1. CHAPTER 8
AN INTRODUCTION TO TRADE FINANCE
The absence of an adequate trade finance • Trade Financing Instruments;
infrastructure is, in effect, equivalent to a barrier to • Export Credit Insurances; and
trade. Limited access to financing, high costs, and
• Export Credit Guarantees
lack of insurance or guarantees are likely to hinder
the trade and export potential of an economy, and 1. Trade Financing Instruments
particularly that of small and medium sized
enterprises. The main types of trade financing instruments are as
As explained in Chapter 1, trade facilitation aims at follows:
reducing transaction cost and time by streamlining
a) Documentary Credit
trade procedures and processes. One of the most
important challenges for traders involved in a This is the most common form of the commercial
transaction is to secure financing so that the letter of credit. The issuing bank will make payment,
transaction may actually take place. The faster and either immediately or at a prescribed date, upon the
easier the process of financing an international presentation of stipulated documents. These
transaction, the more trade will be facilitated. documents will include shipping and insurance
documents, and commercial invoices. The
Traders require working capital (i.e., short-term
documentary credit arrangement offers an
financing) to support their trading activities.
internationally used method of attaining a
Exporters will usually require financing to process or
commercially acceptable undertaking by providing for
manufacture products for the export market before
payment to be made against presentation of
receiving payment. Such financing is known as
documentation representing the goods, making
pre-shipping finance. Conversely, importers will need
possible the transfer of title to those goods. A letter
a line of credit to buy goods overseas and sell them
of credit is a precise document whereby the importer’s
in the domestic market before paying for imports. In
bank extends credit to the importer and assumes
most cases, foreign buyers expect to pay only when
responsibility in paying the exporter.
goods arrive, or later still if possible, but certainly not
in advance. They prefer an open account, or at least A common problem faced in emerging economies is
a delayed payment arrangement. Being able to offer that many banks have inadequate capital and foreign
attractive payments term to buyers is often crucial in exchange, making their ability to back the
getting a contract and requires access to financing for documentary credits questionable. Exporters may
exporters. require guarantees from their own local banks as an
additional source of security, but this may generate
Therefore, governments whose economic growth
significant additional costs as the banks may be
strategy involves trade development should provide
reluctant to assume the risks. Allowing internationally
assistance and support in terms of export financing
reputable banks to operate in the country and offer
and development of an efficient financial
documentary credit is one way to effectively solve this
infrastructure. There are many types of financial tools
problem.
and packages designed to facilitate the financing of
trade transactions. This Chapter will only introduce
three types, namely:

2. 60 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE
b) Countertrade and overhead costs. It is especially needed when
inputs for production must be imported. It also
As mentioned above, most emerging economies face provides additional working capital for the exporter.
the problem of limited foreign exchange holdings. Pre-shipment financing is especially important to
One way to overcome this constraint is to promote smaller enterprises because the international sales cycle
and encourage countertrade. Today’s modern counter is usually longer than the domestic sales cycle.
trade appears in so many forms that it is difficult to Pre-shipment financing can take in the form of short-
devise a definition. It generally encompasses the idea term loans, overdrafts and cash credits.
of subjecting the agreement to purchase goods or
services to an undertaking by the supplier to take on e) Post-Shipping Financing
a compensating obligation. The seller is required to
accept goods or other instruments of trade in partial Financing for the period following shipment. The
or whole payment for its products. ability to be competitive often depends on the trader’s
credit term offered to buyers. Post-shipment
Some of the forms of counter trade include: financing ensures adequate liquidity until the
• Barter – This traditional type of purchaser receives the products and the exporter
countertrade involving the exchange of receives payment. Post-shipment financing is usually
goods and services against other goods and short-term.
services of equivalent value, with no f) Buyer’s Credit
monetary exchange between exporter and
importer. A financial arrangement whereby a financial
• Counterpurchase – The exporter undertakes institution in the exporting country extends a loan
to buy goods from the importer or from a directly or indirectly to a foreign buyer to finance the
company nominated by the importer, or purchase of goods and services from the exporting
agrees to arrange for the purchase by a third country. This arrangement enables the buyer to make
party. The value of the counterpurchased payments due to the supplier under the contract.
goods is an agreed percentage of the prices
g) Supplier’s Credit
of the goods originally exported.
• Buy-back – The exporter of heavy A financing arrangement under which an exporter
equipment agrees to accept products extends credit to the buyer in the importing country
manufactured by the importer of the to finance the buyer’s purchases.
equipment as payment.
2. Export Credit Insurance
c) Factoring
In addition to financing issues, traders are also subject
This involves the sale at a discount of accounts to risks, which can be either commercial or political.
receivable or other debt assets on a daily, weekly or Commercial risk arises from factors like the
monthly basis in exchange for immediate cash. The non-acceptance of goods by buyer, the failure of buyer
debt assets are sold by the exporter at a discount to a to pay debt, and the failure of foreign banks to
factoring house, which will assume all commercial and honour documentary credits. Political risk arises from
political risks of the account receivable. In the factors like war, riots and civil commotion, blockage
absence of private sector players, governments can of foreign exchange transfers and currency
facilitate the establishment of a state-owned factor; devaluation. Export credit insurance involves insuring
or a joint venture set-up with several banks and exporters against such risks. It is commonly used in
trading enterprises. Europe, and increasing in importance in the United
States as well as in developing markets.
d) Pre-Shipping Financing
The types of export credit insurance used vary from
This is financing for the period prior to the shipment country to country and depends on traders’ perceived
of goods, to support pre-export activities like wages needs. The most commonly used are as follows:
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3. CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE 61
• Short-term Export Credit Insurance – An export credit guarantee is issued by a financial
Covers periods not more than 180 days. institution, or a government agency, set up to
Protection includes pre-shipment and promote exports. Such guarantee allows exporters to
post-shipment risks, the former covering the secure pre-shipment financing or post-shipment
period between the awarding of contract financing from a banking institution more easily.
until shipment. Protection can also be Even in situations where trade financing is
covered against commercial and political commercially available, companies without sufficient
risks. track records may not be looked upon favourably by
• Medium and Long-term Export Credit banks. Therefore, the provision of financial
Insurance – Issued for credits extending guarantees to the banking system for purveying export
longer periods, medium-term (up to three credit is an important element in helping local
years) or longer. Protection provided for companies go into exporting. The agency providing
financing exports of capital goods and this service has to carefully assess the risk associated
services. in supporting the exporter as well as the buyer.
• Investment Insurance – Insurance offered to 4. The Role of Governments in Trade
exporters investing in foreign countries. Financing
• Exchange Rate Insurance – Covers losses as
a result of fluctuations in exchange rates The role of government in trade financing is crucial
between exporters’ and importers’ national in emerging economies. In the presence of
currencies over a period of time. underdeveloped financial and money markets, traders
have restricted access to financing. Governments can
The benefits of export credit insurance include: either play a direct role like direct provision of trade
• Ability of exporters to offer buyers finance or credit guarantees; or indirectly by
competitive payment terms. facilitating the formation of trade financing
enterprises. Governments could also extend assistance
• Protection against risks and financial costs in seeking cheaper credit by offering or supporting
of non-payment. the following:
• Access to working capital.
• Central Bank refinancing schemes;
• Protection against losses from foreign
exchange fluctuations. • Specialized financing institutes like
Export-Import Banks or Factoring Houses;
• Reduction of need for tangible security when
borrowing from banks. • Export credit insurance agencies;
• Assistance from the Trade Promotion
Export credit insurance mitigates the financial impact Organisation; and
of the risk. There are specialized financial institutions
available that offer insurance cover, with premiums • Collaboration with Enterprise Development
dependent on the risk of the export markets and Corporations (EDC) or State Trading
export products. Enterprises (STE).
3. Export Credit Guarantees a) Central Bank Refinancing Schemes
Under this type of schemes, the Central Bank will
Export credit guarantees are instruments to safeguard
rediscount the commercial bills of exporters at
export-financing banks from losses that may occur
preferential rates. This will provide the cheap
from providing funds to exporters. While export
post-shipment financing necessary for exporters to
credit insurance protects exporters, guarantees protect
quickly turn around funds for further export business.
banks offering the loans. They do not involve the
Here, the government is subsidizing the cost of funds
actual provision of funds, but the exporters’ access to
that exporters have to pay if they rediscount their bills
financing is facilitated.
with commercial banks.
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4. 62 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE
In a similar scheme, government could also offer d) Support from Trade Promotion Organisations
factoring services at subsidized rates. (TPOs)
b) Export-Import Bank (EXIM Bank) As explained earlier, banks are often reluctant to lend
to exporters because of their lack of knowledge about
The Export-Import Bank (EXIM Bank) specifically the creditworthiness of the traders, and as a result may
caters to the needs of exporters and importers and raise interest to compensate for the risks taken. TPOs
those of investors in foreign markets. It offers various are in a position to know the strengths and weaknesses
services, including long-term direct loans to foreign of the individual trading houses and exporters, and
buyers for loans and equipment sales of sufficient could share information with financial institutions to
sizes. facilitate access to financial services.
Several countries, including developed nations, have
TPOs are the government agencies that are most
EXIM banks. For example, the United States EXIM
directly involved with the trading community, often
Bank was created in 1934 and established under its
supporting promising trading and exporting
present law in 1945. Its primary role is to aid in
enterprises. The support and assistance given by the
financing US exports, and for medium-term
TPOs could act as a signal to banks as to which
(181 days to 5 years) transactions, it co-operates with
companies are creditworthy companies. In addition,
US commercial banks by providing export credit
TPOs could establish network of financial
guarantees. In setting up the EXIM Bank, the US
institutions, identify their credit requirement, and
recognized that job creation is a consequence of
match trading enterprises and financial institutions
exports. Its main customers are SMEs in the United
based on these requirements.
States.
c) Export Credit Insurance Agencies e) Export Development Corporation and State
Owned Enterprises
Export credit insurance agencies act as bridges
In most emerging economies, there are a few key
between banks and exporters. In emerging economies
conglomerates with a diverse range of products,
where the financial sector is yet to be developed,
substantial export capacity and sustainable financial
governments often take over the role of the export
resources. They could be private sector export
credit insurance agent. Governments traditionally
development corporations (EDCs) or state-owned
assume this role because they are deemed to be the
enterprises (SOEs).
only institutions in a position to bear political risks.
Several countries in Asia and Africa have such an Governments could harness these enterprises as
organization. However, the viability of such an mechanisms to assist other local firms, especially
organization depend on the volume of business and SMEs, to export their products or import goods.
income from insurance premium. In that context, Unlike the SMEs, the EDCs and the SOEs have the
credit insurance policies vary according to the type financial resources and trade expertise needed to
of exports. For example, short term policies on the participate in trading activities. Smaller exporters
sale of raw materials on 180 days terms are covered could sell their products to the EDCs and SOEs and
up to 95 per cent for commercial risk and 100 per receive payment earlier than if they exported directly
cent for political risk. Such trades are considered by themselves. Small importers could also purchase
relatively secure. Nonetheless, it is good practice to goods from the EDCs and SOEs, which have the
get the exporter to bear a certain portion of the risk. financial strength to bulk purchase from abroad.
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5. CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE 63
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. Large
Western 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 dealing
with 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, increasing
the 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
5. Conclusion increasingly be challenged by competing countries as
unfair export subsidies under existing and future
This Chapter has explained the need for trade finance WTO rules.
and introduced some of the most common trade
finance tools and practices. A proactive role of The role of the government and other parties involved
governments in trade finance may alleviate the lack in trade finance will need to evolve along with the
of trade finance in emerging GMS economies and country’s economy. Underlying the functions
contribute to trade expansion and facilitation. provided by the different players is the need for a clear
However, the best long-term solution in resolving the and effective legal environment. The commercial
constraints in trade financing is to encourage the legal system must be transparent. Laws of property,
growth and development of a vibrant and competitive contract and arbitration must be clear. The
financial system, comprising mainly private sector commercial legal environment must be integrated
players. This point is important as some of the with the financial infrastructure framework in order
government-supported trade financing schemes may for it to be effective.
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6. 64 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE
6. For Further Reading... mobilizing domestic finance for development is
addressed in the joint ESCAP-ADB report
• One illustration of government’s proactive role available at: http://www.un.org/esa/ffd/escap-
in trade finance in Asia and the Pacific is the rpt2001.pdf.
creation by the Australian government of the
Export Finance and Insurance Corporation • The International Trade Center (ITC), a joint
(EFIC) in 1991. (http://www.efic.gov.au). initiative of UNCTAD and the WTO, is a
source of practical guides and manuals on
• A well-developed domestic financial system can international trade finance issues (http://
go a long way toward facilitating trade by www.intracen.org/tfs/docs/overview.htm).
making trade financing easier. The issue of
TRADE FACILITATION HANDBOOK FOR THE GREATER MEKONG SUBREGION