CHAPTER EIGHT Introduction to International Payments The basics: Exporters and importers have different interests as regards payments, Importers would rather pay after delivery (open account), but this would expose the exporter to the risk of non-payment. Conversely, a powerful exporter may insist ‘on payment in advance, but this would expose the importer to the risk of non- delivery. A classic compromise is provided by the letter of credit (iC) transaction, ‘which provides the exporter with an advance guarantee of payment but also protects the importer from nondlelivery. The documentary collection protects the exporter from non-payment, but does not provide an advance guarantee of payment (as does the 1/C), Many exporters seek initially to protect themselves with export credit insurance, which allows them to offer competitive credit terms (such as open account) 81 Overview ‘The payment term in an export contract is crucial. Given the difficulty and expense of enforcing contracts abroad, control of the payment term may translate into control over a ‘commercial transaction, When an importer is able to obtain “open account” terms, it has great latitude to object to late delivery or the non conforming quality of the good. ‘a. Payment options 1) Rayment in advance ~ This option is the safest for the exporter, but it is often “unavailable in competitive markets. A partial advance payment (€.g., 20-30%) may be ‘more acceptable to the importer and therefore more realistic, but it still eaves the exporter exposed to risk on the balance. Despite the great risks to the importer of ‘payment by cash in advance, some importers find they have no choice. Importers from, developing markets may find it necessary to pay in advance in order to obtain high- demand or usury goods. Payments in ince of a bank guarantee issued by the exporter's bank 2) Payment backed by standby credit or bank guarantee ~ This option is sometimes neglected by strong exporters. The exporter grants open account terms backed by a standby credit or bank guarantee. Ifthe importer fails to pay on the invoice date, the exporter draws against the standby credit or guarantee. The advantage to the exporter is that the documentation is not as complicated as with an ordinary commercial LC ‘The advantage to the importer lies in receiving open account terms from the exporter; if payment is made within agreed upon dates, use of the standby credit or bank guarantee will never be triggered, The danger to the importer is that the exporter could unfairly claim the standby credit or bank guarantee, so this option is to be used only with highly trusted exporters 108100 Gude to Exprt impor 4 etn 3) Documentary credit or “DiC” (also known asa ‘letter of credit’, “commercial credit” or LIC?) — Niter cash in advance, this is usually considered the next safest method for the exporter. However, because of its complex documentary nature, the documentary credit can be relatively expensive in terms of banking fees. Moreover, the exporter ‘must have a rigorous document: preparation system in place to avoid the risk of non- payment due to non-conforming documents being presented to the bank. 4) Documentary collection ~ Not as letter of credit for the exporter but significantly cheaper; the seller must be willing t0 take the risk that the importer will ‘not pay or accept the documents, 5) Open account ~The exporter delivers the goods, then waits for the agreed upon credit period for payment (often expressed as “net 30”, “net 60” or “net 90°, meaning that the balance is payable in 30, 60 or 90 days). This is the least safe method for the exporter, to be used when the importer is fully trusted and creditworthy. The exporter should consider the need for protection with credit insurance. b. Export credit insurance (or “trade credit insurance’ ‘Export credit” insurance or “trade credit” insurance is one of the key security devices employed by export firms. Export credit insurance is often offered by governmental entit (n the US. Eximbank). When an exporter can obtain insurance for sales to a particular importer, the exporter is much more willing to offer credit terms. c. Exchange rate risks ‘The easiest way for the exporter to avoid exchange rate risk is to require payment in its ‘own currency. However, in competitive markets exporters must accept payment in foreign currencies, thereby exposing themselves to exchange rate fluctuations. The various mechanisms for dealing with exchange and currency risk are summarized in the last section of this chapter, 4d. Use of factors: credit-checking, advances, collections Factors are financial services companies that take on many of the financial and accounting, ‘management processes related to international payments. Exporters may wish to turn late accounts over to an international collection agent or fictor (see Chapter 10 on Factoring and Forfaiting), . Other risk-management and finance objectives ems with Export payment mechanisms, such several key uses: the documentary credit, 2 1) Means of payment ~ There are simple ways for the importer to effect payment, such as by bank draft or wire transfer, but in an international transaction these alone would leave either the exporter or importer entirely at risk (clepending on whether payment was made before or after receipt of the goods). In international trade, bank cheques are uncommon, More common is to find payment effected when the importer (or its bank) accepts or pays the exporter’s draft or bill of exchange. Drafts or bills of exchange are simply payment devices (and when used alone are referred to as clean 107chapers bills). However, traders have found further protection by requiring the attachment of additional documents to the bills of exchange; these bundles of documents are then processed through banks: hence, documentary bills 2) Security mechanism ~ Documentary credits provide security for each of the parties involved. The exporter is guaranteed payment provided the shipping documents are in order. The importer is protected against paying for non-shipment; and by requiring the provision ofa certificate of inspection, the importer can also have the security that the goods shipped are of contract quality With documentary bills, the exporter's goods (represented by the bill oflading or other transport document) and the importer’s payment (represented by the imposters acceptance or payment of the bill of exchange) are exchanged through a neutral third party, the bank. This removes the danger that either the exporter or importer will unfairly end up with both goods and money. Documentary bills, which are used in both documentary credit and documentary collection operations, therefore represent a linkage of payment and security functions. Note, in contrast, that standby credits and demand guarantees are meant to be used primarily as security instruments rather than payment devices. Thus, if an exporter agrees to grant the importer 90-days credit, backed by the importer’s standby credit (or bank guarantee), the standby credit is not meant to be the primary payment device. Rather, the exporter will submit invoices for payment to the importer at the appropriate time. The exporter will seek recourse 0 the standby credit only if the importer shoul fail to pay. Security devices will be considered in detail in Chapter 11 Each of the international payment options has different risk-reduction and documentary characteristics. Generally, the reduction of risk is purchased atthe cost of sgreater documentary complexity and higher banking fees or service costs. Parties tend to choose the cheaper and simpler options when they have a great deal of confidence in each other, or when one of the parties has such a strong bargaining position that it is able to force the other to accept somewhat risky terms. 3) Finance devices ~ Finance, in contrast to payment, is related to the need to grant credit to the exporter or importer. Exporters can use letters of credit as financing devices for export operations, especially by using transferable or back-to-back credits. Bills of exchange, cither alone or in combination with documentary credit or collection operations, can be used as sources of finance for both exporter and importer. Commonly, importers would like to be granted a credit period (from 30 up to 180 days or more), so they can re-sell the goods before they have to pay the exporter. Exporters may be willing to grant these terms provided the importer (or the importer's bank) undertakes to pay at the end of the credit period, as by issuing a deferred payment letter of credit or “accepting” a term bill of exchange (in a practice known as “accepted” or “avalized” bills). Exporters are able to discount the accepted bills for ready payment. Discounting practices, such as “forfaiting”, are covered, along with factoring and other short-term finance devices, in Chapter 10. 108100 Gude to Exprt impor 4 etn 82 Payment methods in practice ‘a. Payment on open account \With open account payments the exporter ships the goods to the buyer and then transmits an invoice and other shipping documents; ‘e., the importer “buys now, pays later”. These are sometimes called sales “on credit”, because the seller extends credit without documentary security for the buyer's indebtedness. For the importer, of course, open account terms are quite advantageous, as there is no need to pay for the goods until they have been received and inspected. An importer may be able to sell the goods and use the proceeds to pay the exporter’s commercial invoice when it arrives, ‘Open account sales are common in domestic sales, but less so in international transactions because they substantially increase the risk for the seller. An export seller should only agree to open account terms if he has absolute confidence in the import buyer, as well as in the stability of the buyer's country and its import regulations. An additional source of security is asstable market in the particular goods, because in unstable markets a sudden drop in prices will often motivate importers (0 try to escape their contracts, Despite the risks, open account trading at the international level has significantly increased. In the past, major barriers, such as a lack of transparency and apprehension about eross— border exposure, limited international open account trade, Advances in technology and increased financial knowledge are diminishing these concerns, as both buyers and sellers recognize the benefits, such as reducing costs and improving efficiencies through cross: border open account trading. Sellers on open account are welladvised to include “retention of title” clauses in their contracts, Such a clause allows the seller to reclaim the goods sold, or the proceeds from the goods, in the event the importer becomes insolvent before paying for the goods. b. Payment in advance With payment in advance the seller takes no risk whatsoever. Conversely, the importer is at serious risk and should never consider payment in advance unless full information on the reputation of the seller is available, If advance cash payments are macle at all, they are most ‘commonly only partial payments. Full payment in advance does occur, however, and is most ‘common when the exporter’s products are in extremely high demand and the importer or importer’s country are not a priority for the exporter. A variation on cash in advance is for an advance payment to be made via some form of documentary instrument, such as under a “red clause” letter of ered, ‘& Open account backed by a standby credit or demand guarantee Many exporters fail to consider that open account payment backed by a standby credit or «lemand guarantee can be as secure as cash in advance (and even more secure than partial cash in advance). Although the exporter grants the importer credit and expects payment by bank transfer or other similar means upon presentation of commercial invoices, the standby credit or demand guarantee isa very desirable payment security Ifthe importer does not pay the invoice, the exporter, under the standby credit or guarantee, can easily claim the amount of the invoice. The danger here, of course, is for the importer, An unscrupulous exporter 100chapers could make an unfair or fraudulent claim under the standby credit or bank guarantee. The ICC Banking Commission has endorsed and approved rules specifically designed for standbys and bank guarantees (sce Chapter 9). 4. Collection - documentary collection/clean collection \Whilecash in advance represents the ideal option fortheexporter, and openaccount payments, represent the ideal for the importer, the next two payment mechanisms are compromises ‘with benefits for both parties: the documentary collection and the documentary credit, ‘The ducumencary collection iy diferent fun dhe clean collection, clean collection is essentially an open account payment male via a bill of exchange. The exporter ships the ‘g0ods.and then sends the importer bill of exchange via the importer’s bank. A documentary collection, on the other hand, allows the exporter to retain control of the goods until it has, received payment (or obtained an assurance of receiving payment). Generally, the exporter ships the goods and then assembles the relevant commercial documents, such as the invoice and the bill of lading, then turns them over, along with a draft, to a bank acting as an agent for the exporter. The bank will only release the bill of lading to the importer if the importer pays against the draft or accepts the obligation to do so at a future time. There are two possibilities: 1) D/P “Documents Against Payment” (or “Cash against documents”) - The importer pays the draft in order to receive the bill of lading (the document that enables the importer to obtain delivery of the goods); hence, this form of collection is referred to by banks alternatively as “cash against documents”, “documents against payment”, “D/P" or “sight D/P" 2) D/A~SDocuments against acceptance” - Here, the importer accepts the draft in order to receive the bill of lading. By accepting the draft, the importer acknowledges an ‘unconditional legal obligation to pay according to the terms of the draft, ‘The exporter's instructions to present a draft for acceptance or payment will be transmitted through a series of banks. Usually this will involve atleast the exporter’s bank (known as the remitting bank) and a bank in the importer’s country (known as the collecting or presenting bank, because it presentsthe relevantdocuments forcollection tothe drawee). Thissomewhat long information chain makes it crucial that the exporter’s initial instructions be precise and complete. Thus, the process begins when the exporter fils outa collection instruction (also called a lodgement form), in which the exporter indicates the instructions the banks are to follow. On the basis of this information, the remitting bank prepares its collection instruction, which will accompany the documentary collection when itis transmitted to the collecting or presenting bank. The banking practice relating to collection arrangements is, standardized in ICC’s Uniform Rules for Collections (WCC Publication 522). ‘The advantages of documentary collections for the exporter are that they are relatively easy ‘and inexpensive, and that control over the transport documents is maintained until the exporter receives assurance of payment. The advantage for the importer is that there is no obligation to pay before having had an opportunity to inspect the documents and, in some cases (as by an examination in a bonded warehouse), the goods themselves. The disadvantages for the exporter are that documentary collections expose the seller to several risks: the risk that the importer will not accept the goods shipped, the credit risk of the importer, the political risk of the importer's country and the risk that the shipment may fail to clear customs, Therefore, the prudent exporter will have obtained a credit report on. 110100 Gude to Exprt impor 4 etn the importer as well as an evaluation of importers country risk. Another disadvantage for the exporter is that a collection can be a relatively slow process. However, the exporter’s bank may be willing to provide finance to cover the period during which the exporter is waiting for the funds to clear. Under a D/P collection, the importer only takes the risk that the goods shipped may not be as indicated on the invoice and bill of lading, The banks assume no risks for documentary collections (other than that of theirown negligence in following instructions), This is one reason collections generally are significantly cheaper, in terms of bank fees, than documentary credits. During negotiations, a documentary collection may be suggested as a helpful compromise. In terms of relative advantages for exporter and importer, it lies midway between the sale ‘on open account (advantageous for the importer) and the letter of credit (advantageous for the exporter). An exporter will prefer the documentary collection to a sale on open account. ‘Conversely, the importer will prefer a documentary collection to a letter of credit, & Documentary credits (see also Chapter 9) ‘The central risks in international trade are the exporter’s risk of non-payment and the importer’s risk that the goods shipped will not conform to the contract. Both of these risks may be eliminated via the letter of credit, Commercial letters of credit are referred! to by bankers as “commercial credits” and also as “clocumentary credits” - the terms are used interchangeably. Since documentary credits involve relatively complex document processing, they are more expensive than other payment devices and are therefore not always appropriate. Parties with long trading histories or residing in adjacent countries may be willing to make sales on open account or with payment in advance - payment modes that are easier and less expensive than the I/C, but which do not reduce risk, Despite its occasional complexity, the letter oferedit remains the classic form of international ‘export payment, especially in trace between distant partners. The letter of credit is essentially a document issued by the importer’s bank in which the bank undertakes to pay the exporter upon due compliance with documentary requirements. Hence, the term “documentary credit” - payment, acceptance or negotiation of the credit is made upon presentation by the seller of all stipulated documents that comply with the terms and conditions of the documentary credit. These documents (e.g, bill of lading, invoice, inspection certificate) provide a basic level of proof that the right merchandise has been properly sent t0 the importer - although, of course, there is always the chance that the documents may prove to be inaccurate or even fraudulent. Exporters should be aware that documentary credits ofien require impeccable document management on the part of the exporter. A ypical procedure is as follows: 4) Contract. The process begins when the exporter and importer agree on a contract of sale. Typically, itis the exporter that insists on payment by letter of credit - because it does not want to take a credit risk, and cannot get sufficient information on the creditworthiness of the buyer to grant another form of payment. +) Application. The importer then initiates the letter of credit mechanism by going to its bank and requesting it to open a letter of credit ©) Issuanee, Subject to internal credit approval, the importers bank issues the credit (and, is hence called the “issuing bank”), under which it agrees to pay according to the importer’s instructions. The credit is then sent to the exporter or to a bank in the exporters country (depending on the type of credit), a