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CHAPTER 18 FINANCING FOREIGN TRADE

This chapter is primarily factual, describing the various institutions and details involved in financing foreign trade. The most important documents encountered in bank-related financing are the draft, which is a written order to pay; the letter of credit, which is a bank guarantee of payment provided that certain stipulated conditions are met; and the bill of lading, the document covering title and actual shipment of the merchandise by a common carrier. Other documents of lesser importance include the commercial and consular invoices and insurance certificate. Key Points 1. The functions of these instruments, and hence the rationale for their existence, are: 2. To reduce both buyer and seller risk. To pinpoint who bears those risks that remain. To facilitate the transfer of risk to a third party. To facilitate financing.

Each instrument evolved over time as a rational response to the additional risks in international trade posed by greater distances, the lack of familiarity between exporters and importers, the possibility of government imposition of exchange controls, and greater costs involved in bringing suit against a party domiciled in another nation. The existence of government programs that provide subsidized export financing, such as the U.S. Eximbank, creates a market imperfection that MNCs can exploit to lower their risk-adjusted cost of funds. Countertrade has evolved in response to government efforts to control the allocation of foreign exchange. Although an inefficient means of conducting trade, it exists and should be understood.

3.

4.

SUGGESTED ANSWERS TO CHAPTER 18 QUESTIONS

1. What are the basic problems arising in international trade financing and how do the main financing instruments help solve those problems?

ANSWER . The main problems arising in international trade financing are the risks that both buyer and seller bear in
cross border trade, how to allocate those risks in a way that ensures that those best able to bear them or are in the best position to mitigate them do so, to facilitate the transfer of remaining risks to a third party, and to attain financing at as low a cost as possible. The principal financing instruments and mechanisms examined here are the letter of credit, banker's acceptance, factoring, forfaiting, and government export financing and credit guarantees. Letter of credit. The L/C eliminates credit risk to the exporter if the bank that opens it is of undoubted standing and it also reduces the danger that payment will be delayed or withheld owing to exchange controls or other political acts. Other risks that the L/C guards against are explained in the chapter. The L/C also facilitates financing because it ensures the exporter a ready buyer for its product. It also becomes especially easy to create a banker's acceptance. From the importer's standpoint, since payment is only in compliance with the L/C's stipulated conditions, the importer is able to ascertain that the merchandise is actually shipped on, or before, a certain date by requiring an on-board bill of lading.

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Banker's acceptance. With a banker's acceptance, the bank effectively substitutes its own credit for that of a borrower, and, in the process, it creates a negotiable instrument that may be freely traded. This feature lowers the cost of acceptance financing. A banker's acceptance helps an importer who does not have a close relationship with and cannot obtain financing from the exporter it is dealing with. Factoring. By factoring on a nonrecourse basis, exporters can shift to the factor all the credit and political risks on their foreign sales except for those involving disputes between the transacting parties. Even if an exporter chooses not to discount its foreign receivables with a factor, it can still use the factor's extensive credit information files to ascertain the creditworthiness of prospective customers. Despite its high costs, factoring can be quite worthwhile to many firms because the cost of bearing the credit risk associated with a given receivable can be substantially lower to a factor than to the selling firm. As the chapter notes, factoring is most useful for (1) the occasional exporter and (2) the exporter with a geographically diverse portfolio of accounts receivable. In both cases, it would be organizationally difficult and expensive to internalize the accounts receivable collection process. Such companies would generally be small or else would be involved on a limited scale in foreign markets. Forfaiting. This specialized factoring technique, which entails the discounting--at a fixed rate without recourse--of medium-term export receivables denominated in fully convertible currencies (U.S. dollar, Swiss franc, Deutsche mark). is useful in the case of extreme credit risk. Government sources of export financing and credit insurance. Most governments of developed countries provide their domestic exporters with low-cost export financing and concessionary rates on political and economic risk insurance. These credits and guarantees provide exporters with low-cost financing and shift risks to the government. Of course, there is a cost: Taxpayers get to bear these costs, although the risks may be lower since foreign governments may be more reluctant to interfere with payments to other governments than to private firms or banks. 2. The different forms of export financing distribute risks differently between the exporter and the importer. Analyze the distribution of risk in the following export financing instruments. Confirmed, revocable letter of credit.

a.

ANSWER . The revocable letter of credit can be revoked, without notice, at any time up to the time a draft is presented
to the issuing bank. As such, it is favorable to the importer, but the exporter loses the guarantee that funds will be available if she meets the conditions specified on the L/C. b. Confirmed, irrevocable letter of credit.

ANSWER . The confirmed, irrevocable L/C eliminates credit risk to the exporter if the banks that sign it are of
undoubted standing. Other advantages of an irrevocable L/C are detailed in the chapter. c. Open account credit.

ANSWER . Selling on open account is risky to the exporter because it has little evidence of the importer's obligation
to pay. The advantages come in the form of greater flexibility. But here the exporter bears virtually all the risk and the importer practically none. d. Time draft, D/A.

ANSWER . A time draft D/A removes some of the risk faced by the exporter. Documents evidencing title to the
merchandise are turned over to the importer only if the draft is accepted by the importer or his bank. The exporter still bears the risk of shipping goods that will be refused. In that case, the exporter must either sell the goods in the foreign market at a lower price or ship them home at added expense.

254 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED. e. Cash with order.

ANSWER . Cash payment at the time of order provides the exporter with the greatest protection, because payment is
received before he commits any of his funds. There is no risk of starting work on an order and then finding out that the order has been canceled. By contrast, the importer bears risk here because he has no guarantee that the exporter will perform the work as expected. f. Cash in advance.

ANSWER . Cash in advance, prior to shipment or upon delivery of the goods, provides the exporter with a great deal
of protection. The risk is that if cash is not received at the time the order is first processed, the exporter is out some of its cash if the order is canceled before payment is made. The importer bears risk because he has no guarantee that the goods requested will be delivered according to specifications. g. Consignment.

ANSWER . Sending goods on consignment provides some protection to the exporter because he retains title to the
goods until they are paid for. But this is a very risky method since there is little evidence of obligation to pay and it may be difficult to collect if the importer's government imposes currency controls. h. Sight draft.

ANSWER . With a sight draft, the importer receives no credit. This lessens the credit risk to the exporter. With a time
draft, by contrast, the exporter only knows at maturity whether the importer will honor it. As with a draft in general, credit risk is reduced because the shipper, acting on orders of the exporter, will not turn over the goods until payment is made. 3. Describe the different steps and documents involved in exporting motors from Kansas to Hong Kong using a confirmed letter of credit, with payment terms of 90 days sight. What alternatives are available to the exporter to finance this shipment?

ANSWER. The exporter will receive a letter of credit addressed to itself, written and signed by a bank acting on behalf
of the buyer. In the letter, the bank promises it will honor drafts drawn on itself if the seller conforms to the specific conditions set forth in the L/C. The exporter can use the L/C to finance its sale by sending a draft, signed by itself and addressed to the bank that confirmed the L/C, ordering the importer to pay in 90 days the amount specified on its face. When accepted by the confirming bank, this draft becomes a banker's acceptance that the exporter can then sell for cash to finance its shipment. To be honored when presented for payment, the draft must be accompanied by a commercial invoice containing an authoritative description of the engines being shipped, a clean bill of lading certifying that the engines were received in apparently good condition, an insurance certificate, and possibly a consular invoice, which is presented to the local consul in exchange for a visa. Of course, the exporter must manufacture the engines or take them out of inventory, deliver them to the cargo ship, take out the necessary insurance, and fill out the B/L, commercial invoice, and consular invoice (if required). Instead of using the L/C to arrange financing (by creating a B/A), the exporter can also arrange bank financing or use general corporate funds to finance its export. If it does the latter, it will hold onto the acceptance and then present it in 90 days and receive payment at that time. 4. a. Explain the advantages and disadvantages of each of the following forms of export financing. Bankers' acceptances

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ANSWER . The low-risk nature of bankers' acceptances mean that they trade at rates very close to those on CDS. That
is, the exporter can sell a banker's acceptance at a relatively small discount (the lower the interest rate, the lower the discount). On the other hand, there are additional costs attached to a banker's acceptance. Specifically, the accepting bank levies a fee, or commission, for accepting the draft. The bank also receives a fee if a letter of credit is involved. b. Discounting

ANSWER . An advantage of discounting is that the discount rate for trade paper is often lower than interest rates on
overdrafts, bank loans, and other forms of local funding. This lower rate is usually a result of export promotion policies that lead to direct or indirect subsidies of rates on export paper. A disadvantage is that there are often fees involved. c. Factoring

ANSWER . Through factoring, firms can shift credit risks to the factor, who is often in a better position to assess and
bear these risks, and also reduce their costs of the accounts receivable collection process. In addition,.by using a factor, a firm can ensure that its terms are in accord with local practice and are competitive. However, factoring can be quite expensive once account is taken of the fees involved. d. Forfaiting

ANSWER . This specialized factoring technique helps shift extreme credit risk to the forfaiter, usually a multinational
bank. Forfaiting also provides help with administrative and collection problems. As with factoring, these services can be expensive. 5. In order to "meet the competition" from its counterparts overseas, Eximbank will mechanically match the terms of a loan provided by a rival export-financing agency--including the interest rate--when it finances U.S. exports. What problems might arise from this rule of matching nominal interest rates?

a.

ANSWER . The effective subsidy associated with a particular interest rate equals the market interest rate minus the
interest rate actually charged. Since nominal interest rates vary substantially from one country to another, this means that an 8% yen interest rate from Japan can imply a very different level of subsidy than an 8% interest rate on lira from Italy. For example, suppose that the market interest rates from Japan and Italy on a particular export credit are 9% and 15%, respectively. The implied Japanese subsidy will be 1% while the implied Italian subsidy will be 7%. If the intent is to match subsidies, therefore, matching nominal interest rates is a very inefficient way to achieve that objective. b. As of January 15, 1988, the minimum interest rate on government-supplied export credits to rich countries was set at a flat rate of 10.4% for all nations providing such credits. What problems might arise with this rule? Comment on which governments would push for such a rule. Which would be against it?

ANSWER . Countries with high inflation rates tend to have high nominal interest rates while those with low inflation
rates tend to have low nominal interest rates. Thus the real interest rate implied by a given nominal interest rate will be very high for countries with low inflation rates and very low for countries with high interest rates. This means that at any given nominal interest rate, high inflation countries are able to subsidize their exports more than low interest rate countries. To take a not too extreme case, suppose that because of low inflation the nominal market interest rate in Germany is only 7%, while high French inflation results in a nominal interest rate in France of 12%. If the minimum interest rate on government- supplied export credits is 10.4%, then the German government will be forced to charge an above-market rate, while the French government will be able to provide a 1.6% (12% - 10.4%) interest subsidy. It should be obvious that high inflation countries will push for setting maximum rates in nominal terms, while low-inflation countries will be against such a policy.

256 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED. c. How should minimum interest rates on export credits be set so as to ensure comparability across countries?

ANSWER . The best approach would be to tailor the minimum rate to each country according to its level of nominal
interest rates. A simple implementation of this approach could involve setting the minimum rate equal to the risk-free rate in the country for a loan of that maturity plus or minus a constant S. For example, if S is set equal to -2%, then a country whose nominal risk-free rate is 10% would have to charge a minimum rate of 8%, and a country with a nominal risk- free rate of 6% would have to charge a minimum rate of 4%. d. Suppose that instead of subsidizing interest rates, governments turn to export insurance subsidies. Is this move an improvement vis --vis export-credit subsidies? Explain.

ANSWER . The most important aspect of providing export-credit insurance subsidies instead of subsidizing interest
rates on export credits is that with the former the subsidy is limited to the difference between the market interest rate and the risk-free interest rate. In contrast, with interest rate subsidies, the interest rate on export credit can fall below the risk-free rate. In other words, the maximum possible subsidy with export-credit insurance is less than the maximum possible subsidy with interest rate subsidies. e. Why has the U.S. government fought against export-credit subsidies?

ANSWER . They are expensive and lead to misallocation of resources: Unprofitable deals get done. Thus, a nation that
subsidizes exports simply gives away part of its wealth. Moreover, it is doubtful that export subsidies really improve the trade balance. Any increase in exports achieved by a subsidy must necessarily increase the demand for dollars by foreign purchasers of U.S. goods. The increase in demand will boost the dollar's value, encouraging imports and discouraging unsubsidized exports. If investment and savings are unaffected, the trade deficit will not respond to export subsidies. 6. One of the purposes of Eximbank is to absorb credit risks on export sales that the private sector will not accept. Comment on this purpose.

ANSWER . The private sector is always willing to absorb credit risks, but not necessarily at a low price. By providing
low-cost export credits, the government causes uneconomical deals to get done. That is, the government is sending out the wrong signals about the profitability of doing certain deals. The exporter gets the benefits from any export sales while the taxpayer gets stuck with the cost of any credit that defaults. That is, poor foreign credit risks receive low-cost financing, and taxpayers subsidize these bad risks. 7. Comment on the following statement: "Eximbank does not compete with private financial institutions. It offers assistance only in cases in which the export-credit transaction would not take place without its help. Eximbank does not offer direct-loan assistance to foreign buyers when private institutions will provide comparable financing on reasonable terms."

ANSWER . The market always provides financing on "reasonable" terms. Competition among financial institutions
ensures that. But "reasonable" does not necessarily mean low cost. If foreign customers are risky, then the interest rate charged by the market will be high. No private lender will supply funds at 8% if the market rate is 14%. Thus, the Eximbank will find that if it sets a below-market rate on its loans, no private institution will provide comparable financing on the same terms. Although the Eximbank might view this as a problem, most financial economists would not. 8. These questions relate to the Foreign Credit Insurance Association. a. Describe the different risks covered by FCIA. Why does the FCIA require coinsurance?

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ANSWER . FCIA insurance offers protection from political and commercial risks to U.S. exporters: The private
insurers cover commercial risks, and the Eximbank covers political risks. The exporter (or the financial institution providing the loan) must self-insure that portion not covered by the FCIA. Short-term insurance is available for export credits up to 180 days (360 days for bulk agricultural commodities and consumer durables) from the date of shipment. Coverage is of two types: comprehensive (90%-100% of political and 90%-95% of commercial risks) and political only (90%-100% coverage). Under the FCIA lease insurance program, lessors of U.S. equipment and related services can cover both the stream of lease payments and the fair market value of products leased outside the United States. The FCIA charges a risk-based premium that is determined by country, lease term, and the type of lease. Coinsurance is required presumably because of the element of moral hazard: the possibility that exporters might take unreasonable risks knowing that they would still be paid in full. b. What factors affect the insurance premium charged by the FCIA?

ANSWER . The greater the loss experience associated with the particular exporter and the countries and customers it
deals with, the higher the insurance premium charged. The rates depend on the terms of sale, with longer-term sales bearing higher rates. c. Describe the basic features of a typical FCIA short-term policy.

ANSWER . Rather than sell insurance on a case-by-case basis, the FCIA approves discretionary limits within which
each exporter can approve its own credits. Insurance rates are based on the terms of sale, type of buyer, and the country of destination and can vary from a low of 0.1% to a high of 2%. The FCIA also offers preshipment insurance up to 180 days from the time of sale. d. Describe the basic features of a typical FCIA medium-term policy.

ANSWER. Medium-term insurance is guaranteed by Eximbank and covers big-ticket items sold on credit usually from
181 days to five years. It is available on a case-by-case basis. As with short-term coverage, the exporter must reside in, and ship from, the United States. However, the FCIA will provide medium-term coverage for that portion only of the value added that originated in the United States. 9. Low-cost export financing is often a bad sign. Explain.

ANSWER . A country that has a comparative advantage in the manufacture of certain products does not need to provide
subsidies such as low-cost financing to stimulate exports of those products. Its cost advantage will suffice. Thus, the fact that a nation feels it must subsidize export sales to be competitive could indicate that it is a high cost producer. Of course, the possibility always remains that the country is cost competitive but uses subsidies to counter the subsidies that foreign competitors receive. 10. What is countertrade? Why is it termed a sophisticated form of barter?

ANSWER . Countertrade involves purchasing local products to offset the exports of their own products to that market.
Countertrade is a form of barter because both involve swapping goods for goods. Countertrade transactions are often very complex, involving two-way or three-way transactions, especially where a company is forced to accept unrelated goods for resale by outsiders. In this way, countertrade is a sophisticated form of barter; that is, it may involve more than two parties and a number of transactions. 11. What are the potential advantages and disadvantages of countertrade for the parties involved?

258 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.

ANSWER . Countertrade is less efficient than using cash or credit because the products taken in trade are not liquid.
Sellers factor these costs into the price they charge countertrading buyers. Both parties, therefore, bear costs. A principal problem for countertraders is that it causes them to lose sight of the market that they are in. By failing to deal directly with customers, the countertrader never learns what the market really wants or how it might improve its competitiveness. Countertrading also creates other problems. First, the goods that can be taken in countertrade are usually relatively undesirable. Those that can be readily converted into cash already have been. So although a firm shipping computers to Brazil might prefer to take coffee beans in return, the only goods available might be Brazilian shoes. Second, the details are difficult to work out (how many tons of naphtha is a pile of shoddy Polish goods worth?). The inevitable result is a high ratio of talk to action; only a small percentage of deals that are talked about getting done. Lost deals cost money. There are few advantages to countertrading as an economic means of transacting. About the best that can be said for the recipient is that it is preferable to having no sales in a given market. Countertrading may also permit countries to cheat on the cartels they belong to by effectively underpricing their products. Countertrade may also reduce the risk faced by a nation that contracts for a new manufacturing facility. If the contractor's payment is taken in the form of goods supplied by the facility, he has a strong incentive to do quality work and to ensure that the technology and equipment are appropriate for the workforce's skill level, available materials, and so on.

SUGGESTED SOLUTIONS TO CHAPTER 18 PROBLEMS

1. Texas Computers (TC) recently has begun selling overseas. It currently has 30 foreign orders outstanding, with the typical order averaging $2,500. TC is considering the following three alternatives to protect itself against credit risk on these foreign sales: a. Request a letter of credit from each customer. The cost to the customer would be $75 plus 0.25% of the invoice amount. To remain competitive, TC would have to absorb the cost of the letter of credit. Factor the receivables. The factor would charge a nonrecourse fee of 1.6%. Buy FCIA insurance. The FCIA would charge a 1% insurance premium.

Which of these alternatives would you recommend to Texas Computers? Why?

ANSWER . The L/C will cost TC an average of $81.25 ($75 + 0.0025*$2,500) per order, or a total of $2,437.50 (30
x $81.25). The factoring alternative will cost an average of $40 (0.016 x $2,500) per order, or $1,200 in all. The FCIA insurance will cost an average of $25 (0.01 x $2,500) per order, or $750 in all. Thus, the least expensive alternative is the FCIA insurance. b. Suppose that TC's average order size rose to $250,000. How would that affect your decision?

ANSWER . If TC's average order size rises to $250,000, then the L/C will cost an average of $700 per order ($75 +
0.0025 x $250,000), or $21,000 in total. The FCIA insurance will cost an average of $2,500 per order, or $75,000 in total. Thus, the L/C is now the least expensive alternative (factoring is dominated by the FCIA insurance). 2. L.A. Cellular has received an order for phone switches from Singapore. The switches will be exported under the terms of a letter of credit issued by Sumitomo Bank on behalf of Singapore Telecommunications. Under the terms of the L/C, the face value of the export order, $12 million, will be paid six months after Sumitomo accepts a draft drawn by L.A. Cellular. The current discount rate on 6-month acceptances is 8.5% per annum and the acceptance fee is 1.25% per annum. In addition, there is a flat commission, equal to 0.5% of the face amount of the accepted draft, that must be paid if it is sold.

CHAPTER 18: FINANCING FOREIGN TRADE a. How much cash will L.A. Cellular receive if it holds the acceptance until maturity?

259

ANSWER . If L.A. Cellular chooses to hold the acceptance, then in six months it will receive the face amount of $12
million less the acceptance fee of 0.625% (1.25%/2): Face amount of acceptance Less: 1.25% per annum commission for six months Amount received by L.A. Cellular in six months $12,000,000 - 75,000 ________ $11,925,000

b.

How much cash will it receive if it sells the acceptance at once?

ANSWER . By selling the acceptance at once, paying the 0.5% selling commission, and taking the 4.25% discount
(8.5%/2), L.A. Cellular will receive $11,355,000 immediately: Face amount of acceptance Less: 1.25% per annum commission for six months Less: 8.5% per annum discount for six months Less: 0.5% selling commission Amount received by L.A. Cellular immediately c. $12,000,000 - 75,000 - 510,500 - 60,000 ________ $11,355,000

Suppose L.A. Cellular's opportunity cost of funds is 8.75% per annum. If it wishes to maximize the present value of its acceptance, should it discount the acceptance?

ANSWER . Given that L.A. Cellular's opportunity cost of money is 8.75%, then the present value of holding onto the
acceptance is $11,925,000/(1 + (.0875/2)), or $11,425,150 (remember, it must pay the $75,000 commission in any case). Since this figure exceeds the amount of money it would receive from discounting the acceptance, L.A. Cellular should hold onto the acceptance. 3. Suppose Minnesota Machines (MM) is trying to price an export order from Russia. Payment is due nine months after shipping. Given the risks involved, MM would like to factor its receivable without recourse. The factor will charge a monthly discount of 2% plus a fee equal to 1.5% of the face value of the receivable for the nonrecourse financing. If Minnesota Machines desires revenue of $2.5 million from the sale, after paying all factoring charges, what is the minimum acceptable price it should charge?

a.

ANSWER . At a monthly discount of 2%, and an extra 1.5% fee for nonrecourse financing, Minnesota Machines will
pay a total fee equal to 19.5% (9 x 2% + 1.5%) of the face amount of its price for factoring its nine-month export receivable without recourse. In other words, after paying all factoring fees, MM will clear 80.5% of the price it sets. Thus, in order to net $2.5 million on its export sale, MM must set a price P such that .805P = $2,500,000. The solution to this equation is P = $3,105,590. This is the minimum acceptable price to MM. b. Alternatively, CountyBank has offered to discount the receivable, but with recourse, at an annual rate of 14% plus a 1% fee. What price will net MM the $2.5 million it desires to clear from the sale?

ANSWER . If MM decides to discount the receivable with CountyBank, it will pay a total fee equal to 11.5% (.75 x
14% + 1%). Thus, in order to net $2.5 million on its export sale, MM must now set a price P* such that .885P* = $2,500,000, or P* = $2,824,859.

260 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED. c. Based on your answers to parts a and b, should Minnesota Machines discount or factor its Russian receivables? MM is competing against Nippon Machines for the order, so the higher MM's price, the lower the probability that its bid will be accepted. What other considerations should influence MM's decision?

ANSWER . Based purely on net revenue, MM should plan on discounting its receivable. However, this would expose
it to credit risk. Credit risk reduces MM's expected revenue from this sale (at the extreme it may receive nothing, if Russia defaults). This brings up two issues. First, is the price charged by the factor reasonably reflective of the risk of default or delay in receipt of payment? If so, then MM's expected revenue from the sale at a given price will be the same from discounting or factoring even though the most likely revenue will differ. Second, how risk averse is MM? The more risk averse it is, the more reason for factoring its receivable. Most likely, the factor is charging a fair price for the risks involved. In that case, MM will be receiving the benefits of the factor's credit risk analysis and collection skills. In fact, as pointed out in the text, the cost of bearing the credit risk associated with MM's Russian receivable may be substantially lower to the factor than to MM. If so, then MM will actually get a better deal with factoring then with discounting. A more important issue here is the price that MM should charge. Although MM desires revenue of $2.5 million from this sale, that may not be its minimum acceptable revenue. As a Japanese firm, Nippon is likely to focus on market share and so will probably compete very strongly on price. MM will therefore have to price its sale as low as possible. In setting a price, MM should consider the possibility of future sales stemming from this initial order. To the extent that there will be follow-up orders for additional units, parts, and service, MM might consider settling for a lower profit this time around in the expectation that it will make higher profits on future sales. d. What other alternatives might be available to MM to finance its sale to Russia?

ANSWER . MM may be able to take advantage of a government export financing agency to provide it with lower cost
funds. Alternatively, MM may be able to receive low-cost government export insurance, thereby eliminating credit risk at a relatively low price.