Trade Finance: An Introduction

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WTO/ESCAP ARTNeT Capacity Building Workshopfor Trade Research, Bangkok, Thailand, 22 June2009Trade Finance: AnintroductionbyYann Duval,Trade and Investment Division,United Nations Economic and Social Commission for Asia and the Pacific(UN ESCAP)Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Session Overview Part 1 – intro to trade finance Definition and Importance Trade finance tools and instruments––––––FactoringInventory financingStructured financingLeasingExport credit insurance / guaranteesPayment terms Advance payment, L/Cs, documentary collection Trade finance infrastructures; Ideas for research – Part 2 – recent lit. and findings; data sourcesAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Trade Financing? Raising capital– Capital for investment– Working capital Managing risk in trade transactions– Credit insurance and guarantees– Payment terms– HedgingAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

(Trade) FinancingHow important and difficultis it?Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Financing is needed throughout thetrade cycleAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Pre & Post‐Shipping Financing Pre‐Shipping– Prior to the shipment of goods.– To support pre‐export activities like wages and overheadcosts. Post‐Shipping– The period following shipment.– Ensures adequate liquidity until the purchaser receives theproducts and the exporter receives payment.In international trade, the trade cycle is generally longer than in domestic tradeÆ financing becomes very importantAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Obstacles to Asia‐Pacific SMECompetitivenessImportance of factor for competitiveness (%)(note: 95% of firms in Asia are SMEs)Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.orgLacking factor (%)Source: adapted from 2009 UPS Asia Business Monitor

Problems encountered by Asia‐PacificSMEs in financing their activitiesAsia-Pacific Research and Training NetworkSource:2009 UPSAsia Business MonitoronTrade– www.artnetontrade.org

Obstacles to trade and investmentfinancing Lack of collateral, high cost of loan – Some trade finance instruments exists to solvethese problems*Asia-PacificResearchinand*maynot be applicableall TrainingcountriesNetwork suitable for smaller enterpriseson Trade – www.artnetontrade.org

Many types of assets can potentiallybe used to secure ventory/StocksEquipmentBuildings / Land Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Factoring This involves the sale at a discount of accountsreceivable (e.g., export invoices) or other debt assetson a daily, weekly or monthly basis in exchange forimmediate cash. The debt assets are sold by the exporter at adiscount to a factoring house, which will assume allcommercial and political risks of the accountreceivable.Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Asia-Pacific Research and Training NetworkSource: http://www.intfactor.com.sgon Trade – www.artnetontrade.org

Inventory Financing Inventories hold up space and is a cost to theexporter until its is shipped to the importer. Warehouse receipts ‐ These inventories can be asource of fund through both secured and unsecuredloan against the inventories a company has.Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Structured FinancingStructured Financing is a technique wherebycertain assets with more or less predictable cashflows can be isolated from the originator andused to mitigate risks (e.g. transfer of foreignexchange, contract performance and sovereignrisk), and thus secure a credit.Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Structured FinancingDirect sale of rights tofuture production (sold inexport market) toinvestors:Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.orgSource: Rutten UNCTAD

STRUCTURED FINANCECOFFEE IN KENYA – 3 MONTHS CREDITNo StructuredFinanceValue of GoodsUS 7,000,000With Structured FinanceUS 7,000,000Advance Rate50%Loan ProceedsUS 3,500,000US 5,600,000 (Extra creditUS 2.1 mil)Interest rate paLIBOR 15%LIBOR 2.5% (Savings ininterest charged over US 3.5mil US 120,000)Storage/insurance/inspection &other professional fees1.7%2.55% (Additional upfront feesUS 59,000)Total storage etc. etc. & interestcostsUS 304,000US 298,000 (Savings achieved,US 6,000)Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org80% (increased utilisation ofassets by 30%)

Leasing Consider when buying any tangible assets True lease (vs. financial lease)– No asset ownership transfer– Lease term less than life of equipment– Maintenance provided by lessor Main advantage: lower initial expenditureof cash Main disadvantage: overall cost ( andcommitment to property)Asia-PacificResearchand TrainingNetworkLeasevs. Buy calculatoravailableat:on Trade – ysis/calculators/leasebuy.html#results

What is the key difference betweenfinancing international tradetransactions and domestictransactions? The additional risks involved!!!– Country risk– Exchange rate risk– Lack of knowledge/information about your buyer(or supplier) Æ counterparty or buyer default risk– More difficult and costly to resolve disputesAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Export Credit Insurance Export credit insurance involves insuringexporters against possible:– Commercial risk such as non‐acceptance of goodsby buyer, the failure of buyer to pay debt, and thefailure of foreign banks to honor documentarycredits.– Political risk arises from factors like war, riots andcivil commotion, blockage of foreign exchangetransfers and currency devaluation.Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Export Credit Guarantees Issued by a financial institution, or agovernment agency Instruments to safeguard export‐financingbanks from losses that may occur fromproviding funds to exporters.– To assist companies without sufficient trackrecords to obtain credit (and/or export insurance)from banksAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Payment Terms And Associated Risks Advance Payment––––Time of payment : Before shipmentGoods available to buyers : After paymentRisk to exporter : NoneRisk to importer : Relies completely onexporter to ship goods as orderedAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Payment Terms And Associated Risks Open account– Time of payment : after receipt of goods bybuyer (as agreed upon)– Goods available to buyers : Before payment– Risk to exporter : Relies completely on buyer topay account as agreed upon– Risk to importer : NoneAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Payment Terms And Associated Risks Letters of credit (L/C) or Documentary Credit– Time of payment : After shipment is made (onceterms and conditions specified in L/C are met)– Goods available to buyers : After payment– Risk to exporter : Very little or none– Risk to importer : Relies on exporter to shipgoods as described in documentsAn L/C is an undertaking issued by a bank for the account of thebuyer (the Applicant), to pay the Beneficiary (seller) the value of theDraft and/or documents provided that the terms and conditions of theL/C are compliedwith. and Training NetworkAsia-PacificResearchon Trade – www.artnetontrade.org

Goods5BUYER 18ContactLETTER OF CREDITCYCLE2Request L/C3Documents4Issues L/CDocuments1066Advises L/CDocuments9SELLERISSUINGAsia-Pacific Research and Training NetworkBANKon Trade – www.artnetontrade.org711ADVISING/NEGOTIATINGBANK

Payment Terms And Associated Risks Documentary Collection (Documents againstpayments)– Time of payment : After presentation of draft (bill ofexchange)– Goods available to buyers : After payment– Risk to exporter : If draft is unpaid, must dispose ofgoods– Risk to importer : goods shipped are not as describedin the documents (Documents against acceptance)Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

mentsDocuments6COLLECTINGAsia-Pacific Research and Training NetworkBANKon Trade – www.artnetontrade.orgRemittingBank

Payment Terms And Associated RisksBestAdvance51Term of PaymentPaymentDocumentary24Letter of CreditExporter’sDocumentary33Point of ViewCollectionPayment after42arrival of GoodsWorstOpen A/C51Term of Payment(Open Invoice)Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.orgWorstTerm of PaymentImporter’sPoint of ViewBestTerm of Payment

Many of the trade finance tools andinstruments not accessible in countries ofthe region Æ Need to build a TradeFinance Infrastructure“The laws, regulations, institutions and otherinstruments (*) required to:(1) Provide capital and credit to firms involved ininternational trade transactions(2) Manage the risks involved in these transactions,(3) Ensure international payment through efficientmechanisms (e.g., electronic systems)Asia-Pacific Research and Training Network(*) Trainedon staffTrade – www.artnetontrade.org

Are trade finance institutions availableand functioning?Trade Finance Institutional Structure model (TFIS)Level I Institutions: Direct governnmental roleLevel II Institutions: Full or partial governmentownership but limited direct management roleLevel III Institutions: Market driven – No or verylimited government ownershipAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Level I Institutions: Direct governnmental role Central Bank / Monetary AuthorityMinistry of FinanceMinistry in charge of tradeOther financial and insurance sector regulatory bodiesTo PROVIDE WHAT?¾ A stable and favourable macroeconomic, legal and financialenvironment¾A vision and strategy for trade development¾Financial and trade policies and regulations supportive of trade¾Trade promotion and SME development schemesAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Level II Institutions: Full or partial government ownershipbut limited direct management role Export Credit Insurance and Guarantee Agency National Export‐Import Bank (EXIM) Other trade‐related specialized financialinstitutions/agenciesOFFERING¾ Specialized support to SMEs and other organization with limited access totrade credit¾Innovative trade related financing options, export risk management tools¾Tie-ups with International Trade finance firms with expertise in innovativestructures and developing markets¾Asia-PacificAccess to financingby multilateralResearchprovidedand TrainingNetwork financial and donor agencieson Trade – www.artnetontrade.org

Level III Institutions: Market driven – No or very limitedgovernment ownership Commercial banks Other privately owned non‐banking financial institutions(leasing companies, factoring houses )Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Conclusions/ideas for research Trade finance is an essential enabler of trade But little research work in this area as yet– National situation often unclear and unmonitored (from a tradeperspective) Æ See Trade Finance Pointer Methodology and 50 indicators– Which institutional models are most suited to specific context (e.g.,should small economies have EXIM banks?) – How much shouldgovernments be involved and provide guarantees?– Many countries have taken steps to facilitate trade finance since thebeginning of the global crisis? Which of those steps have been (most)effective– Have the global and regional trade finance schemes been effective inAsia, particularly in LDCs? Æ typically involve channeling fundsthrough domestic commercial banks, which may lack capacity to do soeffectively– Is there merit in developing new regional trade finance arrangements,if so which type?Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Annex 1International Standards AndConventions In Trade FinancingAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

International Standards AndConventions In Trade Financing Incoterms 2000– Standard trade definitions most commonly used ininternational sales contracts Uniform Customs and Practice for DocumentaryCredits (UCP500)– UCP500 is the Uniform Customs and Practice fordocumentary credit eUCP– In November 2002, ICC published a new Guide call eUCP tosupplementUCP and500.Training NetworkAsia-PacificResearchon Trade – www.artnetontrade.org

International Standards AndConventions in Trade Financing ICC Uniform Rules for Collection (URC522)– Provides a basic introduction to the operation ofcollections as part of international trade Uniform Rules for Bank‐to‐Bank Reimbursementsunder Documentary Credits (URR 525) Uniform Rules for Demand Guarantees, (RDG 458)Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Annex 2Trade Finance PointersAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

A Good Trade FinanceInfrastructure requires: Appropriate financial sector regulations wellcoordinated and not contradictory International and national finance/banking expertise(public and private sectors) A conducive environment for tradefinance (including an effective legal framework)What is a more favorable environment for trade financedevelopment? How do we know if we have it?Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

ITC’s Trade Finance Pointers (TFPs)Methodology What are TFPs?– Indicators of factors that affect the trade financeenvironment– A trade finance “blood test” result sheet based on 52indicators What are TFPs for?– To detect where to focus efforts to develop a moreconducive trade finance environmentAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

TFPs: 52 indicators in 10 areasMacro Indicators(Indirect Effect)Financial Institutions& Capacity Indicators(Direct Effect)1. TRADE FLOWS2. EXTERNALRESOURCES8. FINANCIALINSTITUTIONS3. EXTERNAL DEBTAND LIQUIDITY9. CAPITAL AND CREDITRESTRICTIONS4. EXCHANGE RATE10. COST OF BORROWING5. MONETARY SYSTEM6. CREDIT MARKET7. LEGALAsia-PacificResearch and Training NetworkENVIRONMENTon Trade – www.artnetontrade.orgTrade FinanceInfrastructureDevelopment

TFPs: Data SourcesSecondary sources for most indicators World Bank Development Indicators 2003 International Financial Statistics, IMF International Trade Finance, ITC www.cofacerating.com Supplemented by a national survey on Legal Environment, Financial institutions, Capital &Credit RestrictionsAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Combined the indicators describe the status of the TradeFinance infrastructure of a country.Benchmarks, calculated with data on all 155 developingcountries, are used alongside traffic lights to depictthree possible situations:Q1: FirstQuartile200Further researchneededQ2:MedianPartially favourable1000Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.orgQ3: ThirdQuartileFavourable

« Ready Reckoner »C O M P O S IT E IN D IC E SCombiningand interrelating 52indicators and10 indices, acountry’soverallposition weighted can be plottedand comparedon a « ReadyReckoner ».MACROECONOMIC TRADE FINANCE ENVIRONMENT1.1102.3.4.5.6.7.8.9.10.W e ig h te d s c o reT ra d e in d ic a to r s4 .5N e t re s o u rc e flo w sE x te rn a l d e b t & liq u id ityE x c h a n g e ra te p o lic y & a v a ila b ilityM o n e ta r y & fin a n c ia l s y s te mC re d it m a rk e tL e g a l e n v iro n m e n tF in a n c ia l in s titu tio n sC a p ita l & c re d it re s tric tio n sC o s t o f b o rro w in g363343433.4.1.0.8.1.3.2.7.4987G O O D654P A R T IA L2001su rvey3T h is s u r v e y2W E A K10012345678910T R A D E F IN A N C E IN S T IT U T IO N A L S T R U C T U R E & C A P A C IT YSee ESCAP/ITC Trade Finance Infrastructure DevelopmentAsia-Pacific Researchand TrainingNetworkHandbookfor details– Methodologyneed furtheron Trade – www.artnetontrade.orgdevelopment but interesting starting point

Optional SlidesAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Key Issues In Trade Finance The mechanics & systems for arranging for andreceiving payment The Legislation and custom requirements of theexport and import countries Foreign exchange policy and other risks associatedwith international trade The institutions ‐ the operations of the bankingsystem in operating the trade finance instruments,and payments and settlements. Infrastructure and a host of ICT servicesAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Trade finance tools and instruments To raise Capital––––Loan / Line of CreditStructured FinancingLeasingInventory Financing To Mitigate risks– Factoring– Export Credit Insurance– Export Credit Guarantee Terms of Payment––––Advance PaymentOpen AccountCollections (Documents against Payment or Acceptance)Letters of CreditAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Contract Value 10m3. Down payment of 15% of Contract ValueImporterExporter4. Delivery of Goods5. Bank pays Loanamt to Exporterafter delivery ofGoods ( 8.5m)1. Bank arrange loan withImporter on 85% of ContractValue ( 8.5m) – Loan AmtCommercial Bank6. PaymentofinsurancefeesECIGS2. ECIGS guarantees 95% of LoanAmount ( 8.075m) 425,000 of Loan Amt remainuncovered as bank risk sharingAsia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Asia-Pacific Research and Training Networkon Trade – www.artnetontrade.org

Trade finance is an essential enabler of trade But little research work in this area as yet –National situation often unclear and unmonitored (from a trade perspective) ÆSee Trade Finance Pointer Methodology and 50 indicators –Which institutional models are most suited to specific context (e.g.,

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