. In the remainder of this section, we will examine how this system works in more detail. Letter of Credit A letter of credit, abbreviated as L/C, stands at the center of international commercial transactions. Issued by a bank at the request of an importer, the letter of credit states that the bank will pay a specified sum of money to a beneficiary, normally the exporter, on presentation of particular, specified documents. Consider again the example of the US exporter and the French importer. The French importer applies to her local bank, say the Bank of Paris, for the issuance of a letter of credit. The Bank of Paris then undertakes a credit check of the importer. If the Bank of Paris is satisfied with her creditworthiness, it will issue a letter of credit. However, the Bank of Paris might require a cash deposit or some other form of collateral from her first. In addition, the Bank of Paris will charge the importer a fee for this Figure 15.1 Preference of the US Exporter Figure 15.2 Preference of the French Importer Figure 15.3 The Use of a Third Party service. Typically this amounts to between 0.5 percent and 2 percent of the value of the letter of credit, depending on the importer's creditworthiness and the size of the transaction. (As a rule, the larger the transaction, the lower the percentage.) Let us assume the Bank of Paris is satisfied with the French importer's creditworthiness and agrees to issue a letter of credit. The letter states that the Bank of Paris will pay the US exporter for the merchandise as long as it is shipped in accordance with specified instructions and conditions. At this point, the letter of credit becomes a financial contract between the Bank of Paris and the US exporter. The Bank of Paris then sends the letter of credit to the US exporter's bank, say the Bank of New York. The Bank of New York tells the exporter that it has received a letter of credit and that he can and ship the merchandise. After the exporter has shipped the merchandise, he draws a draft against the Bank of Paris in accordance with the terms of the letter of credit, attaches the required documents, and presents the draft to his own bank, the Bank of New York, for payment. The Bank of New York then forwards the letter of credit and associated documents to the Bank of Paris. If all of the terms and conditions contained in the letter of credit have been complied with, the Bank of Paris will honor the draft and will send payment to the Bank of New York. When the Bank of New York receives the funds, it will pay the US exporter. As for the Bank of Paris, once it has transferred the funds to the Bank of New York, it will collect payment from the French importer. Alternatively, the Bank of Paris may allow the importer some time to resell the merchandise before requiring payment. This is not unusual, particularly when the importer is a distributor and not the final consumer of the merchandise, since it helps the importer's cash flow position. The Bank of Paris will treat such an extension of the payment period as a loan to the importer and will charge an appropriate rate of interest. The great advantage of this system is that both the French importer and the US exporter are likely to trust reputable banks, even if they do not trust each other. Once the U.S. exporter has seen a letter of credit, he knows that he is guaranteed payment and will ship the merchandise. Also, an exporter may find that having a letter of credit will facilitate obtaining preexport financing. For example, having seen the letter of credit, the Bank of New York might be willing to lend the exporter funds to process and prepare the merchandise for shipping to France. This loan may not have to be repaid until the exporter has received his payment for the merchandise. As for the French importer, the great advantage of the letter of credit arrangement is that she does not have to pay out funds for the merchandise until the documents have arrived and unless all conditions stated in the letter of credit have been satisfied. The drawback for the importer is the fee she must pay the Bank of Paris for the letter of credit. In addition, since the letter of credit is a financial liability against her, it may reduce her ability to borrow funds for other purposes. Draft A draft, sometimes referred to as a bill of exchange, is the instrument normally used in international commerce to effect payment. A draft is simply an order written by an exporter instructing an importer, or an importer's agent, to pay a specified amount of money at a specified time. In the example of the US exporter and the French importer, the exporter writes a draft that instructs the Bank of Paris, the French importer's agent, to pay for the merchandise shipped to France. The person or business initiating the draft is known as the maker (in this case, the US exporter). The party to whom the draft is presented is known as the drawee (in this case, the Bank of Paris). International practice is to use drafts to settle trade transactions. This differs from domestic practice in which a seller usually ships merchandise on an open account, followed by a commercial invoice that specifies the amount due and the terms of payment. In domestic transactions, the buyer can often obtain possession of the merchandise without signing a formal document acknowledging his or her obligation to pay. In contrast, due to the lack of trust in international transactions, payment or a formal promise to pay is required before the buyer can obtain the merchandise. Drafts fall into two categories, sight drafts and time drafts. A sight draft is payable on presentation to the drawee. A time draft allows for a delay in payment--normally 30, 60, 90, or 120 days. It is presented to the drawee, who signifies acceptance of it by writing or stamping a notice of acceptance on its face. Once accepted, the time draft becomes a promise to pay by the accepting party. When a time draft is drawn on and accepted by a bank, it is called a banker's acceptance. When it is drawn on and accepted by a business firm, it is called a trade acceptance. Time drafts are negotiable instruments; that is, once the draft is stamped with an acceptance, the maker can sell the draft to an investor at a discount from its face value. Imagine the agreement between the US exporter and the French importer calls for the exporter to present the Bank of Paris (through the Bank of New York) with a time draft requiring payment 120 days after presentation. The Bank of Paris stamps the time draft with an acceptance. Imagine further that the draft is for $100,000. The exporter can either hold onto the accepted time draft and receive $100,000 in 120 days or he can sell it to an investor, say the Bank of New York, for a discount from the face value. If the prevailing discount rate is 7 percent, the exporter could receive $96,500 by selling it immediately (7 percent per annum discount rate for 120 days for $100,000 equals $3,500, and $100,000 - $3,500 = $96,500). The Bank of New York would then collect the full $100,000 from the Bank of Paris in 120 days. The exporter might sell the accepted time draft immediately if he needed the funds to finance merchandise in transit and/or to cover cash flow shortfalls. Bill of Lading The third key document for financing international trade is the bill of lading. The bill of lading is issued to the exporter by the common carrier transporting the merchandise. It serves three purposes: it is a receipt, a contract, and a document of title. As a receipt, the bill of lading indicates that the carrier has received the merchandise described on the face of the document. As a contract, it specifies that the carrier is obligated to provide a transportation service in return for a certain charge. As a document of title, it can be used to obtain payment or a written promise of payment before the merchandise is released to the importer. The bill of lading can also function as collateral against which funds may be advanced to the exporter by its local bank before or during shipment and before final payment by the importer. A Typical International Trade Transaction Now that we have reviewed the elements of an international trade transaction, let us see how the process works in a typical case, sticking with the example of the US exporter and the French importer. The typical transaction involves 14 steps (see Figure 15.4). The steps are enumerated here.
Figure 15.4 A Typical International Trade Transaction
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