Options in Export Finance
Exporters control the options for their payment. Often, the option chosen will determine the exporter’s competitiveness.
The terms of sale in an export transaction are arranged between the buyer and the seller prior to shipment. Typically, the actual collection of payments internationally is accomplished through the facilities of a commercial bank. The payment method, or financial instrument used, is dependent on such factors as the credit standing of the buyer (importer), any existing exchange restrictions in the buyer’s country, competitive pressure that the seller faces, and the political and economic condition of the country of import.
Most merchandise sales by U.S. exporters to overseas buyers are made on the basis of one of the following methods of payment:
1. Cash in advance
2. Open account
3. Documentary collection
4. Letter of credit
A. OPEN ACCOUNT
Open account sales in international trade may be defined as one in which no financial institutions act as intermediaries between buyer and seller. This mode of payment is usually dictated by custom and competitive terms. The seller must be confident of the buyer’s creditworthiness and ability to pay promptly.
In an open account transaction, the seller is sending the buyer goods without any negotiable instrument evidencing the obligation and is dependent solely upon the buyer to make payment. The advantages of selling on an open account basis are simplicity and reduced banking charges. The seller has little legal recourse in cases of dishonored transactions and typically has a harder time getting dollar exchange from a defaulted buyer. For these reasons, this sales method is used primarily when sellers are dealing with buyers they know well, to established markets, and for sales to foreign branches or subsidiaries.
B. DOCUMENTARY COLLECTION
Export collections require that the seller forward documents and instructions to his bank, which will pass them to a foreign bank for collection. Various banks provide a direct collection service to their customers. Under this method, the exporter or his or her forwarder sends collection instructions directly to the buyer’s bank and a copy to their bank for follow-up.
A collection does not eliminate the market risk associated with the buyer (failure of buyer to take title of material purchased; not uncommon in a period of falling market prices) or the country risk associated with the buyer’s country. When asked for payment by a bank, the buyer could refuse. The bank or banks involved in the collection assumes no liability for payment requested on a collection basis. A sight draft ensures that documents do not pass to the buyer until payment is made. Neither a time draft nor a clean draft provides this protection.
C. LETTER OF CREDIT
Except for cash in advance, the letter of credit affords the seller the highest degree of protection. A letter of credit is issued by the opening bank assuring that certain payments will be made under specified conditions. Normally, letter of credit transactions involve two banks: one in the exporter’s country and one in the buyer’s.
An irrevocable letter of credit replaces the commercial risk associated with the Buyer with that of the bank issuing the letter of credit. Hence, the seller is no longer relying on the buyer’s promise to pay; he or she is relying on the promise and the ability to pay of a bank located in a foreign country. If the seller wishes to reduce the risk of nonpayment further, he or she can request that the bank confirm the letter of credit. From the seller’s viewpoint, this eliminates the foreign country risk and replaces the commercial risk of the buyer’s bank with that of the confirming bank. Payment against a confirmed letter of credit is assured by the confirming bank when documents in good order are submitted.
It is crucial to understand that a letter of credit is not an unconditional guarantee of payment; rather, payment will be made only after the terms of the letter of credit have been precisely fulfilled. Anyone using collections or letters of credit have been precisely fulfilled. Anyone using collections or letters of credit should very carefully read the segment on documents, “How a Letter of Credit Works” because discrepancies that can delay payment often arise upon inspection of the documents.
Foreign trade normally presents the following uncertainties:
A. Country Risk
Country risk is the risk associated with the buyer’s country. This covers the country’s financial condition, stability of currency, social and political climate, and availability of foreign exchange.
Commercial risk is the risk associated with the individual or institution responsible for payment. Because the purchase is in another country, the seller generally not only has less reliable information regarding his financial condition and integrity, but also typically has few avenues of redress should the buyer fail to pay or otherwise violate the agreed upon terms of sale.
The existence of greater commercial and country risk explains why few international transactions are made on an open account or consignment basis.
COMPLETING THE EXPORT TRANSACTION
The initial step in a foreign sales transaction may be taken by the buyer or the seller. A buyer may approach the seller with a request for a quotation, or he may dispatch an offer to buy at stipulated prices and on certain terms and conditions, or the seller may extend his quotation to potential buyers on his own initiative. Regardless of the approach and the formality of such exchanges, once an offer has been accepted by the other party, a contract, known as a sales contract, has been created.
Given the complexities that arise in a foreign transaction where language, custom, and practices may differ, the importance of the sales contract is readily apparent. Hence, companies engaged in foreign trade should have a sales contract form fitted to their basic requirements encompassing all the necessary details to assure a satisfactory conclusion to the transaction. Following is a list of some of the more important items that should be included in such a form:
Merchandise. A complete description specifying standards of grade or quality, catalog numbers, or other descriptive terms.
Quantity. The exact number in units or specific weight, measurement, or volume. Care should be taken as to different weight and measurement systems.
Price. Unit price specifying the currency in which the unit price is expressed.
Terms of Sale (INCO). Normally are expressed as FOB, CIF, etc., with named points or ports to which they apply. These terms indicate the duties and responsibilities of both buyer and seller with respect to point of delivery, costs, and risks to be assumed by each.
Packing. The type of packing is usually determined by the nature of the merchandise, conditions at sea, at the ports, and in transit in the interior as well as by customs regulations.
Marking. Usually are dictated by the customs regulations of the importing country and the requirements of the buyer.
Insurance. The extent of coverage required and who is to provide it should be stated.
Shipping Instructions. Method of transportation and consignment, documents required, and time of shipment should be explicit.
Method of Payment. Whether payment will be effected against cash in advance, on open account, on a collection basis, against a letter of credit, etc.
This list should not be considered complete, but rather used as a guide that can be adapted to fit the needs of individual transactions.