Trade Finance provides essential support to MSMEs by enabling them to expand their operations and compete effectively in domestic as well as international markets with import & export. This article gives a fair idea to MSMEs about how the Trade finance (Import Export Finance) works , trade financing options for international trades and essential considerations to be kept in mind.
Introduction to Export and Import finance authored by Indrajit Samanta, RXIL Global
International trade comes with its own set of complexities. These can emerge from the parties involved in the transaction, including issues such as default, fraud, or unmet order specifications, as well as from factors beyond control like natural calamity, terrorist attack, cyber security, etc. While we cannot do much about the latter, we can ensure safeguarding ourselves in the former case.
The longer distance between the two parties entails longer delivery and credit periods. Importers wait for the goods, while exporters for their payments. Trade finance comes into the picture to bridge this gap. It is a financial instrument that helps exporters to receive funds quicker and importers to receive goods without upfront payments. In effect, it reduces cash flow issues for both.
How Does the Trade Finance Work ?
The exporter would happily receive the payment upfront as soon as exporter ships those goods, or even before that. Exporter wouldn’t like to be in a position where the goods have reached, but exporter hasn’t received the payments for months. On the other hand, if the importer paid in advance and the exporter refused to ship, then that increases risk for the importer. This is where the intermediary comes in, assuring both parties that the transaction will be completed without issues.
The third party is a financial institution, mainly a bank or trade finance company. Here’s how the transaction takes place:
This is how the process takes place:
- Contract Agreement: Contract takes into effect between exporter and importer.
- Shipment and Documentation: The exporter ships goods and presents documents to the Financial Institution.
- Prepayment: Financiers disburse funds to exporter based on the transaction documents shared with financier
- Document Flow: The physical flow of the document is from the exporter’s bank to the importer’s bank, conveying information about the shipment along with documentary evidence.
- Repayment : On the due date, the financier will have to receive funds from the Importer and then the balance payment is transferred to the exporter.
Let us understand various types of export and import finances.
Types of Export Finance
There are two main types of export finance viz. pre-shipment finance and post-shipment finance.
- Pre-Shipment Finance: Pre-shipment finance is provided to an exporter before the goods are shipped. It includes:
- Running account Packing credit: The exporter gets a loan for raw material purchases and packing of goods.
- Order based Packing credit: The exporter gets a loan against specific Export Order to Manufacture the goods for export.
- Post-Shipment Finance: Post-shipment finance is provided to an exporter after the goods have been shipped. It includes:
- Bill discounting: The exporter’s bank pays the exporter against the invoice and charges interest upfront for the financing.
- Factoring: Bank offers With Recourse or Without Recourse Factoring facility to the exporter, where the exporter sells its invoices (Receivables) to Bank / FI / Factoring company at a discount.
- Others:
- Letter of Credit (LC): This is the most common method in international trade. It is an agreement between the seller’s bank and the buyer’s bank. The importer’s bank commits a payment to the exporter’s bank after satisfying the necessary conditions as mentioned in Letter of credit.
- Export Credit Insurance: It protects exporters against the risk of non-payment by the importer due to Financial inability to pay or Insolvencey of Buyer. Bank / FIs may finance against the security of credit Insurance.
Types of Import Finance
The following are the types of import finance:
Buyer’s Credit / Suppliers credit: It is a loan provided to an importer to finance the purchase of goods or services.
The bifurcation of funded and unfunded applies in the case of import finance as well.
Identifying the best Trade Finance Options for MSMEs
MSMEs should wisely choose these options depending on their own needs and risk-taking abilities. Here are a few things businesses including MSMEs should know about funded and unfunded products.
- Funded Products: If you need cash immediately, then funded products are ideal. Bill discounting, export credit, or pre-shipment finance are suitable choices. However, one should also account for the interest charges.
- Unfunded Products: It covers Letter of Credit, Guarantees to support purchase of raw materials, services etc. to manufacture good for export to mitigate the risk and not the payment, one should consider products like LCs and credit insurance.
- Structured Finance Products: Large-value transactions may warrant structured financed products tailored to the specific project requirements. Structured finance products combine all the requirements in the entire supply chain right from pre-export finance, and inventory finance to accounts receivable finance. Here, the financial institution funds the party with several loans at various stages of the transaction instead of a lump sum amount.
- Government Programs: Governments announce schemes like export credit guarantees or other initiatives to support exporters. If your business qualifies for such a scheme, then, you should consider it. Many times, such schemes are announced for a specific sector or in times of distress. Many concessions regarding charges, interest or conditions might make it a better option.
- Recourse Financing: In case of with recourse financing, the Bank would take risk and exposure on Exporters. The pricing and collateral security would depend on the credit standing of Exporter.
- Non-Recourse Financing: In case of without recourse financing, the Bank would take risk and exposure on counterparty (Buyer) and not Exporters. Once the Invoice is financed on without recourse basis, Bank would collect the payment from buyers and will not approach Exporter for repayment except in few conditions as agreed earlier.
Why is Export-Import Finance Needed ?
Export-import finance plays a crucial role in mitigating many risks. It also fosters a smoother trade experience. The following are some benefits, which MSMEs can enjoy with Export Import Finance of such arrangements:
- Cash Flow Management: Exporters and importers can leverage trade finance to manage their cash flow effectively. Exporters receive funds quicker, and importers can defer payments, allowing both parties to maintain healthy cash flow cycles.
- Risk Management: With the help of export finance tools like letters of credit and export credit insurance, exporters reduce the risks of non-payment by importers. Similarly, import finance products like credit insurance can protect importers from supplier defaults or unexpected events.
- Strengthening the Supply Chain: With the help of trade finance, goods delivery becomes faster, and the invoices get settled quicker. This promotes trust between both parties and strengthens their relationship. Thus, it makes the supply chains stronger and long-lasting.
- Business Expansion and Capacity Improvement: Access to trade finance empowers businesses, especially exporters. They can take larger contracts, expand their businesses, and invest in capacities as the financial institutions manage the cash flow and liquidity.
Risks in Trade Finance
Trade finance involves several risks, as outlined below, which MSMEs need to be aware of:
- Country risk: This kind of risk emerges when a country cannot meet its commitments due to economic or political instability.
- Corporate risk: Poor management or financial difficulties may hinder the company’s ability to honour its dues and that kind of risk can affect the smooth flow.
- Commercial risk: It is the risk of fulfilling the conditions of contract by parties involved.
- Fraud risk: An act of dishonesty, forgery and lying can cause a loss to the other party. The entire edifice of trade finance is built on trust. Thus, any such act can cause humungous losses to the other party.
- Documentary risk: It is when a party fails to provide the necessary documents to complete the trade.
- Currency risk: Changes in exchange rates can impact the profitability of any international trade.
- Transport (theft/piracy) risk: The risk of goods being stolen or damaged during the transport.
Conclusion
Trade finance is a critical component of international commerce, serving as a lifeline for both exporters and importers by bridging the gap between the time goods are shipped and when payments are made. By understanding the intricacies of different types of export and import finance, MSMEs can navigate the complexities of international trade more effectively. Whether through pre-shipment or post-shipment finance, letter of credits, or export credit insurance, the right choice depends on individual needs and risk tolerance.
The benefits of utilizing trade finance extend beyond mere financial facilitation; they encompass improved cash flow management, enhanced risk mitigation, strengthened supply chains, and opportunities for business expansion and capacity improvement. Despite the potential risks associated with trade finance, such as country risk, corporate risk, commercial risk, fraud risk, and transport risk, the advantages of streamlined operations and reduced financial uncertainties make it an indispensable tool for global traders.
Ultimately, the decision to engage in trade finance should be based on a thorough assessment of the MSME business’s financial health, operational needs, and risk appetite. By carefully selecting the appropriate trade finance instruments and strategies, MSME businesses can mitigate risks, optimize cash flows, and foster sustainable growth in the global marketplace.
Introduction to Export and import finance authored by Indrajit Samanta, RXIL Global on MSME TALK