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element over the counterparty risk by banks while pricing the trade finance product offered to the trading companies. Research aim is to quantify and validate the ...
EXAMINE TRADE FINANCE METHODS USED BY TRADING COMPANIES GLOBALLY AND EVALUATE THEIR EFFECTIVENESS TEOH TEIK TOE (James Cook University Australia – Singapore Campus) Werner R. Murhadi (Universitas Surabaya, Indonesia) NEETU KATARIA (Anglia Ruskin University, UK)

ABSTRACT This study is planned in the functional area of Trade Finance Methods used by trading companies globally and in Singapore with focus to study on effectiveness in each method. While arriving at the effectiveness of the trade finance method the effort has been to include not just the cost or pricing dimension but also risk mitigation aspects as well as the documentation intensity translating to the convenience factor of the method. Research further attempted to explore importance accorded to country risk element over the counterparty risk by banks while pricing the trade finance product offered to the trading companies. Research aim is to quantify and validate the general understanding on the effectiveness of trade finance techniques employed by the trading companies. Researcher has explored and analysed the relationship or interrelationships between variable – cost effectiveness, risk mitigation and documentation aspects of commonly used trade finance products, so as to obtain effects by causative factors (Creswell, 1994) to have a great insight into the overall effectiveness of the trade finance products being used by the trading companies. Researcher employed „Survey‟ methodology to articulate research questions and hypothesis in the field. Researcher designed and administered the questionnaires to specific set of banking professionals & representatives of trading companies active in trade finance areas. Sample of trading Companies and Banks was carefully selected using stratified random probabilistic sampling approach. Data collected was analysed using non-parametric statistical packages to establish association like chi-square (χ²) and the extent/ degree of association like spearman correlation coefficient( or rs). Researcher concluded that documentation has been sighted as major reason for its lower use as a source of trade finance. Based on the results it can be reasonably deduced that documentation intensity might affect rationality significantly while choosing between letter of credit vis-à-vis other source of finance such as Bill discounting. It can be reasonably inferenced that increased documentation might have resulted in a risky practice of going for clean invoice financing where use of letter of credit would have been optimal from the risk management perspective of the trading companies. Research concluded that country risk is more potent factor considered by the banks where documentary credit like Letter of Credit is extended while creditworthiness might influence pricing where trading company goes in for other trade finance methods such as invoice financing.

Keywords: International Trade, Bill Discounting, Letter of Credit, Clean Invoice Finance & Country Risk



1. Introduction Trading companies from various parts of the globe have set up their offices in Singapore for carrying out trading activities due to varied reasons like better access to ports, good legal system, convenient time zoning etc. Schemes like Global Trading Partners (GTP) etc. administered by International Enterprises, Singapore (IE website, 2012) provide congenial atmosphere for the trading companies. Further Singapore provides strong judicial and legal system and has good presence of financial institutions - 122 commercial banks and 49 merchant banks in Singapore as per Monetary Authority of Singapore (Source: MAS website, 2012). Trading companies deal in multiple commodities who facilitate import- export based on commercial and financial documents. In the process trading companies facilitate to manage the pressures on the working capital cycles of both importers and exporters by stepping in to make payment to the exporters using the trade finance facilities available from the banks based on the title documents. Bank facilities are used till importer pays off on receiving the goods. Trading companies thus always look out for the financing facilities to keep this fund cycle going and would ensure that bank facilities are effective in terms of cost and risk effectiveness. Most effective bank facility would be the one that would optimally balance the cost, convenience of use and the risk for these trading companies. In contrast, the bankers who provide these trade finance facilities would also base the pricing of the trade facilities on the inherent risk of the facility besides considering factors such as creditworthiness of the companies, tenure of the facility and the security offered. Thus it is always a tight rope walk for trading companies to balance finance costs and their trading margins. How efficiently these trading company rotate funds would determine how profitable their operations would be. This would critically depend on trading company using the most effective bank facility. Most effective bank facility is one which optimally balances cost, ease of documentation and the risk mitigation for these trading companies. From industry practice it is observed that trading companies predominantly prefer use of bill discounting as a source of trade finance. Letter of credit- a documentary credit, on the other hand is preferred where there is potential counterparty risk is observed. However documentary credit documentation is really a major hurdle. What are the chances that increased documentation would result in a risky practice of going for bill discounting in such cases? On the Other hand, Banks

who are on the opposite end of the price risk spectrum, has to manage the risk arising out of the trade finance facilities. Are they inclined to build risk premium by way of higher rates while pricing their products. What is the consideration for pricing, is it creditworthiness of buyer or the country risk? Researcher will study various trade finance facilities and design a research methodology which would aim to arrive at the most commonly used source of trade finance, most cost effective source of trade finance and least documentation intensive source of trade finance. Based on the explanation above, this research will study following research questions: (1) Do Trading Companies prefer Bill Discounting over other sources of trade finance like Letter of credit as most cost effective? (2) Is Letter of credit superior product compared to Bill discounting from the perspective of risk mitigation for trading companies? (3) Would excessive documentation influence choice of trade finance method employed by the trading companies? (4) Do banks charge premium based on creditworthiness while pricing the trade finance products to reflect the higher risk. Do banks consider Country risk as more important factor for pricing decision than the counterparty risk 2. Literature Review 2.1.

International Trade

International trade is the buying and selling of goods and services across national borders or Territories as a result of uneven distribution of natural resources in different countries. Both when sourcing supplies and when selling the products, a company is exposed to risk. Such risks cannot be avoided but can only be better managed. Sources of Risk for the Parties involved in trade finance are: Buyer’s Insolvency/Credit Risk refers to the inability of the buyer to honour full payment for goods or services rendered on due date. This is a risk on seller associated with selling or supplying a product or service without collecting full payment or experienced late payment. Buyer’s Acceptance Risk refers to the buyer‟s non-acceptance of goods delivered or services rendered. Unaccepted goods or services may create difficulty for the seller to dispose the goods to another buyer or encounter working capital problem. Knowledge Inadequacy A buyer or seller who intends to expand his business into another product/service/industry/country

may not have adequate knowledge on the risk of the new product/service, local market situation or goods‟ fashion. The lack of knowledge increases the chances of business failure. Seller’s Performance Risk - A seller may fail to carry out his obligations in a sales contract due to one or more reasons, and such non-performance by the seller may have adverse consequential impacts on the buyer‟s business. It could be expensive for the buyer to take legal actions against the seller in his country. Documentation Risk is the risk of non-conformance to specific documentation requirements under a sales contract or documentary credit. Failure in fulfilling documentation requirements may result in seller‟s inability or delay in obtaining payment for goods delivered or service rendered. Economic Risk -Refers to unfavorable economic conditions in buyer or seller‟s country which may affect both parties in fulfilling their obligations. On the buyer side, economic risk may result in buyer‟s insolvency or inability to accept the goods or services. On the other hand, the seller may experience difficulty in producing or shipping the goods per se. Cultural Risk - Different countries have their unique language and culture. The inability to appreciate/accept cultural differences and/or language barrier may result in conflicts and non-completion of the sales contract. Legal Risk - Potential for financial loss arising from uncertainty of legal proceeding or change in legislation, such as a foreign exchange control policy. A sales contract could be frustrated due to changes in laws and regulations. Foreign Exchange Risk -A buyer or seller may deal with foreign currencies in their daily course of business. This implies that they are exposed to fluctuations in foreign exchange market which may result in paying more (by the buyer) or receiving less (from the buyer) in terms of the local currency. Interest Rate Risk is the risk borne by an interest-bearing asset, such as a floating rate loan. An increase in interest rate will result in buyer or seller paying more interest for their floating rate loan. Political/Sovereign Risk refers to the complications that buyer or seller may expose due to unfavourable political decisions or political changes that may vary the expected outcome of an outstanding contract. Examples of political/sovereign risk are changes in fiscal/monetary policy, war, riots, terrorism, trade embargoes, etc.

Transit Risk is the risk of goods being damaged during shipment from the place of origin to the place of destination. Failure in addressing transit risk may result in heavy replacement cost or performance risk.

Trading companies should be mindful of the risk involved. One such step to manage such risk is to consider payment term which varies depending on the negotiating power of the transacting companies. Four common payment terms in international trade: Open Account, Advance Payment, Documentary Credit and Documentary Collection. In this paper, we focus on a documentary credit. A documentary credit, or letter of credit, offers greater security still to the exporter, compared with both open account trading and documentary collections. Just as with a documentary collection, both parties to a documentary credit use their banks as intermediaries. However, in contrast to the documentary collection, under the terms of a documentary credit the importer‟s bank guarantees payment to the exporter, as long as the terms of the credit are met. Trading Company face a reduced risk by using a documentary credit compared with documentary collections because they effectively have a guarantee of payment from a bank. This does rely on the trading company complying with the terms of letter of credit, so care needs to be taken in the preparation of the documentation. As with a documentary collection, it is important that the trading company has sufficient resource to be able to prepare and present documents in accordance with the terms of the letter of credit However, there is still a risk that the bank may not honor the terms of the letter of credit. There is also a country risk in the sense that payment under the letter of credit may be affected by any debt rescheduling for that particular country. Local customs rules also apply, and the trading company will need to ensure the shipment does not breach the terms of any local import rules or restrictions and, if necessary, an appropriate import licence is obtained. Because of the central role of banks in the process, creditworthiness of the counterparty bank is also an important source of risk. This applies particularly when exporting to a new market where the local banks are not well known to the exporter. One solution is for the company to ask its bank to confirm the letter of credit issued by the importer‟s bank, although this will be at additional cost. This further mitigation of risk effectively removes bank and country risk in the importer‟s country.

Despite this focus on the LC, over the years the term trade finance has been shifting away from this sometimes cumbersome method of conducting business. It is now estimated that over 80% of global trade is conducted on an open account basis. While volumes of LCs have remained flat in recent years, their value actually increased and they remain an essential part of emerging market trade and trade in countries where exchange controls are in force. This increase in value is also a reflection of the commodity price boom of 2007/08. Led by large corporates, this form of trade saves costs and time and so has been adopted by smaller corporates as they become more comfortable with their buyer and supplier relationships. Open account transactions can be described as „buy now, pay later‟ and are more like regular payments for a continuing flow of goods rather than specific transactions. This is much cheaper for corporates. 2.2. The future use of documentary credit trade finance technique In the aftermath of the contraction of bank credit and the increased focus on counterparty risk, there was an expectation that the use of import letters of credit, for example, would increase. Because letters of credit provide the seller with more certainty with respect to a purchaser‟s promise to pay, it appeared they would become more popular as all entities refocused on managing the risks inherent in any trade transaction. This would have represented a significant change, as the use of import letters of credit has been declining in recent years. In practice no clear pattern emerged. Initially, as global trade volumes dropped, the use of letters of credit also dropped, although whether these were directly correlated is not clear. Looking into the future it is not obvious that there will be a revival in the use of letters of credit and other trade instruments. They remain relatively expensive to establish, so many companies only seek to use them when the risk profile of the transaction justifies this cost. In other words, they remain most common for transactions with new trading partners. In this way the letters of credit perform their traditional role, which is to reduce the risks inherent in trade. Yet letters of credit and other trade documents also have a funding function, especially for small and medium-sized enterprises which may not have access to the same range of funding tools as larger entities. Letters of credit are important in providing access to pre-export and post-shipment finance, critical elements in those companies‟ working capital cycles. More interestingly, the difficulties in the bank and bond markets have also changed the perspective of many

larger companies towards letters of credit and other trade finance instruments. These instruments benefit the larger companies in two ways. Firstly, the funding techniques open funding streams larger companies have been able to ignore in recent years. With more emphasis on managing funding risk, treasurers in even the largest companies are reviewing their assessment of trade instruments. Secondly, the risk management tools incorporated into trade instruments are of increased interest as companies focus more on managing counterparty risk. These movements have come at a time when bank technologies have made it possible for banks to offer a more coordinated cash and trade proposition, integrating the two sides of traditional banking activity, which historically had remained separate.

2.2.1.

Bill Discounting

Collection/ Bill Discounting is one of the conventional methods of payment in international trade whereby the seller forwards financial and/or commercial documents to the buyer against cash payment or acceptance of a bill of exchange. In collection, banks control the release of documents and payments based on the Uniform Rules for Collection ICC Publication No. 522, but do not commit to pay the seller, unlike documentary credit operations. Collection is suitable in circumstances where the buyer‟s solvency is not in doubt and the seller wants additional security in payment.

2.2.2.

Invoice or Trust Receipt (TR) discounting

Trust Receipt (TR) is a type of short-term import loan to provide the buyer with financing to settle goods imported under Letter of Credit where title of goods is held by the bank. Under a TR arrangement, the Bank retains title to the goods but allows the buyer to take possession of the goods on trust for resale before paying the Bank on TR due date. TR financing is applicable to goods imported under documentary credit. For documentary collection, we offer import loans against Import Invoice Financing is a short term loan applicable to buyer who trade on open account basis. 2.2.3.

Banker’s Guarantee Issuance

A Banker‟s Guarantee (BG) is a definite undertaking by the bank (guarantor) to pay the beneficiary a certain sum of money within a specified period if the applicant (principal) fails to fulfill his contractual or other obligations of an underlying

transaction. It is normally used to secure either a financial or performance obligation of the principal. BG can be issued to both local and overseas beneficiary either in the form of hardcopy or transmitted via SWIFT message MT760 or MT799. 2.2.4.

Overdrafts

Overdrafts can be an effective way to finance working capital. Where offered, they are usually relatively flexible, although this will depend on any terms and conditions applied by the bank offering the facility. An overdraft facility allows a company to run its current or checking account with a debit balance. Overdraft facilities should be prearranged and are sometimes offered by banks without the need for formal security. Where available, overdrafts are usually renewable on an annual basis, although in certain jurisdictions a bank may require funds to be repaid before a facility is renewed. In some locations it is common practice to turn an informal overdraft into a committed facility after a period, often a month. They are not available everywhere, through either market practice or regulation. Some countries prohibit companies from arranging any unsecured overdrafts. In Venezuela, for example, account holders are prohibited from writing cheques with insufficient funds to support them. Their availability may be restricted to short periods. In some countries, for example France, companies may only be able to arrange overdrafts for periods up to about a month, after which banks insist on converting the arrangement to secured borrowing. Banks in Poland, on the other hand, usually require companies to clear their overdraft facilities once a year. Banks can withdraw overdraft facilities on demand. A bank is most likely to withdraw such facilities from a company which relies on them, simply because such companies represent the greatest counterparty risk to the bank. In 2009 a number of UK companies reported that their banks withdrew part of their overdraft facilities when the UK government arranged a moratorium on the payment of VAT. However it occurs, any withdrawal of overdraft facilities to a company which relies on them (whether as a permanent source of funds or as the funding of last resort) will put significant pressure on that company‟s cash flow. Because they are unsecured, overdrafts are often a relatively expensive method of arranging finance. For example, overdrafts in Mexico are usually charged at more than double the prevailing rate on treasury bills. The Basel 2 treatment of overdrafts is less favorable than other techniques, such as invoice discounting. Banks will now be looking more often for a

facility fee and a non-utilisation fee to cover the capital costs associated with such a facility. 2.2.5.

Bank lines of credit

As an alternative to an overdraft facility, companies can arrange lines of credit with one or more of their banks. These are appropriate when the company requires greater security of finance or in locations where overdraft facilities are prohibited or not available. The company can arrange a line of credit with a bank, which it can draw against as necessary. This will require formal documentation to be drawn up between the company and the bank, so a line of credit will take longer to arrange than an overdraft facility. The bank will charge an arrangement fee (for establishing the facility), a commitment fee (for putting funds aside for the company‟s use) and a margin on all funds actually drawn down from the facility. Different credit lines are available. Some will require all the committed lines to be drawn down at the start of the facility and then repaid over the term (a „term loan‟). Others will allow committed funds to be drawn down and repaid as often as necessary (a „revolving‟ facility), as long as the maximum level of the commitment is never exceeded at any one time. Banks require all committed funds to be repaid at the end of the facility, although it can be possible to roll one facility into another without repayment. Based on the brief explanation above, we make a hypothesis: H1

Bill discounting is more cost effective way of trade finance than Letter of Credit

H2

Letter of Credit is mitigates risk better than Bill Discounting.

H3

Documentation for Letter of Credit is more onerous compared to that for Bill discounting.

H4

Pricing of Clean Invoice Finance does not vary with credit-worthiness of Borrower.

H5

Country Risk is more important than counterparty risk while pricing letter of credit.

3.

Research Methodology These research used „Survey‟ methodology to articulate research question or the

hypothesis in the field. Questionnaire designed to administer specific set of banks who are active in providing trade finance to trading companies. Survey research methodology is generally mapped to relativist epistemologies (Easter-Smith, 2008, p.83) which assume that there are regular patterns in human and organisational behaviour which are often difficult to detect and to explain. As a result cross-sectional designs, which enable multiple factors to be measured simultaneously, are employed. Researcher had used factual & inferential survey designs. Factual questions in the questionnaire were used to collect and collate the factual data on the cost effectiveness of Invoice financing as a trade finance tool. Inferential questions in the questionnaire which is aim to establish relationship between use of trade facility vis-àvis documentation intensity. Cross Sectional survey was performed by the researcher. Participants included banks incorporated in Singapore & branches of the global banks and trading companies were included local trading companies as well as branches of the global trading companies. Researcher included the trading companies from varying sizes in term of their turnover and those dealing in different trading products. Data collected would be quantitative and any qualitative data would be quantified. Researcher used both qualitative (non-numerical form) and quantitative (numerical form) data for the purpose of conducting research using various sources of data. Questionnaire and Interviews were used as in Delphi Study, where the aim is to gather opinions from carefully selected group of experts (Collis, 2009, p.192) Researcher used primary and secondary sources of data. For Primary sources, interviews were carefully scheduled with bank respondents due to confidentiality or commercially sensitiveness perceived by interviewees (Easterby-Smith, 1991 cited in Collis, 2009, p.144). Questionnaires using Likert scale were developed as a source of primary data. Primary Sources included self-administered questionnaires, Interviews- Face to face, email & telephonic with the representatives of 30 Banks & 50 Trading companies. Secondary sources of data included organisation‟s websites, annual reports, Journals etc. Official websites of 10 major banks and 8 trading companies were reviewed for trade finance practices. Discrete details of data collected from the respondent category-wise as per under:

TABLE 3: SOURCES OF DATA Source of Data

No. of Respondents Banks

Trading Companies

Surveys - Questionnaire

24

35

Interviews

6

15

Face to Face

3

4

Telephonic

2

11

Emails

1

Nil

Total

30

50

Websites

10

8

Annual Reports, Journals etc.

5

7

PRIMARY DATA

SECONDARY DATA

Researcher will select sample using stratified random probabilistic sampling based on various factors such as size, span of operations, experience in similar activities etc.. TABLE 4: SAMPLE SELECTED- BANKS

Span of Operations Sample Size

Local

30

20%

Local with Global regional presence Banks 20% 40%

ForeignRegional 20%

Years in Operation Sample Size 30

< 3 years 13%

3-5 years 47%

5-10 years 34%

>10 years 16%

10%-15% 40%

15% & above 10%

Size of Operations- Proportion of Trade finance Sample Size 30

< 5% 16%

5%-10% 33%

TABLE 5: SAMPLE SELECTED- TRADING COMPANIES Span of Operations Sample Size 50

Local 24%

Local with Global regional presence 20% 34%

ForeignRegional 22%

AgriCommodities 28%

Non-Agri (excl. Energy Energy) Related 26% 28%

Others

40-100

Business Segment Sample Size 50

18%

Size of operations* Sample Size 50

< 40

40%

20%

200 and above 10%

< 3 years

3-5 years

5-10 years

>10 years

20%

30%

30%

20%

30%

100-200

* No of Trade Finance Transactions per month Years of Operation Sample Size 50

Preferred Source of Trade Finance

Sample Size 50

Bill Discounting 36%

Letter of Credit 12%

Invoice Finance 48%

Bankers Guarantee 4%

Researcher used Excel and SPSS (Statistical Package for Social Sciences) or PASW (Predictive Analytics SoftWare) for analysing quantitative data. Researcher analysed data using following statistical techniques: Researcher will use the descriptive statistics to summarize data in a compact form so that it can be presented in tables, charts or other graphical forms to help ascertain patterns which will aid subsequent Hypothesis detection/ confirmation (Lovie, 1986 cited in Collis, 2009, p. 221). Researcher will analyse data by using the following descriptive statistics: Distribution, Central Tendency Measures: Mean(μ), Mode & Median, Dispersion Measure: Range & Standard Deviation, Normal Distribution – Skewness (extent of asymmetry beyond +1 & -1 indicates Skewness) & Kurtosis ( extent to which

distribution is flat or peak) distribution where responses are heavily in the centre are peaked (+3) or where scores are widely distributed (-3) are flat. Researcher also used inferential statistics that helped to lead her to conclusions about the target population based on the random sample (Kervin, 1992 cited in Collis, 2009, p.222). Following non parametric tests/ techniques were used since the data collected was largely Ordinal/Nominal: Test of Association: Chi-Square test (χ²) and Test of Correlation. Strength of association between the two variables is measured by correlation coefficient. Pearson correlation measures linear relationship, while Spearman correlation measures non-linear relationship. Number varies between +1 and nearer the value to 1 more is the association either positive or negative. 4.

Results, Analysis & Discussion

4.1. Results 4.1.1. Bill Discounting was preferred by trading companies over Letter of Credit in terms of cost effectiveness. Of the total 50 respondents from various industry segments and varies level of operations and varied sizes, 37 of the respondents preferred Bill discounting over Letter of credit. 4.1.2. Based on the sample data results were deduced for the total population using chi- square test of „goodness of fit‟. Following conclusions were drawn : We sampled 50 Trading companies and evaluated whether the Trading companies who consider Bill Discounting was equal to the number of Traders who consider LC in terms of cost effectiveness (expected outcome representing null Hypothesis H0). The data was analyzed using chi square goodness of fit test. Observed frequencies for Bill Discounting (f=37) compared with that observed for LC (f=13) was much higher. The null hypothesis was rejected, χ² (1) = 11.520, p