FRAMEWORK & PRINCIPLES OF INTERNATIONAL BANKING INTERNATIONAL TRADE COMMERCE

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1 FRAMEWORK & PRINCIPLES OF INTERNATIONAL BANKING INTERNATIONAL TRADE COMMERCE

2 INDEX 1. Introduction 3 2. International means of collection and payment Classification of the means of payment Remittance Documentary credits Conclusions International cash management Cash pooling international Swift Net Financing on foreign trade operations Working capital financing for imports International confirming International leasing Working capital financing for exports International factoring International forfaiting Export finance Risks in international operations Definitions and types of risks Political-country risk Commercial risk Financial risks Extraordinary risks Sureties and guarantees Summary of basic risks Foreign trade risk insurers

3 1. INTRODUCTION Domestic trade and international trade share the same characteristics. International trade is essential for sustainability and economic growth. International trade and foreign trade have different characteristics. The internationalization of a company involves the exports and imports and the direct investment. Trade, either domestic or international have, in general terms, the same attributes and basic characteristics. At present, international trade is of great importance for all countries involved, not only in economical but also political. Through their participation in this activity, countries are able to develop various strategies, attitudes and positions that will not only produce foreign incomes- essential for growing and sustaining a healthy economy-but also it gives presence and signification on the international arena. The terms international trade and foreign trade are often used interchangeability. However, in their strictest sense, there is a fundamental difference. > International trade. This is the activity as a whole, that is to say the set of guidelines, requirements, directives and rules governing the activity itself, regardless of the specific countries concerned. > Foreign trade. This is the economic and legal relationship that exists in a given place and time between two or more countries, specifically identified. Finally, with one or other perspective, it should be understood when talking about internationalization of a company, that export refers to the sale of its goods or services for consumption or use in a different origin customs territory; that import refers to the purchase of goods or services for consumption or use in its customs territory, and that direct investment referes, when placed in a foreign country capital for the creation or purchase of assets (companies) with the purpose of establishing a permanent base of the company in that country

4 Show what you know The difference between international trade and foreign trade is: a. Foreign trade is the activity as a whole, irrespective of the country or countries involved, whereas international trade is all of the exports made by one specific country. b. Foreign trade is the political and economic relations established between any two countries over time, whereas international trade is the activity between different countries at a specific moment. c. International trade is the activity as a whole, irrespective of the country or countries involved, whereas foreign trade refers to the economic and legal relationship existing in a determinate time and place between two or more specified countries. d. Foreign trade is the activity as a whole taking place between different countries, whereas international trade refers to the legal and international relations between two specific countries. Correct answer: c - 4 -

5 2. INTERNATIONAL MEANS OF COLLECTION AND PAYMENT The means of payment and collection used in international transactions are different to those used in domestic markets. Depending on whether they are subject to documents handling, the means of payment may be simple or documentary. Remittance is the processing banks perform on the financial or commercial documents generated in commercial transactions. These may be simple or documentary remittances. With letters of credit, the issuer entity pays an amount to the exporter in the name of the importer through the exporter s bank, against the presentation of certain documents and within a time limit. Documentary credits may relate to imports or to exports. There are also other different types of documentary credits. The means of payment and collection used in international transactions have certain aspects in common that set them apart from those used in sales and purchase operations in domestic markets. Means of payment involve payment for those of whoever is purchasing (buyer, importer) and means collection involve collection for those of whoever is selling (seller, exporter). From now on it will use either one name or another, but it will always be referring to both, the sale and the purchase. The choice of payment means must be agreed between the buyer and the seller and must be clearly stated and put in writing the commercial contract. One of the main concerns of a company when it should start selling in foreign countries is difficult to really know the customer. In national operations it is relatively simple to obtain references or data on any companies from which an order is received, but all of this become much more complex when other countries are involved

6 In addition to the language barrier and lack of local knowledge, there is also less certainty about information sources to which use to go or how to find it. It is always possible to turn to specialist consultants or state bodies present in other countries (for example the Spanish Institute for Foreign Trade ICEX), but the uncertainty over whether payment for the sales will eventually be received is one that will always remain. In all commercial transactions there is an exchange of goods or services, for which payment can be made in accordance with three different scenarios. Payment before delivery or advance payment The importer receives the goods after having made the payment, with the corresponding risk of losing the money. This suggests that the seller does not have full trust in the buyer, and conversely, that the buyer has a large amount of trust in the seller. Payment at the time of delivery or cash payment This involves risks for both parties, depending on the method of payment agreed upon. It makes necessary for the seller to present the goods and deliver the necessary documents for their transmission against cash on delivery. Payment after receiving the goods A deferred payment represents a risk for the exporter, whereas the importer receives a kind of financing. This is a regime of confidence in the buyer by the seller. In light of all this, the choice of means of payment must be based upon: The position of strength in negociation between buyer and seller; the trust between the two parties; the presence of third parties (banks) increasing the trust between the two parties

7 2.1. Classification of the means of payment Depending on whether or not they are subject to the management of financial and/or commercial documents, means of payment can be classified as follows: Simple means of payment These are based on relationships where there is a high level of trust between the two parties. The commercial documents are not tied in with the payment. These means of payment are bank notes, personal checks, bank checks (or drafts) and payment orders. Documentary means of payment These provide both the buyer and the seller with added security, as the movement of the funds is tied to the exchange of financial and/or commercial documents. These means of payment are the remittance and the documentary credit. In the context of the European Union, it is essential to talk about SEPA (Single Euro Payments Area), an area in which companies, citizens and other operators can make and receive payments in euros under the same basic conditions and with the same rights and obligations, regardless of their location and the fact that the payments may cross borders. SEPA is a new harmonized way in which payments in euros can be made, principally using three main instruments: transfers (or payment orders), direct debits, and payment cards. The SEPA territory currently consists of the 28 countries in the EU, the 4 countries from the EFTA (Iceland, Liechtenstein, Norway and Switzerland) and the special cases of Monaco and San Marino. As remittances and letters of credit are more specific means for foreign trade payment, the focus here will be on analyzing in more detail these two means of payment

8 2.2. Remittance Remittance (or collection) is the processing banks perform, in accordance with instructions received, on the financial and/or commercial documents generated in a commercial operation. The financial documents are the instruments to obtain payment, for example bills of exchange, promissory notes, checks, etc., whereas the commercial documents (for example invoices, shipping documents, insurance documents, etc.) are those required to take control of the goods, customs clearance, etc. Bill collections are regulated internationally by the International Chamber of Commerce (Uniform Rules for Collections, Publication No. 522). This publication regulates and standardizes the relationships, obligations and responsibilities of the various parties involved. The uniform rules for collections regulate handling of collections as well as the relationships, obligations and responsibilities of the parties involved, whenever this is established in the collection instruction. Remittances are means of payment whereby the initiative for debt cancellation is taken by the exporter putting into circulation the documents requested, whether financial and /or commercial. Remittances are a revocable means of payment Simple remittances Simple remittances (or clean remittance) involve financial documents (bills of exchange, drafts, checks, promissory notes, etc.) that the exporter issues on the importer for the amount, time and currency agreed upon and enable the exporter to manage the collection for operations through a financial entity. They are a revocable means of payment. There are two types of simple remittance, based on the time limit for payment

9 At sight drafts. These relate to remittances involving cash payments. The financial document agreed upon is usually a bank draft or a bill of exchange at sight. Time drafts. These relate to remittances with deferred payments. The financial document agreed upon is usually a bank draft, a bill of exchange or a promissory note payable on maturity, which will have been agreed upon by the exporter and the importer

10 In simple or clean remittances there are only documents relating to payment and acceptance of payment, i.e. financial documents. The commercial documents, used for customs clearance and for the transfer of ownership of the goods, are submitted (separately from the bank s handling of the payment) by the exporter directly to the importer, who commits to accepting the payment obligations when the bank presents them with the financial document involved in the clean collection Documentary remittance Documentary remittance is a means of payment whereby the exporter entrusts its financial entity with the collection operation involving the set of export documents agreed upon with the importer, which may or may not be accompanied by financial documents. The commercial documents proving ownership of the goods and detail the operation. They are delivered to the importer by the collecting bank upon payment of the amount or acceptance of the financial document, so the importer may withdraw the goods at the place of destination. As with simple remittance, there are various distinct types of documentary remittances based on the time limit for payment. Remittance against payment Payment for the goods in cash depends upon delivery of their corresponding documentation (those proving ownership, shipping documents, etc.). The exporter gives instructions to its bank for them to manage the collection of the (commercial and/or financial) documents against payment. Remittance against acceptance These are collections with payment deferred to a specified maturity date. The exporter issues a financial document to the importer with a determinate maturity period, and gives instructions to its bank for them to manage acceptance on the part of the importer. This procedure involves including a financial document along with all of the commercial documents. Collections against Remittance against acceptance and bank guarantee These are a kind of third category of remittances against acceptance and with deferred payment. The extra element included in this category is a request for a bank guarantee covering payment of the debt. In practice, these are no longer used very much, as to provide a guarantee people usually choose to directly issue a documentary credit

11 For exporters, the main advantage of documentary remittance is that they will keep possession of the documents and therefore of goods until the importer makes the payment or accepts the financial document. It must also be taken into consideration that the exporter is in a better position as regards financing, as it is the remitting bank who has the control of the remittance operation. Furthermore, as in simple remittances, it is the exporter that initiates the collection operation. Documentary remittance do not provide extra security of receiving payment, and may revoked and cancelled at any moment. They will only add security when there is also issued a bank garantee

12 2.3. Documentary credits Documentary credits (also called letter of credit) are the most significant payment method in international trade, because it is the one that best protects the interests of the parties. It is the ideal mean of payment when exporter and importer are not known and distrust of each other. This is an agreement under which the issuing bank, at the request of the applicant (importer) and in accordance with its instructions, commits to paying the beneficiary (exporter) through its bank an amount against the presentation of certain documents within a period of validity established for the credit and under the terms and conditions agreed upon. The International Chamber of Commerce s most recently published edition of the Uniform Customs and Practice for Documentary Credits is UCP 600. These rules apply to all types of documentary credits, provided that the text of the credit expressly indicated. This means of payment is unique in being irrevocable, and as a result its use continues to grow and achieve ever wider levels of acceptance among parties involved in international operations. This means of payment appeared as a consequence of the internationalization of commercial transactions, as opening up to new markets meant a reduced potential for parties to know each other well. Other influential factors include any economic and/or political instability in the importer and exporters countries. This all serves to indicate that the importer does not have much trust in the exporter, not wanting to pay before receiving the goods, and that the seller likewise has some misgivings about the solvency and good faith of the buyer, not wanting to ship the goods without having received reimbursement for their export. Documentary credit provide an internationally accepted way of achieving commercial commitments, as the operation is backed up by the involvement of financial entities. The issuing of a documentary credit constitutes a firm commitment to payment, acceptance of bank drafts or negociation on the part of the issuing bank. This means that once the credit has been issued, changes are only possible if all of the interested parties are in shared agreement

13 Parties involved and process Parties involved in documentary credits Applicant This is the natural person or organization that makes the request to the financial entity for the opening of a documentary credits, indicating the conditions and committing to payment, provided the terms and conditions of the credit are met. Normally the applicant will be the importer. Beneficiary This is the party to whom the credit is issued. It is the natural person or organization to which the issuing bank makes a commitment for payment, acceptance or negotiation under the terms and conditions established in the documentary credit. It is normally the exporter. Issuing bank This is the bank that issues the credit at the request of the applicant or of its own accord. It is the financial entity chosen by the applicant to issue the documentary credit, in accordance with its instructions. The issuing bank makes an initial study of the risk, and once the request is approved and the credit opened, it guarantees the payment to the beneficiary or any intermediary institution involved. Intermediary banks The advising bank is the bank that advises the credit at the request of the issuing bank. It is the bank designated by the issuing bank to notify the beneficiary of the content of the credit issued. Normally this is a bank that is established in the country of the beneficiary. The confirming bank is the bank that adds its confirmation to a credit upon the issuing bank s request or authorization. This constitutes a firm commitment on its part, providing an additional guarantee to that of the bank issuing the credit, provided that the documents fulfil the terms and conditions of the credit. As a result, a confirmed documentary credit represents twice the guarantee of receiving payment for the beneficiary. The paying bank is the bank in which the credit is available, or any bank in the case of a credit available with any bank. It is the bank delegated by the issuing bank to pay, accept or negotiate the documents or drafts issued, in accordance with what is established in the documentary credit. Intermediation by banks provides seriousness and assurance to the parties involved regarding the fulfilment of the payment means procedure

14 The issuing bank must be a major recognized bank that is solvent, and preferably will be one that has an international presence. If the issuing bank is a subsidiary of a different international bank, this will facilitate the documentary credit operation, even though they are in fact separate entities. Once it has received notification from its (advising) bank that there is a documentary credit open in its name, the beneficiary (exporter) of the documentary credit should check the text, content and conditions in order to be sure that what is stated fully matches what has been agreed between the buyer and the seller and coincides with the commercial contract signed by the two parties

15 If there are any differences in form or content, this should be immediately communicated to the advising bank and to the applicant (the buyer) in order to make the necessary corrections. The material execution of the order will only begin once everything is approved by the beneficiary

16 Characteristics of documentary credits Documentary credits can be classified in various different ways: According to the time of payment According to the place of drawing At sight payment: payment is made at the time of delivery of documents in the designated entity. Deferred payment: through the acceptance or negociation of documents. Also there is a called mixed payment that is a means halfway between sight payment and deferred payment, consisting of a partial sight payment by the nominated bank when the documents are presented, with this entity making a commitment to complete the remainder of the payment in one or various instalments, as per what is indicated in the documentary credit. Drawing under documentary credit is understood as delivery by the beneficiary of the documents indicated in the terms of the credit, within the period agreed upon. Drawable with the issuing bank is a type of documentary credit in which the documents, in accordance with the terms and conditions of the credit, must be presented at the issuing bank in order for the payment commitment to be brought into effect. This type of credit is favourable for the importer as they will not have to pay until the documents arrive at the issuing bank. Drawable with the advising bank is a type of credit where the documents can only be presented for payment, acceptance or negotiation at the advising bank or the confirming bank, which will forward the documents to the issuing bank in order to effect the payment commitment. Drawable with any bank means that the documents, in accordance with the terms and conditions of the documentary credit, can be presented at any bank, which forward them to the issuing bank in order to effect the payment commitment. According to the responsibility of the issuing bank Confirmed documentary credit mean that the credit has been confirmed by a bank, either the advising bank or another. This entity makes a commitment to the beneficiary additional to that of the issuing bank to pay the credit. Unconfirmed documentary credit represent credit where the advising bank limits its involvement to notifying the beneficiary of the documentary credit and authenticating it, without taking on any responsibility or commitment. The commitment to pay the documentary credit only affects the issuing bank. Unconfirmed documentary credits are very similar to documentary remittance but the key difference is that they are an irrevocable means of payment

17 Perspective on documentary credits There are two types of documentary credits: 1 / Import documentary credit: The risk of issuing import documentary credits is covered under the foreign trade line (or risk) that the importer maintains in the financial institution. In the event that payment is deferred, it allows offer the advance payment to the beneficiary at sight without a further risk assessment (cash advance). 2 / Export documentary credit: It is issued by the importer s bank to the beneficiary s institution in favor of the latter. The risk of issuing is therefore supported by the importer. In the event that either deferred payment, you can make a purchase without recourse and may be possible to advance the deferred payment with interest deduction and commissions therefore debt disappears from the balance sheet (cleaning balance sheet) and credit score (CIRBE- Bank of Spain Central Credit Register) is not affected affected (commercial forfaiting) Types of documentary credit In accordance with their particular characteristics, documentary credits may be: 1 / Transferable or endorsable: the beneficiary may give instructions to the nominated bank (payer, acceptor or negotiator bank) for the credit to be able to be drawn in full or in part by one or more beneficiaries. A documentary credit may only be transferred once, and may be transferred to various beneficiaries provided the total amount of the transfers is no greater than the total amount of the documentary credit. 2 / Subsidiary or back to back: the beneficiary of the documentary credit requests the opening of a separate credit, offering the documentary credit already opened in its favour as a guarantee. This type of documentary credit is associated with two different documentary credits. The first is a credit issued in favour of the first beneficiary and the second is a credit issued by the advising bank upon the order of the first beneficiary in favour of a second beneficiary. Transferable or back to back documentary credits are a good solution when the seller is acting as an intermediary. They facilitate the opening of documentary credit to third parties with the financial assistance involved in having the initial credit as a guarantee (directly or indirectly) for the new transaction. 3 / Revolving: this is a type of documentary credit that is automatically renewed as it is drawn, under the same terms and conditions, for an agreed length of time or as many times as

18 specified in the credit. These documentary credit can be classified according to their renewal either by amount or by time. Revolving credits significantly reduce banking costs, maintaining an equal level of protection for recurrent operations over a length of time. 4 / Stand-by: these are documentary credits with bank guarantee that comes into effect in the event of non-fulfilment of obligations by the applicant. They are called Stand-By Letters of Credit. These credits may by applied for by the exporter or by the importer, depending on the type of non-fulfilment the guarantee is to cover. If the guarantee covers a potential default on payment, the importer will be the applicant for the credit and the exporter will be the beneficiary. In contrast, if the guarantee is to cover a potential non-fulfilment by the exporter of its obligation to ship the goods contracted, the exporter will be the applicant and the importer will be the beneficiary of the credit

19 Stand-by letters of credit are very useful in the world of commodities trading. They are also widely used for trading in services. If the buyer opens stand-by letter of credit for the complete order, there is no need for conventional documentary credit, as the exporter will already be protected and at a lower cost. 5 / With advance clause: use of this type of documentary credit enables the exporter to receive advance payments from the importer before the goods are shipped. A red clause is used when funds are needed for the purchase of materials required for the manufacture of the products specified in the contract. The documentary credit specifies the advance payment amount and the way it is to be made. A green clause is very similar to the red clause, the difference being that the exporter must provide the bank with documentation proving that the funds received have been used to buy the materials for which the advance was intended, and that they are in possession of said materials. These types of documentary credit with advance clauses are currently decreasing in use, as it is more common to agree upon an advance payment independently of the documentary credit, reducing the costs for the documentary credit by virtue of the lower amount involved Main conditions and discrepancies As already mentioned, the importer and exporter agree upon the conditions to be met in a documentary credit in order to the beneficiary can be paid. It is very important to define the documentary credit conditions clearly and by mutual agreement, so as to avoid subsequent modifications to conditions and not to risk that the beneficiary not using the documentary credit. Do not forget that documentary credits, being irrevocable, cannot be modified or cancelled without the approval of all of the parties involved, that is to say the beneficiary, the importer, and the issuing bank, as well as the confirming bank in cases when this role is also involved. The applicant must provide the issuing bank with a certain minimum set of details in order to proceed with the opening of the documentary credit, some of which are very important

20 With the exception of some unusual special cases, such as fraud, the buyer and seller usually just want their end of the deal to be fulfilled (the goods purchased and the collection of payment, respectively). Accordingly, it is uncommon for discrepancies to be found or raised during the operation or the bank intermediation, when they do not affect the successful result of the transaction. Documentary credit are said to have discrepancies with the terms when the exporter does not present the documentation in accordance with the terms and conditions of the credit. People in banks responsible for checking the documents are not experts in the goods for which the documentary credit are issued, so the checks are based on the strict contents of the documents, and any fault or divergence regarding what is specified in the terms of credit may be cause for discrepancy. In this regard, it should be clarified that spelling or typing errors that do not affect the meaning are not considered as discrepancies. However, using a full stop instead of a comma or vice versa can lead to discrepancies. Among the most common discrepancies in the use of documentary credits, the following may be highlighted: Presentation of documents after the deadline. Expiry of the credit validity period. Regarding invoices, a shortage of copies or incorrect detailing of the goods, including weights, dimensions and erroneous amounts. The shipping documents may show that the shipment occurred after the deadline. In the insurance documents the most common discrepancies usually relate to the coverage provided, the insurance expiry dates or the the use of a currency other than that used for the commercial transaction. Further examples include presentation of the documents after the credit expiry date or the shipping date, or after the deadline for delivery to the bank. Documentary credit provide great benefits to the importer and the exporter alike, with the main drawback for both of them being the cost

21 Documentary credits eliminate commercial risk, but not political risk. However, any political risk that could affect an export operation is avoided in the case of confirmed documentary credits. Importers may point to other disadvantages such as the impossibility of cancelling the credit without explicit agreement from the exporter, the requirement to have been granted credit lines or make a provision of funds to open the documentary credits, and the lack of guarantees by the bank regarding the authenticity of the documents and the correct goods being received. It is to the importer s advantage that payment for the goods is conditioned by fulfilment of a series of pre-agreed requirements, providing security that the settlement will only be made if the terms and conditions of the credit have been met. In addition, the importer may negotiate improvements in the terms of sale, as they are providing the exporter with assurances for the receipt of payment. The most important advantage for the exporter is the security regarding receipt of payment, which does not depend upon the importer s situation given that there is an irrevocable commitment from the financial entity. The exporter will receive payment provided they meet the terms and conditions indicated in the documentary credit, even if there are disputes regarding the goods, which are discrepancies to be settled by separate means. By their very nature, documentary credits facilitate the export financing (pre and post) of commercial operations by financial entities Conclusions No international commercial transaction, whatever its nature and means of payment, should be made without a commercial contract signed between the buyer and the seller. The contract must have a clause Form and terms of payment in which the parties clearly and unequivocally agree upon the payment instrument to be used, the milestones or payment stages, and the commercial and/or financial documents that will serve to comply with the payment. Finally, the development or execution of the contract will start from the date on which are given by fulfilled and satisfied all conditions that make operative the contract, according to the chosen form of payment

22 Show what you know A documentary credit: a. is immediately invalidated if it contains any defect of form. b. cannot be modified or cancelled without the approval of all of the parties. c. can never be modified, cancelled or invalidated. d. none of the above answers is correct. Correct answer: b

23 3. INTERNATIONAL CASH MANAGEMENT International cash management signifies a set of techniques and procedures which aim to manage the monetary funds of the company. Cash pooling is a service for companies which requires the automated management of their international liquidity in a centralized manner to optimize their treasury and to control their flow of collections and payments. The SWIFT network is a platform that facilitates the exchange of financial information using a variety of file formats. In general terms, international cash management (ICM) can be understood as the day-to-day running of a company and its relationships with banks: incoming and outgoing payments, and negotiations. ICM is a global service that enables companies to manage their treasury position and their liquidity both national and international level, with the following benefits: efficient management of working capital, with all incoming and outgoing payments centralized; comprehensive management of the subsidiaries balances held in other entities and/ or countries; monitoring of the daily positions in all their entities; reduction of funding requirements and financial expenses; performance optimization of the treasury; reduction of administrative tasks. The three main groups with which is related to the cash management are: > Clients. Who provide incoming money or collections > Suppliers. Who cause outgoing money or payments

24 > Financial entities. Any entity that provides financing or channels the investment of funds Firstly, it is worth highlighting an aspect that is rarely taken into consideration: financial entities are the companies most important suppliers. This is so because they continuously supply the following: Financing: lines of credit or discounting, loans, leasing, etc. Services: outgoing and incoming payments, deposits, transfers, direct debits, drafts, etc. Information: on financial markets, clients, legal regulations, etc. The basic principles of cash management are: Alternative cost of money over time Being convinced that it is not the same to collect payment today than tomorrow and that this delay carries a cost. Value dating The collaborating financial entity expresses the date the document is received in its accounting. Reduction of idle balances Defined as the volume of immobilized funds that are not essential to the running of the business. Optimization of the transactions float The operational cash flow is not always exact and this can be seen when maturity is reached without payment having been made. Cash management addresses the complete process of administration and control of a company s cash flows and treasury position. As such, it focuses on the optimization of liquid funds and the company s capacity to generate them. This enables appropriate financial planning and an improvement in the efficient handling of the organization s different operational processes as regards their interrelations with incoming and outgoing payments and treasury forecasts, thus aiding management of the treasury s liquidity deficits and temporary excesses

25 3.1. Cash pooling international Cash pooling is an efficient and automated way of managing a company s international treasury position. It consists of a service for companies that require automated management of their international liquidity in a centralized manner, to optimize their treasury position and to control their incoming and outgoing payments and cash flows. It is very well-suited to companies with accounts in different countries and to groups of companies who are seeking centralized management of their subsidiaries

26 This method is wholly configurable and makes it possible to concentrate balances in whichever accounts that company specifies and at the times they require, and to set minimum balances to be maintained and establish their periodicity. It is important to define and analyse the concept of the cash flow. As such, it should be remembered that: A company s cash flow usually has ups and downs in its volume and frequency, but rarely discontinuities. The amount of funds in the accounts for suppliers, customers and treasury represent funds inmobilizated. Any alteration in any of the different parts of the system (customers, suppliers and treasury) will quickly spread to the rest. As regards the idea that the treasury should be limited to managing money, management methods incorporating cash management highlights three basic characteristics: 1 / Dynamism As the money is in continuous movement, the measures taken should be dynamic, to be able to adapt to the company s cash flow. 2 / Global vision Given that any alteration in any part of the circuit will quickly spread to the rest, no section can be overlooked, and so a global perspective is required. 3 / Anticipation Because a passive approach leads to a late arrival at the solution, being proactive is essential when working with money, as the time for action is very limited by banking instruments. Clarifying the key concepts mentioned above, it is important to discuss the value date, which is the date as of which the money from a transaction (a payment, a collection, the taking of a loan, a transfer) is effectively allocated to the bank account. It is a concept that can be

27 likened to availability (another way to look at it would be that, depending on whether it is an incoming or outgoing payment, the accrual of interest starts or stops as of the value date). The treasury should be managed only by value date (treasury forecasts, incoming or outgoing payments, interest calculations, transfers of funds between accounts, etc.), not by the operation or accounting date. Another concept that must be highlighted is the float, which can be either commercial (the average period from when the invoice expires to the date when the payment or collection is made) or financial (number of days from a payment is received or made until the funds are (or longer) available for value). With these observations in mind, the treasury s functions can be listed: always decide the best management tool (for payments, collections, deficit management, investment of surplus, etc.); forecasting positions (bank balances by value date) sufficiently in advance; making sure that sufficient liquidity is available at all times and under the best conditions regarding period, cost and operational characteristics; establishing and developing relationships both externally (banking vs negotiation) and internally (rest of the company vs treasury forecasts); monitoring and checking interest, charges, and banking costs; measuring exposure to financial risk (commercial, interest and exchange currency rate) and, where applicable, performing coverage operations; in some companies the conciliation and accounting of bank movements is also the treasury s responsibility Swift Net The SWIFT network is a perfect communication platform for international company that facilitates the exchange, through the SWIFT network, of financial information both in interbank standard format files as files in a proprietary format of the financial entity

28 Advantages of the SWIFT network Standardization The message exchange is the same for all banks. Accessibility Communication with all banks using the same key. Efficiency Cost rationalization deriving from the standardization of formats, the elimination of operational risks and the reduction of operating costs. Simplicity One sole connection per company. Integration Better integration with companies back offices. Show what you know What is the name of the platform that facilitates the exchange of financial information using a variety of file formats? a. Cash pooling b. Cash Management c. SWIFT network Correct answer: c

29 4. FINANCING ON FOREIGN TRADE OPERATIONS In the financing of working capital for imports, the importer grants the exporter a deferment in the collection of the goods being supplied. Confirming is used to finance import and export operations. Leasing allows buyers to dispose of an asset by paying a periodic fee for a set period and at the end of which, you can buy it by paying a specified residual amount. Exporter companies often need financing to deal with the mobilization deferred payment which has granted the buyer and, in many cases, to manufacture goods that are to be exported. Factoring consists of an agreement by which an exporting company transfers to a factoring company all or part of of collection rights, and commercial credits it has with its customers. In export finance, the bank from the exporter s country give a credit to the importer. Export insurance agencies may be state-owned or private insurance companies, or a combination of the two Working capital financing for imports The financing of working capital for imports is the financing provided by the exporter granting a deferment in the incoming payment of the goods supplied (vendor financing). The term also applies when a financial entity replaces the exporter in granting finance to the importer, paying on its behalf the amount of goods and deferring debit to a previously agreed date (bank financing). Importer companies main need for financing stems from the time lag between payment to the exporter for purchase of the goods and the incoming payments from sales in its domestic market. This type of financing lets the importer defer payment for the import goods until they obtain the necessary funds

30 It depends upon the solvency of the importer or the guarantees they can provide, either eliminating the risk through payment by a documentary credit with deferred payment, or through sureties and bank guarantees or acceptable negotiable instruments. The instruments most often used in bank financing are financial effects, accepted bills of exchange or promissory notes issued by the importer that the financing bank discounts or negotiates at the interest rate agreed upon, paying the resulting liquid to the exporter: 1 / The well-known credit policies (also known as credit accounts or credit lines). 2 / Loan policies (also known as loan accounts). Both of these depend on the type of goods being imported and the periodicity of the operations. A credit policy differs from a conventional loan in which the first is a form of short-term financing to cover liquidity mismatches in the treasury of the company, usually to normally finance the current assets of the company, which is granted to a limit of availability based on the solvency of the company, guarantees and other conditions. The balance of the overdraft is the difference between the limit granted and total imports financed, which can be released as they operations are repaid. In bank financing of imports, financial institutions assume the risk that the importer does not fulfill its commitment to pay, which can be reversed in the quality of a solvent means of payment, guarantees or bank guarantees, etc. We talked about it when referring to import documentary credits. Normally this type of financing could take any length of maturity period, but in practice and because it relates to imports it is most often used in short-term and medium-term operations

31 4.2. International confirming Confirming is an administrative and financial service that can be applied to both import and export financing operations. This form of financing involves the financial entity assuming on behalf of its client (the importer) management of payments to the suppliers, such that these payments are fully guaranteed. As the invoices to pay are approved by the debtor, the confirming provider will notify the suppliers to this circumstance and of the possibility of non-recourse financing. This allows exporters to advance collections ahead maturity by means of discounting and, in turn, financial entities allow the importer to advance or defer its payments according to its financial needs. It is said to be an administrative service because the financial entity manages the payments to suppliers, and takes care of the classification, accounting and monitoring of maturities for the payments its client has to make. The financial entity provides the suppliers with confirmation of the payments to be made at maturity. Are there limits to confirming financing? Confirming does not have established financing limits, and can go as far as the all of the invoices a company has. It is established by a contract between the financial entity and the importer that is normally annual and renewable automatically. To which companies is it offered? This type of operation is not offered to all companies, as it involves a certain degree of risk for the financial entity. It is normally offered to companies with a recognized level of solvency and a high volume of purchases. Which companies require this type of service? Companies with a large number of suppliers normally companies in sectors such as construction, distribution and automobiles. Companies with complex payment systems due to high volumes of suppliers and varying payment periods, a cause for high administrative costs

32 Companies that hope to improve their purchasing conditions; since confirming provides payment security, may persuade suppliers to improve prices, extend the payment periods, etc. What is the operational process? A confirming operation starts with a request from the importer to its financial entity for a confirming contract. The entity investigates its solvency and if is an acceptable payment capacity, it proceeds to formalize the contract. The importer pays the costs for formalizing the contract and informs its suppliers of the existence of the confirming contract for the payment of invoices on its behalf. The exporter sends the goods to the importer and issues the corresponding invoice, sending it to the importer for its approval. Once the invoices have been accepted they are sent to the financial entity, which notifies the suppliers that the invoices have been approved and of their payment at maturity, offering payment in advance by discount. The banking cost of confirming has two components: 1 / The cost to the importer for the administration provided. 2 / A cost to the supplier in cases where they accept the financing offered. The importer must pay for the costs of preparation of the confirming contract, as well as the charges for initiating the service, for the initial study and for management of payments. If it also defers payment, it must pay the corresponding financial costs. Advantages and disadvantages of confirming Confirming provides advantages for both the importer and the exporter, thus strengthening their relationship. The importer makes savings on the costs associated with managing its payments, has better control over outgoing funds, cuts out purely administrative tasks, simplifies its payment system and improves its position with its suppliers, in light of what they are offered

33 For an exporter, confirming equates to the elimination of default risk and a saving on costs related to managing collections and drafts. In addition, it gives the option for financing, which would make the client accounting entry into a treasury item. Normally it can have any maturity period, but in practice it is most commonly used in all types of operation with a maximum of two years International leasing Leasing or financial leasing is a finance contract whereby the buyer can make use of an asset either movable or immovable assets acquired and employed for a certain purpose, in return for a periodical fee during a set period, at the end of which an option may be exercised to purchase the asset for a specified residual amount. They may also sign a new leasing contract or return the asset to the seller once the period agreed upon between the buyer and seller has come to an end. While there is a difference between export and import leasing, based on whether the asset starts on domestic territory and is exported abroad, or if it starts abroad and is then imported into domestic territory, in practice import transactions are much more common those involving export. The leasing process involves a leasing entity from the importer s country negotiating with the exporter for the purchase and financial leasing of the assets to the importer. The exporter makes a cash sale, meaning that any commercial risk or exchange rate risk is borne by the leasing entity. Types of leasing Financial leasing The lessor makes a concession of use for the asset in exchange for the lessee paying a certain number of regular installments, without any commitment regarding maintenance or repair of the asset

34 Operational leasing Together with the transfer of the asset in exchange for the regular installments, the lessor makes a commitment towards its maintenance. In accordance with the contract terms, the asset may be returned and replaced by another if a technological improvement becomes available. Leasing is generally used to finance medium-term and long-term operations for assets with a useful life of at least two years. Furthermore, it is recommended for equipment that is to be used for a set period or when optimal maintenance conditions are required. Banks can conduct leasing operations, and for large operations can be done through several banks jointly associated for the operation (this is called operation syndicated ). This financing arrangement is often used as a solution for purchasing equipment with a high probability of obsolescence due to technological developments, for example computers. It is also used when the purchase involves major capital investments, in cases such as aircraft and ships. The processing of leasing operations tends to be relatively swift and the financing cost is reasonable, albeit higher than other means of financing. Financing operations through leasing may mean that the importer can improve its financial conditions, since the exporter will receive cash payment for it. The lessee of the equipment must pay regular installments as well as an advance at the time of signing the contract. The period for a leasing arrangement is normally from 2 to 3 years for movable assets and from 10 to 15 years for immovable assets. Also, there are fiscal benefits, as the financial charges are considered as a deductible expense, and accelerated amortization of the assets leased is permitted. Spanish corporation tax permits amortization of assets at double or even triple the rate legally established, depending on the turnover

35 Differences between international leasing and a loan Leasing Obtained faster and with more flexibility LOAN Obtained more slowly Does not appear on the balance sheet Increases the liabilities of the balance sheet The interest and the part corresponding to the asset s amortization are deductible Only interest on the loan is deductible Entails a faster amortization of the equipment Entails a less flexible amortization of the equipment 4.4. Working capital financing for exports The main need for financing in an exporter company relates to the mobilization of the deferred payment granted to the buyer. On many occasions financing is also needed for the manufacturing of the good to be exported. This type of financing allows companies to defer their payments to suppliers, collect advance payment for exports already shipped, and finance the purchase of the goods to export or the raw materials needed to manufacture the product to be exported. Exporters need to finance their operations due to the time difference that may exist between reception of an order and collection of the payment. These financial needs may arise in the manufacturing period (or assembly) of the order, and it is called pre-financing, or may originate from the period there since the merchandise is delivered until the time when payment is received, and it is called post-financing, which is the conception of financing most widely recognized, granting the exporter when it allows the importer deferred payment.this was mentioned previously when commenting on export documentary credits. The financial entity assumes much less risk for being awarded the order and because there is a bank that guarantees it

36 Pre-financing of exports The aim is to make available the liquidity required for the manufacture or acquisition of the goods to be exported. The pre-financing period, which will last at most from the time the order is received until the delivery of the goods (normally shipment), varies depending on the activity (manufacturing, trading or provision of services) and the type of product being exported (agricultural products, durable goods, industrial goods, etc.) The exporter can request the financing at any moment during this period, and the party providing the financing (the buyer or a financial entity) will advance them a part of the amount they are set to receive for the resultant sale of the goods. If an export documentary credit is held, this provides proof that the order in production is sold and guaranteed by a bank. This type of financing is normally formalized via credit or loan policies. The money obtained (by credit or advance) is used to finance the manufacture or acquisition of the goods to be exported, and even to finance the maintenance of the stock. Post-financing of exports The objective is to mobilize funds that the exporter has tied up as a result of the deferments of payment granted to its customers. In this scenario, the maximum period will be from the time the goods are delivered (normally shipment) or the service is provided until the effective receipt of payment for the transaction. It would be bank credit to finance the period from shipment until the date of payment established by the importer. Full financing of the process When it is a case of exports with deferred payment, in practice what occurs is full financing of the process (pre-financing and post-financing), either through two successive independent operations, either through a single operation that includes both phases, which is more normal. Normally this type of financing could take any length of maturity period, but in practice and because it relates to exports it is most often used in short-term and medium-term operations. Due to the fundamental importance of exports to countries economies, governments are favourable towards financing some export operations in the long term with official support export credits, as will be seen in more detail further on, when discussing export finance

37 4.5. International factoring International factoring consists of an agreement by which an exporter company transfers all or part of its collection rights, from its trade related credit (bills of exchange, invoices, promissory notes, etc.) involving its customers (debtors) to a factoring company, known as a factor. As such, the factor takes ownership of the customer debts and takes responsibility for dealing with the collection management. The transferor company also has the chance to insure against the insolvency risk relating to the debtor. When the transferor and the debtor are based in different countries it is classed as export factoring, with involvement from two factoring companies, one connected to the importer and the other to the exporter. In such cases, the transferor is the exporter and the debtor is the importer company. Factoring contracts must specify the precise services that the factor undertakes to provide for the exporter. These services can be classified as three types. Administrative services These are services involving information management and administration, such as studies and analyses of the solvency of importers, accounting and administration of the credits transferred by the exporter, management of collections at maturity and monitoring of pending collections, with regular reporting to the exporter on the state of its accounts and potential incidents. Financial services These include credit studies, selection and classification according to the risk from the exporter s debtors; payment of invoices to the exporter; and advance payment of invoices pending collection. The upper limit of the advance payments tends to be between 80% and 90% of the total amount. Services for coverage against risks These include guarantee of payment in case of insolvency of the debtor. Coverage insolvency risk up to 100% is offered. Debtors are considered insolvent in case their lockouts, or bankruptcy or a default that exceeds the established payment period without contractual claims

38 The factor always reserves the right to leave out of the factoring any of the exporter s debtors that are not deemed worthy of a sufficient level of confidence regarding their ability to meet the payments. It should also be remembered that factoring companies do not cover political risks. There are no limits to factoring as regards quantity, but for it to be applied, the trade related credits must have some specific characteristics: They must originate from sales of goods or the provision of services. The products cannot be perishable. The sales must be regular or have a repetitive nature, it does not apply to ad hoc operations. It does not apply for direct sales to consumers; it must be between companies. Although there are exceptions, the payment must be short-term. The transferor takes on a series of obligations with the factor when they sign a factoring contract. There is a principle of exclusivity whereby the company may not operate with various factoring companies at the same time, unless said companies are in agreement. There is also a principle of globality that obliges the transferor company to present all of its invoices from the customers included in the factoring contract. The aim of this principle is to ensure that the exporter does not only transfer credits that are problematic or in doubt. The globality may be delimited based on certain characteristics that are easily identifiable, for example for a line of products, for a certain geographic area or for a specific campaign, etc. Being a matter eminently financial and insurance, banks and insurance companies were the types of companies that provided operations to deal with these situations. However, these companies found that they too lacked sufficient tools to assess companies that they did not know and were located in other jurisdictions. These causes led to the creation of factoring associations. Factoring associations Factoring associations are organisations in which the members are from different countries, have mutual collaboration agreements regulating the operating rules and arbitration in case of conflicts between them

39 One of the most famous of these associations is Factor Chain International (FCI). It was created in 1968, has headquarters in Amsterdam, and is an umbrella organisation of various member factoring companies. According to its data, it has 400 members in 90 countries. The main functions performed by FCI s services are as follows: research on the credit standing of buyers, accepting credit risk, protection against defaults; incoming payments and invoices management, immediate financing based on pending receipts for future dates. The way it works is illustrated as follows. As can be seen, the buyer and seller parties are in contact only for the negotiation. They come to an agreement regarding the product being sold, the amount, the payment period and other contract terms. From this point onwards are the factors (banks or factoring companies) that manage all the opeative

40 Classification and advantages of factoring The different factoring methods can be classified based on certain different criteria: Moment of payment Payment upon collection, the factor pays the transferor when it receives payment for the invoice; payment with delay limit or payment at maturity, the factor pays the transferor on the agreed date, regardless of whether the debtor has paid. Insolvency risk Factoring with recourse means there is no coverage of insolvency, the transferor accepts the risk and in the event of a default, the factoring company can reclaim the debt from either the transferor or the debtor. The alternative is non-recourse factoring, where the factoring company does cover the insolvency risk relating to the debtors. The transferor is only responsible for the certainty of the credit, and in the event of a default the factor may only make a claim on the debtor. This is the type of factoring used most often, typically employed by companies seeking liquidity and guarantees regarding incoming payment. When financing is granted, the procedure results in the factoring company advancing funds to the exporter or transferor. This amount normally goes up to around 80% of the exporter s invoicing. Given that factoring operations encompass a number of different services, such as management of clients studies on debtors, payments management, and accounting, the cost tends to be high. Said cost can be broken down into three components: study costs (the exporter has to pay for each importer whose invoices are transferred), costs for the research services (financial analysis and credit classification) and the cost of the factoring fee (the cost of the administration services and the collection of the exporter s credits). In the case of non-recourse factoring, the cost of covering the insolvency risk will also be included. The fees charged are set by means of a percentage of the value of the invoices to be collected. This percentage depends on what is negotiated between the exporter and the factor, but also on a number of other circumstances such as: the number amounts of the invoices, the conditions and deadlines for the collections, whether insolvency risks are covered (factoring with recourse or non-recourse factoring), the number of debtors and their solvency, whether globality clauses are included, and the interest on the advance payment which is the amount charged by factoring companies for advancing funds to exporters on assigned invoices

41 Usually there is a variable interest rate similar to that of the banking market as well as a margin, which depends on the sector and the interval on time between the granting and the maturity of the credit. Factoring provides a number of advantages for exporters, in particular: Minimizing risk In the case of non-recourse factoring, risks relating to default or delays in collecting payment are eliminated. Furthermore, the company improves its balance sheet ratios, as it replaces the customers account into cash. Deferment of payments Because they are able to receive advance payment, exporters can grant deferments of payment to importers, thereby increasing their competitiveness. Simplifying accounting Accounting procedures and the monitoring of collections are simplified, which entails lower costs and time savings, allowing for optimization of resources. The main drawback is the banking cost, as well as the fact that the exporter is held to the classification of risks provided by the factor. Factoring is normally used for closed export operations over the short term, and occasionally over the medium term International forfaiting Forfaiting is a system for financing exports whereby the financial entity making a firm purchase of the debts owed to the exporter, which are in the form of internationally accepted financial documents, such as bills of exchange, promissory notes, documentary credits, guarantees and others which the exporter receives to implement the deferred payment of the

42 operation, and whose drawee is the foreign buyer. It amounts to a fixedrate discount of non-recourse against the exporter. When the financial documents are documentary credits, the forfaiting may be called nonrecourse purchase of export documentary credits. Forfaiting is mainly a financial operation for exporters, who are assured of collecting payment since the forfaiter entity takes on the full risk of default, it being a non-recourse credit operation. This type of financing arrangement is set up individually for each export contract, enabling immediate realization of credits and deferred payment operations, over the medium and long term. The exporter is protected against the right of return, meaning that in the event of a default, because it is a non-recourse operation the forfaiter will have to try to collect the payment form the importer or call upon whatever sureties or guarantees might be held. A forfaiting operation involves the transferor (or exporter), the debtor (or importer), the forfaiter (the credit institution acquiring the financial instruments and taking care of collections) and the guarantor (entity guaranteeing the importer s payment commitment, which may be an entity in the importer s country or a recognized financial entity from another country). Also involved are the banking entities related to the means of payment used. The solvency classification made with regard to the importer will determine whether or not sureties or other bank guarantees are required from a leading financial entity in its country, or from another country with a better country risk rating, including multilateral entities or even, depending on the type of operation, from International Financial Institutions. The timeframe for these operations varies between six months and five years, depending on the market conditions and the operational risks. It is therefore possible to relate forfaiting to short term, medium term and long term financial operations, but chiefly it relates to the longer term. In short, what is known as commercial forfaiting is the non-recourse purchase of deferred payment documentary credit

43 The forfaiting operational procedure begins with the formalization of an agreement between the exporter and the financial entity (or forfaiter). The latter, following a study of the operation, issues a document proposing the conditions for the transaction and clearly indicating the waiving of recourse against the exporter. The exporter informs the importer of the transfer of its collection rights in favour of the forfaiter and they establish the terms of their sales contract, including the financial conditions of the forfaiting. Once the contract has been formalized, the order is carried out. When the importer receives the goods, it informs its guarantor, sending it the financial documents. The guarantor then sends these payment commitments to the exporter, which delivers them to the forfaiter in return for the corresponding payment. At maturity, the forfaiter presents the guarantor with documents in order to collect payment. The guarantor then charges the debt to the importer. The forfaiting can take effect when the financial documents are delivered as a discount or as an advance payment. In this case the forfaiter acquires an irrevocable commitment to non-recourse discounting on the financial documents to be delivered in the future by the transferor. This allows the exporter to make commercial transactions in knowledge of the cost the transaction will entail at a future date. This irrevocable commitment involves a fee that is charged at the time it is made

44 Specific characteristics of forfaiting As specific characteristics can be indicate: Means Bills of exchange, promissory notes, documentary credit, documentary remittances, etc. The transfer of assignment of the effects is done by endorsement. Timeframe: from 6 months up to 5 or 7 years, depending on the goods exported and the destination country. Guarantees Bank guarantee or guarantee by swift thereof. Currency Any convertible currency, although the use of a strong currency (such as the US dollar, the euro or the sterling pound) facilitates the negotiations. Documentation It is a fundamental aspect, and includes both the credits themselves (with their guarantees), duly endorsed, as a copy of the contract and, where appropriate, other additional documents (for example. import license, bill of lading, etc.). Furthermore, if the destination country has strict foreign exchange control legislation, a document authorising the debtor to transfer currency abroad may be required. Maturities At regular intervals (e.g. monthly, quarterly, half-yearly, etc.) and if possible for the same amount each time. There may be just one maturity date. Discount rate Fixed rate, based on LIBOR. (It may also be variable, although this is not common.) The spread reflects the liquidity of the assets (commercial and political risks, interest rate risk, secondary market transferability, etc.). Amount As one would expect, there is no official standard, but the typical minimum threshold is between 100,000 and 150,000 US dollars, or its equivalent

45 Exporters pay a commitment fee for the delay between when the contract is signed and when the documents on which payment is collected are delivered. This percentage is calculated from the date of the commitment until the discount on the amount being financed. Other costs and fees associated with forfaiting > Fees and costs of covering commercial risk. These costs originate in the sureties, bank guarantees and insurance premiums, charged to either the exporter or the importer. Normally these risks are covered by export credit agencies (ECAs). > Fees and costs of covering political risk, extraordinary risk or transfer risk. The insurance depends on the conditions established by the market based on the importer country classification. > Administration fee. This depends on each different entity s rates. Forfaiting is generally used for operations with countries where there is an elevated level of risk, those in development or suffering from political or economical instability, where circumstances prevent or advise against using other financing systems such as export credits. This type of financing arrangement is commonly used by companies exporting equipment goods and services with regular and large invoices, to the same country and customer. Such companies seek to transfer their risks and gain liquidity. Forfaiting operations are very advantageous for exporters, enabling them to finance 100% of their operation with relatively simple processing. In addition, there are no restrictions on which products can be exported and it can be used for countries that are not accepted for official credit. Once the operation has been approved, the exporter receives the amount in cash and without recourse, thereby improving its liquidity, freeing up its commercial discount lines, lowering its debt ratios and cutting out default risk, exchange rate risk and interest rate risk. This means of financing allows it to increase its competitive advantage in the sale, since it can provide long term financing to importers

46 The main drawback of forfaiting is the high costs, and the fact that in some cases it may be difficult to obtain a guarantee or a surety from the importers. Comparison of the similarities and differences between international forfaiting and factoring CONCEPTS FACTORING FORFAITING Services Financing and others Financing Goods financed Normally stocks, intermediate goods and consumer goods Normally equipment goods Timeframe Short term Up to 7 years Scope Local transactions and foreign trade Normally foreign trade Number of transactions The limit is set analysing the customer Studied case by case Recourse With recourse or nonrecourse Non-recourse Documents No specific documents required Bills of exchange, promissory notes, documentary credits, etc. Contact with the exporter Habitual Sporadic or habitual Way of receiving the finance Flexible, once the credit is granted, the amount required may be taken immediately In full or in part, but established previously

47 4.7. Export finance Buyer credit The financial entity from the exporter s country grants a buyer credit to the importer, who has the obligation to repay it, and the amount is payed to the exporter. This is the most common type of export credit. Use may be with commercial interest or with called the OECD Consensus s Commercial Interest Reference Rates (CIRRs), which regulate the conditions of the interest rates, maturity periods, financing of local costs, etc. It can also intervene Spain s ICO (Instituto de Credito Oficial) via the Reciprocal Interest Adjustment Contract (CARI). Main aspects Duration They are usually long-term loans and are generally used for a wide range of products or services that may be exported, such as the acquisition of equipment goods, turnkey projects and plants, machinery, engineering, construction, etc. Payment surety bonds In these operations the debtor may be public or private. They may involve an entity from the importer s country that guarantees its payments. Advantages for the exporter This type of financing allows the exporter to increase their competitiveness and enables them to access new markets, greatly reducing the risk of default. Furthermore, because it is not a banking tool, company do not use the credit lines having granted neither lose borrowing capacity as the deferment of payment and the debt are taken on by the financial entity. The operational process of a buyer credit is initiated with the formalization of a sales contract between the importer and the exporter (export contract)

48 In turn a a credit agreement is set up with official support between the Spanish financial entity, the importer and its credit institution. In accordance with the OECD consensus, a maximum of 85% of the exports from one particular country are financed, provided there is a 15% advance payment on the entry into force of the commercial contract, which among other things includes the signing of the financial agreement between the buyer/debtor and the bank/lender. In some cases the debtor may request to finance more than 85%, in which case the financing may be complemented with supplementary commercial credit. This part may be covered with a risk policy from a private insurance company. The exporter delivers the commercial documents or certifications to its financial entity, which pays them the contract amount less the sum already paid. Credit risks regarding default on payment by the debtor to the borrower bank are covered by insurance from the Export Credit Agency (ECA), i.e. State insurance companies, and which set out to promote exports from a country. The Spanish ECA is called CESCE and covers a percentage (up to 99% in some cases), of the political risk, extraordinary risk, commercial risk and the risk of default on loan repayments that the buyer has taken on.as credit operations, in adition the cover by credit insurance, a guarantor or endorser to the satisfaction of ECA may be necessary. When the customer is the State or State-owned, the endorsement is the State itself, which is called sovereign guarantee

49 Supplier credit In this type of credit it is the exporter that receives the financing. This involves an advance normally non-recourse of the exporter s rights for collection from the importer. These collection rights may be in the form of promissory notes or other negotiable instruments. The operational process is similar to that previously described; a sales contract is formalized between the exporter and the importer, and a credit agreement either commercial or with official support is established between the Spanish financial entity and the exporter, in this case based on the discounting of negotiable instruments. The importer pays at least 15% of the contract amount as an advance payment for the goods and services

50 The exporter supplies the goods or provides the contracted services against the delivery by the importer of the negotiable instruments, which may be guaranteed by an entity in the importer s country. The exporter delivers the negotiable instruments to its financial entity, which discounts them and gives payment. At maturity the exporter s financial entity presents the financial documents to the importer to collect payment. They are usually medium-term or long-term loans and are generally used for the acquisition of services or equipment goods and turnkey plants, etc. Credit risks regarding default on payment by the debtor to the exporter, which would cause non-payment to the borrower bank, are covered in terms of political risk, extraordinary risk and commercial risk likewise by insurance from the ECA. As credit operations, in adition the cover by credit insurance, a guarantor or endorser to the satisfaction of ECA may be necessary. When the customer is the State or State-owned, the endorsement is the State itself, which is called sovereign guarantee Lines of credit This type of arrangement is similar to that of buyer credit, with the difference that instead of being a fixed amount for a specific operation, the importer is granted a credit limit for various export operations. They are granted by Spanish financial entities to give official support to the financing of purchases of goods and services sold by different Spanish suppliers to foreign importers

51 These lines are often agreements between governments in order to facilitate the financing of exports. In some cases the lines may be limited to a specific sector or product range. These lines also tend to be medium-term or long-term loans that are generally used for the acquisition of services and equipment goods, turnkey plants, etc Multilateral financing Multilateral financing is an activity based on funds made available by multilateral organizations and international financial institution (IFIs) for purchases of their needs or to carry out projects in the various countries where they operate. Spain collaborates in these organizations as an associate or donor country, depending on circumstances, regularly providing funds. As such it is a good source of financing for the development of all kinds of opportunities. In brief summary, there are three main figures: > 1 / The United Nations: non-financial organization that works through various cooperation agencies. > 2 / European Union: financial organization that works through Europe Aid and the European Investment Bank, among other such organizations. > 3 / World Bank and regional banks such as the Inter-American Development Bank, the Asian Development Bank and the African Development Bank, among other such financial organizations

52 Show what you know In supplier credit, who receives the financing? a. The importer b. The exporter c. Both the importer and the exporter Correct answer: b

53 5. RISKS IN INTERNATIONAL OPERATIONS The concept of insurance owes its existence to that of risk. International trade operations bring with them various types of risk. Country risk consists of factors other than the commercial risks that are taken into account to determine the solvency and confidence in a country for granting it financial facilities or make trade exchanges. The commercial risks consist of all events relating to the possibility that a natural person or organization might fail to comply with a financial or contractual obligation. The financial risks add to the difficulty of economic management and may lead to a restructuring of the incoming and outgoing payments. Among them are the risks involving bonds and guarantees, the insurance itself, the foreign exchange rate risk and the interest rate risk Definitions and types of risks Risk is the root cause for the existence of insurance. When an insured asset gets damaged, this results in a claim and losses. The losses lead to the payment of the compensation stipulated in the insurance contract. Risks to companies > Due to cause. Due to the factor that produces it or its nature > Due to time. Due to when it takes place Any situation rooted in conditions of uncertainty may result in: Economic risk This is also referred to as non-financial risk. It is risk that makes it difficult or even impossible to obtain the desired operating result from the business

54 Financial risk This refers to risk that clearly relates to the company s financial structure or debt position. Risk is something that is inherent to business ventures, something that must be taken as par for the course. It is an element that can occur at any stage of a contractual process and in any type of contract, which will not disappear even with the most in-depth of risk analysis. Risk is something that must be managed as best as possible. The systematic procedure used to deal with risk is dynamic, as it varies depending on the type of risk and adapts to circumstances that change over time. It is necessary to identify each risk factor, to look at the repercussions on the production process, to study how it can be avoided, accepted, transferred or absorbed. It is likewise necessary to analyse the incidence of the risk in relation to the cost of its coverage (when possible), looking at how to approach it and evaluate it and how to limit it or reduce it, also identifying the methodology for monitoring and managing each risk. For purely illustrative purposes, different risks that may exist in an international trade operation are listed below, some with greater and some with lesser incidence: Political risk & country risk, commercial risk, legal risk Customer risk, financial risk, tax risk Project risk, design risks, supply risk, construction and assembly risk Commissioning risk, performance risk and warranty risk Though it is clear that it is impossible to cover some kinds of risks, the most common risks and those of greatest economic effect can be covered. It is perhaps worth mentioning another risk, which is clearly known and insurable, but not to be studied in detail here. The risk referred to is that of goods transportation, which is covered in the illustrative list above as a subcategory of supply risk

55 Lastly, the special means of financing, mentioned earlier when discussing financing of exports and imports (these being to a certain degree also alternative instruments of payment), do themselves cover some of the risks listed: > Confirming. Contract rescission risk and default risk > Leasing. Credit risk > Factoring. Credit risk and default risk > Forfaiting. Credit risk and, in most cases, exchange rate risk and interest rate risk 5.2. Political-country risk Country risk is understood as the risk existing in debts from a country considered as a whole, due to circumstances other than normal commercial risk, including sovereign risk, transfer risk and all other generic risks deriving from financial activities. More than just a category of risk, country risk is a whole set of factors, distinct from events considered as commercial risks, and taken into account to determine the degree of solvency and confidence a country merits for granting it financial assistance or for conducting international trade. It is included together with political risk but covers a wider concept. Political decisions are strongly related to the socio-political and macroeconomic situation of a country at a given time and may impede the fulfilment of contract payments for reasons outside the control of the two parties. Political risks are understood as events that lead to economic failure for the exporter, that stem from laws, acts and other measures either explicit or implicit that are adopted by the authorities in the importer s country,

56 and that lead to the buyer or its guarantor not meeting the payment for the export or breaching the contract. It is worth highlighting the possibility of minimizing the political risk when collection is made using a documentary credit or by a confirmed documentary of credit. This confirmation can come from the payer-issuing bank at zero cost to the beneficiary. However, if the documentary credit is not issued this way, confirmation may be provided by the financial entity, directly, or by an exports insurance company. In both of these cases the fees for the risk coverage will be charged to the beneficiary Sovereign risk This is the risk regarding State creditors or entities for which the State is the guarantor, insofar as any legal actions against the final borrower may be ineffective for reasons of sovereignty. This contingency arises from the possibility of not collecting payment for an export or not recovering an investment when operating directly with the Governement of a country or its State owned companies administration, or when credit is granted to the private sector but guaranteed by the State Transfer risk This is also known as insolvency risk and is associated with residents in countries that suffer from widespread difficulties paying their debts. This may be caused by a lack of foreign currency or by restricted access to foreign currencies, dues to the actions or regulations of the authorities in the country in question. Transfer risk always relates to private foreign debt for which the Governement does not hold responsibility, not being the guarantor

57 Companies are subject to transfer risk when it is not possible to receive the value of the exports they make, or to repatriate an investment (capital, interest or dividends) from a country. This may be a result of the economic situation in that country, in which the authorities may prevent their residents from fulfilling their obligations Commercial risk Commercial risks consist of all events relating to the possibility that a natural or legal private persons might fail to comply with any type of financial or contractual obligation. As mentioned when discussing documentary credit, it is worth highlighting that when using documentary credit as a means of payment, there is no commercial risk due to the irrevocable nature of this negotiable instrument. Commercial risks are made up of a series of contingencies that can be grouped into three types of collateral risk: 1. Contract termination risk 2. Credit or financing risk 3. Non-acceptance of goods risk Contract termination risk This relates to events that can happen prior to the sending of the goods (the manufacturing or acquisition period) or while services have been contracted but not yet provided, events that cause the termination or nonfulfilment of the sales contract unilaterally on the part of the buyer, with the exporter unable to play a part in this decision. The causes that can give rise to this type of risk are: unilateral termination of the contract by the foreign buyer;

58 measures adopted by the authorities in the importing country or our country that make it impossible to carry out the export or receive payment; catastrophic or extraordinary events in the country of destination that prevent the export taking place Credit or financing risk Any transaction that is not settled by a cash payment gives rise to credit, the consequence of which is the possibility that the buyer might not fulfil its obligation to repay the debt as per the amounts and instalment periods agreed upon in the contract. Credit risk is a contingency the exporter must face whenever the sales contract stipulates a deferment of payment, affecting the period between the date the goods are delivered or the service is provided until the dates on which payment is received of the agreed amount. At this time, the provision of financing allowing for deferred payments is of vital importance for exporter companies from a commercial point of view. As a result of this exposure to deferred payments three contingencies arise, worthy of mention: Foreign exchange rate risk When the currency agreed upon to make the repayment for the transaction is different from that of the exporting country. Credit risk It is coming from the possible insolvency or bankruptcy, of fact or of law, by the buyer caused when the exporter is not settled by a cash payment. Non-transfer risk This is result of political decisions in the importing country that lead to the blocking or delaying in sending currency overseas to the seller to settle the transaction

59 Non-acceptance of goods risk The signing of the international sales contract initiates a bilateral relationship between the seller and the buyer that results in a series of reciprocal rights and obligations, which basically it focus on two: 1 / The seller has to deliver the products that are the object of the contract with no defects or vices and under the conditions agreed upon. 2 / The buyer commits to take possession of the goods, taking all reasonable measures to make the delivery possible for the exporter, and must pay the price in accordance with the terms agreed in the contract. In practice, this risk becomes for the export company similar to termination of the contract, but much more serious and expensive, because it involves major damage, since the merchandise is fully manufactured. A rejection of the goods by the importer can be based justifiable events such as a failure to meet the contract requirements, or may stem from changes in the importer s initial plans Financial risks Today s financial risks add to the difficulty of economic management and may lead to a restructuring of the collections and payments. This risk includes a range of contingencies, such as: risks involving bonds and guarantees; the insurance itself; the foreign exchange rate risk; and the interest rate risk. The most important aspects are commented on next

60 Exchange rate risk This exchange rate risk is always present when the dealing in a foreign currency. It is risk with consequences that directly affect the business s trading account and, in turn, its profit and loss. This comes as a result of the positive or negative difference between the real exchange rate for a currency and the rate estimated in the offer. Currencies should not be used for speculating. The foreign exchange rate risk must be covered using one of the hedging instruments available on the market. Given that the payments for transactions are hardly ever made in cash, but rather via deferred payments, the collection is settled at a date subsequent to the export. Fluctuations in currency values entail uncertainty about exchange rates at maturity. The longer the maturity period, the greater the uncertainty. As regards coverage of the exchange rate for import and export transactions, there are various basic financial instruments: Forward Plus exchange risk insurance This insures the exchange rate for a set with a barrier or limit quotation to the rate charged. If the limit is not reached, a better rate is obtained; if the limit is reached or passed, the transaction is made at the insured rate. Flexible exchange risk insurance Open exchange: a final maturity date and an overall amount are established for the sale or purchase, but partial amounts may be transacted at the agreed exchange rate throughout the validity period of the insurance. Closed exchange: this is a commitment to forward sell or purchase a foreign currency when the amount and the maturity are established; the client is committed to taking or providing the currency amount at the agreed due date

61 Foreign exchange options These involve paying a premium at the time of the subscription of the option to have the right but not the obligation, to purchase or sell a currency amount at a certain price at a future date, depending on market developments. A purchase option is known as a call option and a sale option is called a put option. In addition, there are further ways that this risk may be reduced or delimited. Self-insurance This includes actions such as revision clauses regarding the exchange rate, the opening of accounts in foreign currencies, netting (the offsetting of multiple collections and payments), invoicing in euros, or invoicing and financing in the same currency. Transferring risk to third parties Using alternatives means of payment and financing such as forfaiting and confirming, or foreign buyer credit. Other products Although there are, but are used much less, due to their technical complexity, other products from the derivatives market such as currency swap transactions or currency futures Interest rate risk This risk arises as a consequence of variations in interest rates and differing maturity periods for an entity s assets and liabilities. The entity can only be free from this kind of risk by achieving a perfect fit between its assets flows (collections) and liabilities (payments), it would be safe from this type of risk; but the instruments that provide the financial markets do not allow to go beyond them closer as much as possible. In the context of foreign trade transactions, it is generally a risk of marginal or very little importance for short-term operations. Nevertheless it is worthy of consideration in operations

62 financed over the medium or long term, as it may result in an increase in the financial charges envisaged, or in a greater cost for financing obtained in countries with high inflation rates Extraordinary risks Catastrophic and extraordinary risks are defined as all contingencies apart from those considered political risk that are outside the control of the contractual parties (in particular the importer) and prevent either payment being received for the exports or the fulfilment of the contract. The scenarios most commonly noted as extraordinary risk include a variety of events which can be both natural and man-made. 1 / They may be wars, revolutions, riots, revolts and any other situations of the like occurring outside Spain that prevent the debtor from fulfilling its payment commitments. 2 / Extraordinary risks can also be catastrophic phenomena taking place outside this country and preventing a foreign debtor from making payments, such as floods, fires, earthquakes, tidal waves, hurricanes, meteorites, volcanic eruptions, nuclear accidents and so forth. 3/ When these events lead to the insolvency or bankruptcy of the debtor. 4/ Risks classed as extraordinary by the provisions of the insurers regulating compensation in the event of such claims. It corresponds to the exclusive condition of Force Majeure in a contract. These risks can be insured in certain conditions Sureties and guarantees A surety or bank guarantee is a commitment taken on by one party (the guarantor) to meet the contractual obligation contracted by another party (the guaranteed party) with a third party (the beneficiary of the guarantee) to compensate any non-fulfilment by the guaranteed party

63 As such, the financial entity guarantees the final payment or fulfilment of the obligations contracted by its client with a third party. As a result, if the client does not pay or duly fulfil its obligations, the holder of the guarantee will demand of the financial entity issued the guarantee for payment of the corresponding amount. Guarantees and sureties in foreign trade are always irrevocable, unconditional and to be paid upon the first demand. Bank guarantees may adhere to the ICC s rules URDG 758 (2010 edition) for first demand guarantees, or to the legislation in the corresponding country, either that of the guarantor or that of the counter-guarantor. A guarantee issued by our bank may be re-issued locally by a bank in the country of destination, which is done through a correspondent bank. A guarantee can be issued in two ways, either directly to the beneficiary (notification of the guarantee is given by a correspondent bank) or by means of a counter-guarantee through a correspondent bank. International commercial relationships can take many different forms, from tendering processes to import and export contracts that require guarantees of their fulfilment or of certain obligations deriving from them. In the majority of cases, sureties and guarantees are an essential requirement to fulfil the agreed conditions. There are guarantees whereby the guaranteed party is obliged to pay a certain amount, and there are those that cover the non-fulfilment of commitments entered into by the guaranteed party

64 Principal guarantees and sureties The main guarantees used in foreign trade cover a diverse typology: Tender guarantee or bid bond Performance guarantee or performance bond Maintenance guarantee or faithful compliance Advance payment guarantee or repayment guarantee Payment guarantee Guarantees for customs authorities or other official organizations Guarantees can be classified as technical, economic-commercial or financial. Technical guarantees These relate to fulfilment of the commitments entered into by the guaranteed party, that is the client s technical capacity to meet the commitments taken on. For example: the import of goods under the temporary importation arrangement; participation in tender and auctions processes; the execution of works and supplies; the correct operation of machinery sold; and other similar commitments. These guarantees do not entail a direct payment obligation. Economic guarantees These ensure operations in which the guaranteed party has a commitment to pay a specific amount at maturity of a fixed period. They may be: Economic-commercial guarantees. These relate to trade transactions and deferred payments for purchases of all kinds of goods, as well as payment instalments, cash advances and hire payments. Financial guarantees. These relate to credit or loans taken by the guaranteed party from other entities, the repayment to these entities becoming the responsibility of our bank. Due to increased global use of international guarantees, customers can have many operations simultaneously with guarantees in force. It is worth knowing that in the United States banks do not issue guarantees, but rather standby letters of credit. As such, in countries where the American dollar is prevalent, stand-by letters of credit are also used, under the UCP600 regulations and the more specific ISP 98. The

65 most significant difference is that with stand-by letters of credit, the beneficiary must present a document proving the default (the most typical are the buyer request or the supervising entity certificate), whereas bank guarantees payment is at first demand Summary of basic risks The tables below summarise the principal basic risks together with its sub-factor risks, the main factor of contingency and forms of coverage they can use: Political-country risk and extraordinary risks Type of risk Contingency Coverage Political risk Sovereign risk Insolvency risk Catastrophic or extraordinary risk Prevention of fulfilling the contract Difficulties in recovering receivables Lack of solvency for meeting obligations External forces that prevent fulfilment of the contract Insurance, confirmation of the means of payment, stand-by letters of credit, guarantees, granting of non-recourse credit Insurance Multilateral organizations/ agencies Commercial risk Type of risk Contingency Coverage Risk of contract termination Credit risk Risk of default Prevention of fulfilling the contract Insolvency of fact or law of the debtor Lack of solvency for meeting obligations Insurance, confirmation of the means of payment, stand-by letters of credit, guarantees, granting of non-recourse credit Financial risks Type of risk Contingency Coverage Foreign exchange rate risk Interest rate risk Losses from downward currency trends Losses from downward interest rate trends Banking market instruments Financial market instruments Self-coverage mechanisms

66 5.8. Foreign trade risk insurers Widely and traditionally known as Export Credit Agencies (ECAs), nowadays these official insurers act in a broader scope than simply that of export credit defaults, as commented upon already. ECAs may be Stateowned or private insurance companies, or a combination of the two. In Spain the risks of Spanish companies deriving from foreign trade activities abroad are insured by CESCE, which is State-owned company, and of which the majority shareholding is public, the rest being in the hands of banks and insurance companies. Until the 1990s CESCE was the only company to dedicate itself to providing coverage of commercial risks and political and extraordinary risks. At present, all insurance companies authorised by the Directorate-General of Insurance can cover the risks from export operations. Examples other than CESCE include Crédito y Caución (Atradius group, Dutch ECA), Solunion (Mapfre and Euler Hermes, the German ECA) and Coface Ibérica (a subsidiary of French ECA Coface). ECAs act with a double profile: On their own account As conventional insurance companies and in stiff competition with others in the sector covering commercial risks. On the state s account Covering political and extraordinary risks, in which their activities must adhere to certain supranational regulations, the objective of which is to prevent situations of unfair competition between countries. The political risks covered include: failures to effect currency transfers because of decisions by the government in the importing country; losses occurring as result of transfers made in

67 a currency other than that agreed upon; wars, revolutions or similar situations; defaults by State-owned purchasers; and catastrophes or extraordinary events such as expropriation, requisitions, destruction or damage of goods produced outside of Spain that prevent the customer from receiving the goods. Normally, the commercial risks insured are: insolvency risk caused by very late payment; and insolvency risk caused by a declaration of bankruptcy or cessation of payments, when it is proven that the transaction payment cannot be recovered and that starting legal proceedings would be futile. Commercial insurance does not cover fines, penalties or any other damage of this kind unless expressly stated in the policy. Furthermore, operations involving illegal products cannot be insured, and guarantees do not include interest on arrears, restitution costs or banking brokenness. When insurance companies talk about claims with losses it refers to the materialization of any of the risks covered in the corresponding insurance contract, which results in them having to indemnify the beneficiary of the contract. Whether the losses are a result of political or extraordinary causes or a result of strictly commercial causes, the main issue is that it is a significant disruption for the exporter, and that this disruption stems from its exposure to two basic types of risk: the risk of contract termination and the risk of default. In the end, it is of little matter to the exporter whether the cause of its potential loss is a decision by its customer or a specific action by a government; what really matters to the exporter is not being able to deliver and collect from the pending order, or not being able to collect payment from an order already delivered. The various different types of policies available on the insurance market today are based on covering at least the basic risks discussed

68 Types of coverage There are five types of coverage for export operations: 1 / Pre-financing default. 2 / Contract termination. 3 / Default risk. 4 / Execution of guarantees. 5 / If there is financing, default on the medium or long term credit repayments. All ECAs have a variety of policies that cover almost any situation that might arise in the context of a company s internationalization. By way of illustration, CESCE has the following types of coverage for foreign trade: Risk s on the State s account Insurance for commercial, political and extraordinary risks. Operations with a payment period of under two years: Individual supplier credit policy; Individual documentary credit policy and Open documentary credit policy. Operations with a payment period of two years or above: Buyer credit policy; Individual supplier credit policy; Insurance policy for works abroad; Insurance for guarantors against risk of bond execution; Insurance for exporters against risk of bond execution; Bank guarantees policy; Insurance policy for compensation operations; Insurance for project finance operations and Insurance policy for investments abroad. Surety Guarantees the policyholder with regard to the responsibilities demanded as a result of non-fulfilment of the obligation guaranteed, be that either by law or by the contract between the parties. Tender guarantees and performance guarantees (for works, supplies and services), public advance funds and stockpiling, and obligations to customs authorities. Other products: for specific operations: Open insurance policy for factoring/forfaiting and Open insurance policy for confirming

69 Most common types of policies The following are the most common types of policies Individual policy Conceived to respond to the needs of stand-alone exports, that is exports made on an ad hoc basis or by non-habitual clients; to insure a specific operation. Private buyer. State-owned buyer. Note that, as you might logically expect, when a buyer has State-owned legal status, it is considered that there are not commercial risks (that is to say a non insolvency risk concerning the buyer). Floating or open policy Provides total or partial coverage for the exports realized to different importers and markets over the validity period (normally one year) for the maximum amount established in the policy. This type of arrangement is devised for exporters with numerous regular customers, and involves an initial credit classification of said customers by the insurer. The intention is to cover a wide range of operation types in the framework of the conditions agreed upon. Show what you know Which of the following types of risk is considered a financial risk? a) Foreign exchange rate risk b) Non-acceptance of goods risk c) Contract termination risk d) Sovereign risk Correct answer: a