Trade Payments - Advance remittance

I will be covering various types of trade payments in this and coming articles

As has been stated earlier trade can happen through any of the following methods

a.       Advance payments

b.      Collections

c.       Letters of Credit

d.      Bank Guarantees / Standby Letters of Credit

e.      Consignment / on account sales

Advance Payments

As the name indicates this simply denotes cash-and-carry type of trade. The purchaser / importer has to remit the funds in advance to the seller / exporter for goods to be transported on realization.

 The reasons for this kind of trade are several

i.                     Purchaser is new in business

ii.                   Purchaser does not have any track record with the seller

iii.                 Purchaser approached the seller directly and does not have any references to whom 

              seller can relate to

iv.                 Demand for goods is more than the supplies

v.                   Purchase amount is small and is not viable for other modes of trade payments

vi.                 The product is so customized / specially manufactured that finding other buyers is  very difficult

The advantage of this method of payments is that there are no hassles and additional costs like interest loading on credit period etc.

Sellers / Exporters holds the maximum advantage in this kind of trade. They receive the payment in advance and can transport the product afterwards. We have often observed that the buyer sends the remittance in advance and receives the goods only after a gap of nearly 90 – 180 days. This means the seller starts manufacturing the goods only after receipt of funds.

Buyer / Importer will be at a disadvantage. He has to part with the money upfront and wait for the receipt of goods. Even then there is no guarantee that he will be receiving the goods of the same quality and quantity and upto his specifications.  There are instances where the importers were cheated by fly-by-night operators. Though they can resort to arbitration and legal avenues for settlement of disputes and claims, they will be very costly and most often the buyer has to engage somebody in the country of the seller for resorting to these remedies. One more avenue available to the buyer is to demand the seller to forward a guarantee from a reputed Bank in the country of the seller or a guarantee from a banker in his own country that the goods will be supplied against the advance remittance and on failure to supply can demand payment under the guarantee. In all such cases the seller will demand the cost of guarantee (bank commission etc) over and above the invoice value.

However this may not work in cases iv, v or vi above as the seller holds all the advantages and may not be ready to provide a guarantee of this type. Also if the seller is highly reputed while the buyer is very small trader then also their demand for a guarantee will not work.

Trade & Trade Finance - Instruments for Finance

Trade Finance relates to the activity of financing by financial institutions for the increase of trading activity between two entities either in the country (domestic) or across borders (international). Unlike the other types of financial services / instruments like overdrafts, cash credits, term loans etc., which can be used for any purpose this particular class of instruments fall under the class of Trade Finance because as explained above they are meant specially for financing trade activities generally between merchants, an agent and a merchant or between agents / brokers.

Let us look at the instruments –

• Letters of Credit (L/C)
• Guarantees
• Bills Discounting / Purchase /Acceptances
• Factoring / Forfaiting
• Pre and Post-shipment Finance
• Buyers and Suppliers Credit
• Structured Financial Instruments like collateralization

 We will be looking at each of these in coming articles.

Trade & Trade Finance

Trade is exchange of goods & services between two entities. The entities can be individuals, firms, companies or even nations / government agencies. The trade can be in the form of cash for goods, cash for services, goods for services or even goods for goods. The last one is known as barter and it even happen now. The location of these entities for the purpose of trade is immaterial, they can be located in the same city, same state, same country or even different countries. When they are located in the same country it is known as domestic trade and when they are located across borders of two nations it is international trade. The requirements of trading instruments, finance etc., will be different based on whether it is domestic or international.

Let us look at the process of trade between two entities. Let us take the assumption that these two entities are located in two different countries. That is we are talking about the trade across the borders.

The main limiting factors or entry barriers for trade can be any of the following

•     Trade Customs & Practices
•     Language
•     National Laws
•     Knowledge about the business entity
•     Trade Terms (also known as Inco Terms)

The importer / exporter starts with a disadvantage. The need to understand what are the trading practices in the country with which they are going to deal, how much time is taken for transportation of goods, what are the documents required for domestic and foreign government customs departments, what will be the charges for transportation and more importantly the reliability of the counter party are necessary for success of a trade transaction.

Now a days a lot of information is available from the internet about the above points which can be used to a certain extent. There are websites which bring the buyers and sellers together and there are even website which specialize in acting as an exchange between the buyers and sellers of particular products. We can look at the examples like www.alibaba.com, B2B (business to business) portals like www.tradeindia.com, www.export-japan.com, exporters directories available on the net etc. There are even some websites like ebay which specialize in auctioning where an item can be put up for auction and the products can be sold. However these latter sites may not be of much use for serious exporters or importers as they in general deal with collection items like stamps etc.

Continuing with the difficulties in identifying a counter party, a visit to the country concerned will add further to the knowledge. However the most tricky part is getting details about the reliability of the counter party. This applies to both sides, what if the exporter sends junk instead of the goods purchased after getting the money? Or simply vanishes away after receiving money from the importer? Or what if the importer becomes bankrupt to release the good sent by exporter? Or disputes the quality of the goods and pays only after a long time or does not pay at all or again as above simple vanishes away with the goods? These are the incidents which are happening even today particularly with the increasing global trade. There are some agencies called rating agencies which provide the rating of the individuals, firms, companies in the developed countries like Dun & Bradstreet. However these ratings are optional and may not be available everywhere. What if we want to sell goods to a person in say Eritria or Mongolia thinking that there is good business opportunity there. Firstly it is very difficult to locate these countries in the world map and secondly we might be asking for too much if we look for a rating agency.

We can see how trade can still flow and what are the remedies / mitigants available for these concerns. To mitigate these possibilities and based on the trust the trading entities generally resort to the following methods

Advance Payment – Cash and Carry

Collections – Forward the documents through the bankers to other party’s

                     bankers for the trade proceeds

Letters of Credit – A trade finance instrument guaranteeing payment based on

                            documents submitted

Open Account – Consignment trading ie send the goods in consignments and

                      receive payments / proceeds

If you plot these available options on a scale of trust and risk it looks like this

From the view point of an exporter the above graph shows that they will be comfortable with the options of Advance Payments, Letters of Credit, Collections and Open Account in that order because of the risk involved. The choice will be reverse for an importer. It starts from Open account and goes towards Advance payments. The two instruments available in the middle viz., Collections and Letters of credit offer a little comfort to both the exporters and importers. Of these two, with a better structuring and controls incorporated the Letters of Credit offer a better choice for both importers and exporters and hence the predominance of this particular instrument in the world trade.

We will be looking at these over the next series of Articles.