International trade finance is generally categorized under inter-firm trade credit
and intermediated trade finance. In inter-firm trade credit, payments are transferred
directly from importer to exporter either after or before delivery through “open
account”
48 or “cash in advance”
49 payment terms, respectively. In intermediated
trade finance, a financial intermediary such as a bank issues a letter of credit
50 to the
importer to facilitate the trade with the exporter.
51 The typical letter of credit is a
sophisticated mechanism designed to mitigate the risks borne by exporters and
importers.
Intermediated trade finance is commonly used in both low and middle-income
countries, as traders rely on the credibility of financial intermediaries rather than the
credibility of trading partners. Since intermediated trade finance comes at a cost, its
use has been declining in high-income countries. This can be discerned from the
result of a survey on country-wise relevance of payment terms conducted by the
Association of Executives in Finance, Credit & International Business (FCIB).
52 The
study indicates that firms’ use of payment terms varies a lot across different
destination countries. The correlation seems to be strong between firm managers’
perceived riskiness of the destination country and the adoption of a specific payment
term. Although the letter of credit is a popular payment term for imports in China, the
overall use of letters of credit appears to be the least common payment term globally.
It has to a large extent been replaced by inter-firm trade finance in terms of open
account, which is a more competitive payment term. A most likely reason for the
popularity of open account in financially developed Northern and Western European
countries is simply because better enforcement mechanisms are generally available
in such jurisdictions that reduce the opportunity cost of adverse selection.
48 In “open account” the exporter extends a trade credit to the importer, which allows the latter to
postpone the payment for the goods typically by 30–90 days after the date of delivery of the goods.
Apart from the cost of capital, the credit risk of non-payment is borne by the exporter or his external
creditors.
49 In “cash in advance” the importer pays for goods ordered before the shipment of the goods by the
exporter. The importer is exposed to the transactional risk of non-delivery or delivery of low-quality
goods.
50 Letters of credit are mainly used to settle international trade transactions where a financial
intermediary offers trade finance against a fee. The importer’s local bank, which issues a letter of
credit assures payment after delivery and/or the exporter’s fulfillment of the obligations agreed upon
in the sale contract. The exporter commonly receives the payment via an advising or confirming
bank, which is usually the exporter’s local bank.
51 When using a letter of credit, the exposures to counterparty risks, i.e., both non-payment and
non-delivery risks for the traders are eliminated at the trading level. Since the importer’s bank
absorbs the credit risk, the exporter is exposed only to the comparatively lower risk of a bank
defaulting. Seemingly, for the fee paid to the issuing bank, the importer’s transactional risk is
reduced to the risk of receiving goods failing to meet quality requirements. Provided that these
goods are detected at the time of delivery, and consequently not be paid for, the importer’s
additional cost would then be restricted to eventual negative effects on the business in terms of
loss of sales, higher production costs, etc. For a detailed discussion on the topic see Ahn (2011).
52 Schmidt-Eisenlohr (2013).
52
A. Basu Bal and T. Rajput
and intermediated trade finance. In inter-firm trade credit, payments are transferred
directly from importer to exporter either after or before delivery through “open
account”
48 or “cash in advance”
49 payment terms, respectively. In intermediated
trade finance, a financial intermediary such as a bank issues a letter of credit
50 to the
importer to facilitate the trade with the exporter.
51 The typical letter of credit is a
sophisticated mechanism designed to mitigate the risks borne by exporters and
importers.
Intermediated trade finance is commonly used in both low and middle-income
countries, as traders rely on the credibility of financial intermediaries rather than the
credibility of trading partners. Since intermediated trade finance comes at a cost, its
use has been declining in high-income countries. This can be discerned from the
result of a survey on country-wise relevance of payment terms conducted by the
Association of Executives in Finance, Credit & International Business (FCIB).
52 The
study indicates that firms’ use of payment terms varies a lot across different
destination countries. The correlation seems to be strong between firm managers’
perceived riskiness of the destination country and the adoption of a specific payment
term. Although the letter of credit is a popular payment term for imports in China, the
overall use of letters of credit appears to be the least common payment term globally.
It has to a large extent been replaced by inter-firm trade finance in terms of open
account, which is a more competitive payment term. A most likely reason for the
popularity of open account in financially developed Northern and Western European
countries is simply because better enforcement mechanisms are generally available
in such jurisdictions that reduce the opportunity cost of adverse selection.
48 In “open account” the exporter extends a trade credit to the importer, which allows the latter to
postpone the payment for the goods typically by 30–90 days after the date of delivery of the goods.
Apart from the cost of capital, the credit risk of non-payment is borne by the exporter or his external
creditors.
49 In “cash in advance” the importer pays for goods ordered before the shipment of the goods by the
exporter. The importer is exposed to the transactional risk of non-delivery or delivery of low-quality
goods.
50 Letters of credit are mainly used to settle international trade transactions where a financial
intermediary offers trade finance against a fee. The importer’s local bank, which issues a letter of
credit assures payment after delivery and/or the exporter’s fulfillment of the obligations agreed upon
in the sale contract. The exporter commonly receives the payment via an advising or confirming
bank, which is usually the exporter’s local bank.
51 When using a letter of credit, the exposures to counterparty risks, i.e., both non-payment and
non-delivery risks for the traders are eliminated at the trading level. Since the importer’s bank
absorbs the credit risk, the exporter is exposed only to the comparatively lower risk of a bank
defaulting. Seemingly, for the fee paid to the issuing bank, the importer’s transactional risk is
reduced to the risk of receiving goods failing to meet quality requirements. Provided that these
goods are detected at the time of delivery, and consequently not be paid for, the importer’s
additional cost would then be restricted to eventual negative effects on the business in terms of
loss of sales, higher production costs, etc. For a detailed discussion on the topic see Ahn (2011).
52 Schmidt-Eisenlohr (2013).
52
A. Basu Bal and T. Rajput