International Trade Financing

Foreign trade differs from domestic trade with respect to the instruments and documents employed. Most domestic sales are an open account credit; the customer is billed and has so many days in which to pay. In international trade, sellers are seldom able to obtain as accurate or as thorough credit information on potential buyers as they are in domestic sales. Communication is more cumbersome and transportation of the goods is slower and less certain. Moreover, the channels for legal settlement in cases of default are more complicated and more costly to pursue. For these reasons, procedures for international trade differ from those for domestic trade. There are three key documents: an order to pay, or draft; a bill of lading, which involves the physical movement of the goods; and a letter of credit, which guarantees the creditworthiness of the buyer. We examine each in turn.

THE TRADE DRAFT

The international draft, sometimes called a bill of exchange, is simply a written statement by the exporter ordering the importer to pay a specific amount of money at a specific time. Though the word "order" may seem harsh, it is the customary way of doing business internationally. The draft may be either a sight draft or a time draft. A sight draft is payable on presentation to the party to whom the draft is addressed. This party is known as the drawee. If the drawee, or importer, does not pay the amount specified upon presentation of the draft, he defaults and redressment is achieved through the letter of credit arrangement to be discussed later. A time draft is payable so many days after presentation to the drawee. A 90 day time draft indicates that the draft is payable 90 days after sight. An example of a time draft is shown in Fig. 24 2.

Several features should be noted about the draft. First, it is an unconditional order in writing signed by the drawer, the exporter. It specifies an exact amount of money that the drawee, the importer, must pay. Finally, it specifies an exact interval after sight at which time this amount must be paid. Upon presentation of the time draft to the drawee, it is accepted. The acceptance can be by either the drawee or a bank. If the drawee accepts the draft, he acknowledges in writing on the back of the draft his obligation to pay the amount specified 90 days hence. The draft then is known as a trade acceptance. If a bank accepts the draft, it is known as a bankers' acceptance. The bank accepts responsibility for payment and thereby substitutes its creditworthiness for that of the drawee.

If the bank is large and well known and most banks accepting drafts are the instrument becomes highly marketable upon acceptance. As a result, the drawer, or exporter, does not have to hold the draft until the due date; he can sell it in the market. In fact, an active market exists for bankers' acceptances of well-known banks. A 90 day draft for $10,000 may be accepted by a well known bank. Say that 90 day interest rates in the bankers' acceptance market are 12 percent. The drawer then could sell the draft to an investor for $9,700, or $10,000 [$10,000 X .12(90/360)]. At the end of 90 days, the investor would present the acceptance to the accepting bank for payment and would receive $10,000. Thus, the existence of a strong secondary market for bankers' acceptances has facilitated international trade by providing liquidity to the exporter.

BILLS OF LADING

A bill of lading is a shipping document used in the transportation of goods from the exporter to the importer. It has several functions. First, it serves as a receipt from the transportation company to the exporter, showing that specified goods have been received. Second, it serves as a contract between the transportation company and the exporter to ship the goods and deliver them to a specific party at a specific point of destination. Finally, the bill of lading can serve as a document of title. It gives the holder title to the goods. The importer cannot take title until he receives the bill of lading from the transportation company or its agent. This bill will not be released until the importer satisfies all the conditions of the draft.

The bill of lading accompanies the draft, and the procedures by which the two are handled are well established. Banks and other institutions able to handle these documents efficiently exist in virtually every country. Moreover, the procedures by which goods are transferred internationally are well grounded in international law. These procedures allow an exporter in one country to sell goods to an unknown importer in another and not release possession of the goods until paid, if there is a sight draft, or until the obligation is acknowledged, if there is a time draft.

LETTERS OF CREDIT

A commercial letter of credit is issued by a bank on behalf of the importer. In the document, the bank agrees to honor a draft drawn on the importer, provided that the bill of lading and other details are in order. In essence, the bank substitutes its credit for that of the importer. Obviously, the local bank will not issue a letter of credit unless it feels the importer is creditworthy and will pay the draft. The letter of credit arrangement almost eliminates the exporter's risk in selling goods to an unknown importer in another country, Facilitation of Trade. From the description, it is easy to see why the letter of credit facilitates international trade. Rather than extending credit directly to an importer, the exporter relies on one or more banks, and their creditworthiness is substituted for that of the importer. The letter itself can be either irrevocable or revocable, but drafts drawn under an irrevocable letter must be honored by the issuing bank. This obligation can be neither canceled nor modified without the consent of all parties. On the other hand, a revocable letter of credit can be canceled or amended by the issuing bank. A revocable letter specifies an arrangement for payment but is no guarantee that the draft will be paid. Most letters of credit are irrevocable, and the process just described assumes an irrevocable letter.

The three documents described the draft, the bill of lading, and the letter of credit are required in most international transactions. Established procedures exist for doing business on this basis. Together, they afford the exporter protection in selling goods to unknown importers in other countries. They also give the importer assurance that the goods will be shipped and delivered in a proper manner. The financial manager should be acquainted with the mechanics of these transactions if the firm is engaged in exporting or importing.