Basic Trade Finance Tools: Payment Methods in International Trade

Daniele Giovannucci, Senior Consultant, Agribusiness & Markets Thematic Group, World Bank

Contents:

• Introduction
• Road Map
• Notes

Abstract: The increasing participation of relatively inexperienced enterprises in international trade calls for a concise and jargon-free, general reference to the many ways by which traders can arrange for payments to be made and the relative merits, from a risk standpoint of each. The most common methods i.e. letters of credit, are covered in some detail including their basic mechanics and examples. This document was improved by the comments of Richard Ruehle, Vice President International Banking, Mellon Bank and Patrick Lecoy, Agribusiness Specialist, World Bank. Some sections are adapted from the Methods of Payment section of the Agricultural Export Transportation Handbook published by the USDA.

I. Introduction

Many agro-enterprises, even those that operate on a global scale are sometimes unfamiliar with the legal controls, cultural expectations, business practices, and regulatory mechanisms of other countries. This is especially true for emerging agro-enterprises in developing countries. Today, international trading partners can conduct business never having even met or spoken with each other. Inadequate knowledge of the options that are available increases transactional uncertainty and the possibility of loss.

In the presence of such uncertainties the likelihood of trade is reduced. More than ever, private sector development programs are aware of the increasing globalization of trade. The implementation of trade promotion initiatives, import-export programs, production of high-value crops for export, business development centers and other trade related programs require the participants have a good understanding of one of the most critical aspects of trade: getting paid.

As new technologies and advances in communications are changing trade logistics and speeding and facilitating transactions, businesses are finding new opportunities and new ways to operate. Today, financial letters of credit can be opened by email, commitments for foreign exchange hedges can be made over the telephone and the purchase of container loads of produce and their shipping costs can be charged to corporate credit cards. Despite these cutting-edge advancements most payment transactions still follow basic rules.

This teaching tool intends to serve as a straightforward and relatively jargon-free, general reference to the many ways by which traders can arrange for payments to be made.

II. Road Map

Credit check

Insuring payment starts long before a contract is signed. It is up to the seller, or his representative, to perform 'due diligence' or a reasonable assessment of the risks posed by the potential buyer. The caveat, "know who you're dealing with" applies firmly here. Even the most rudimentary market research ought to be able to provide some information on the buyer:

• In many developed countries chambers of commerce, Better Business Bureaus or their equivalents are a good start
  
• In the U.S. the Red Book or the Blue Book can be used to assess buyers of horticultural products
  
• some of the larger credit reporting services such as TRW and Dun & Bradstreet have international affiliates and a reasonably priced credit check can be conducted in a matter of minutes via the Internet
  
• Trade associations and trade promotion organizations can sometimes be informative
  
• Of course, freight forwarders, and even banks can be excellent sources of information
  
• Many sellers are uncomfortable directly asking the buyer to provide references but this can yield not only useful information about the buyer but also access to an expanded network, not to mention potentially improving the buyer's conscience since he must consider that his standing with other sellers in this network would suffer should he not make timely payment

Questions to ask before selecting the payment method

The next step is for the seller to use the information to make a decision based on a frank assessment of his risk tolerance. Answering some simple questions at this stage can help to avoid catastrophe later on.

• Can the business afford the loss if it is not paid?
  
• Will extending credit and the possibility of waiting several months for payment still make the sale profitable?
  
• Can the sale only be made by extending credit?
  
• How long has the buyer been operating and what is his credit history?
  
• Are there reasonable alternatives for collecting if the buyer does not meet his obligations?
  
• If shipments is made but not accepted can alternative buyers be found?

Common Payment Methods

Once acceptable risks have been determined then the most appropriate payment method can be selected. While this document is a useful starting point, the advice of a qualified financier or banker should be sought at least for the first transactions. Here is a list, beginning with those that present the least risk for the seller, of the most common payment methods. They are further described below:

1. Cash in Advance

Cash in advance clearly is risk-free except for consequences associated with the potential non-delivery of the goods by the seller. Cash in advance is usually a wire transfer or a check. Although an international wire transfer is more costly (from US$15 to more than US$100), it is often preferred because it is speedy and does not bear the danger of the check not being honored. The check can be at a disadvantage if the exchange rate has changed significantly by the time it arrives, clears and is credited. On the other hand, the check can make it easier to shop for a better exchange rate between different financial institutions.

For wire transfers the seller must provide clear routing instructions in writing to the buyer or the buyer's agent. These include:

• The full name, address, telephone, and telex of the seller's bank
  
• The bank's Society for Worldwide Interbank Financial Telecommunications (SWIFT) and/or ABA numbers
  
• The seller's full name, address, telephone, type of bank account , and account number.

No further information or security codes should be offered.

2. The Commercial Letter of Credit

2.1A Basic Understanding

The letter of credit (LC) allows the buyer and Seller to contract a trusted intermediary (a bank) that will guarantee full payment to the seller provided that he has shipped the goods and complied with the terms of the agreed-upon Letter. This instrument, although inherently simple, can have many variations.

The LC serves to evenly distribute risk between buyer and seller since the seller is assured of payment when the conditions of the LC are met and the buyer is reasonably assured of receiving the goods ordered. ¹ This is a common form of payment, especially when the contracting parties or unfamiliar with each other. Although this instrument provides excellent assurances to both parties, it can be confusing and restrictive. It can also be somewhat expensive, ranging from several hundred U.S. dollars up to 5 percent of the total value. ²

LCs are typically irrevocable, which means that once the LC is established it cannot be changed without the consent of both parties. Therefore the seller, especially when inexperienced, ought to present the agreement for an LC to an experienced bank, a trusted broker, and its freight forwarder so that they can help to determine if the LC is legitimate and if all the terms can be reasonably met. A trusted bank, other than the issuing or buyer's bank can guarantee the authenticity of the document for a fee.

2.1B Disadvantages

The LC has certain disadvantages. If even the smallest discrepancies exist in the timing, documents or other requirements of the LC the buyer can reject the shipment. A rejected shipment means that the seller must quickly find a new buyer, usually at a lower price, or pay for the shipment to be returned or disposed. Besides being one of the most costly forms of payment guarantee LCs also take time to draw up and usually tie up the buyer's working capital or credit line from the date it is accepted until final payment, rejection for noncompliance, expiration or cancellation (requiring the approval of both parties). | link to Annex 2. Common Discrepancies that Cause Non-payment|

The terms of an LC are very specific and binding. Many traders, even experienced ones, encounter significant difficulties because of their failure to understand or comply with the terms. Some statistics show that approximately 50 percent of submissions for LC payment are rejected for failure to comply with terms! For example, if the terms require the delivery of four specific documents and one of them is incomplete or merely delivered late then payment will be withheld regardless of whether every other condition was fulfilled and the shipment received in perfect order. The banks whose job it is to ensure a safe payment transaction will insist that the terms be a fulfilled exactly as written. The buyer can sometimes approve the release of payment if a condition is not fulfilled but changing terms after the fact is costly, time consuming and sometimes impossible. The lesson is clear: consider all of the details before accepting an LC and be certain that the details are followed to the letter. | link to Annex 1. Seller's Checklist|

2.1C The basic mechanism

At least four parties are involved in any transaction using an LC:

a) Buyer or applicant
b) Issuing bank or Applicant's bank
c) Beneficiary's bank or receiving bank
d) Seller or beneficiary

a) Buyer or applicant. The buyer applies to his bank for the issuance of an LC. If the applicant does not have a credit arrangement with this issuing bank then he must pay in cash or other negotiable security.

b) Issuing bank. The issuing or applicant's bank, issues the LC in favor of the beneficiary and routes the document to the beneficiary's bank. The applicant's bank later also verifies that all of the terms, conditions, and documents comply with the LC, and pays the seller through his bank.

c) Beneficiary's bank. The seller's or beneficiary's bank verifies that the LC is authentic and notifies the beneficiary. It, or another trusted bank, can act as an advising bank. The advising bank is used as a trusted bridge between the applicant's bank and the beneficiary's bank when these do not have an active relationship and to verify the authenticity of a document. It also forwards the beneficiary's proof of performance and documentation back to the issuing bank. However, the advising bank has no liability for payment of the LC.

The beneficiary, or his bank, can ask an advising bank to confirm the LC. This means that the confirming bank also promises to ensure that the beneficiary is paid when he is in compliance with the terms and conditions of the LC. ³The confirming bank charges a fee for this service. ⁴This is most useful when the issuing bank and its credibility is not familiar to either the beneficiary or his bank, or if the issuing bank (even a well-established one) is in a high-risk country.

d) Beneficiary or Seller. The beneficiary must ensure that the order is prepared according to specifications and shipped on time. He must also gather and present the full set of accurate documents, as required by the LC, to the bank.

| link to Figure 1. Letter of Credit Diagram |

2.2 Variations

Letters of credit can be quite flexible in the design and each is used for a specific purpose. For example, a Back to Back LC allows a seller to use the LC received from his buyer as collateral with the bank to open his own LC so that he can purchase the inputs or supplies necessary to fill his buyer's order. Because of the the dependency on other parties and extra steps to fulfill the original transaction, the risk is increased and some banks may therefore be reluctant to open a Back to Back LC.

Since letters of credit are simply financial contracts they can very enormously just like any other contract. Some LC variations include: Revolving, Negotiable, Straight, Red Clause, Transferable, and Restricted. But perhaps the safest and most desirable letter of credit, at least from the seller's point of view, is the Standby letter of credit.

2. 3 Standby Letter of Credit

The standby LC is unlike other letters of credit and is more of a bank guarantee. It is most often used not as the primary payment method but rather as a fail safe method or guarantee for longer-term projects. This LC promises payment only should the buyer fail to make an arranged payment or otherwise fail to meet pre-determined terms and conditions. Otherwise, the buyer pays on receipt of goods or according to the credit terms arranged with the seller. Should the buyer default, the seller must then apply to the bank for payment -- a relatively simple process without the burden of complicated documentation.

It is somewhat simpler for the seller or beneficiary to comply with the terms this instrument and its use therefore favors the seller. Since the standby LC can remain valid for years (Evergreen Clause) it eliminates the cost of separate LCs for each transaction with a regular client. It is not commonly used in agribusiness trade.

3. Documentary Collection

To collect payment from a foreign buyer using documentary collection, the seller sends a draft or other demand for payment with the related shipping documents through bank channels to the buyer's bank. The bank releases the documents to the buyer upon receipt of payment or promise of payment. The banks involved in facilitating this collection process have no responsibility to pay the seller should the buyer default unless the draft bears the aval (ad valutem) of the buyer's bank. ⁵ It is generally safer for exporters to require that bills of lading be "made out to shipper's order and endorsed in blank" to allow them and the banks more flexible control of the merchandise.

Documentary collection carries the risk that the buyer will not or cannot pay for the goods upon receipt of the draft and documents. If this occurs it is the burden of the seller to locate a new buyer or pay for return shipment. Because the bill of lading for ocean freight is a valid title to the goods and is a negotiable document whereas the comparable airway bill is not negotiable as an ownership title, documentary collections are only viable for ocean shipments.

4. Hybrid Methods

In practice, international payment methods tend to be quite flexible and varied. Frequently, trading partners will use a combination of payment methods. For example: the seller may require that 50% payment be made in advance using a wire transfer and that the remaining 50% be made by documentary collection and a sight draft.

5. Open Account

Open account means that payment is left open to an agreed-upon future date. It is one of the most common methods of payment in international trade and many large companies will only buy on open account. Payment is usually made by wire transfer or check. This can be a very risky method for the seller unless he has a long and favorable relationship with the buyer or the buyer has excellent credit. Still, there are no guarantees and collecting delinquent payments is difficult and costly in foreign countries especially considering that this method utilizes few official and legally binding documents. Contracts, invoices, and shipping documents will only be useful in securing payment from a recalcitrant buyer when his country's legal system recognizes them and allows for reasonable (in terms of time and expense) settlement of such disputes.

Other Payment Methods

Consignment

Although not technically a method of payment, its use in international trade merits mention. The consignment method requires that the seller ship the goods to the buyer, broker or distributor but not receive payment until the goods are sold or transferred to another buyer. Sometimes even the price is not pre-fixed and while the seller can verify market prices for the sale date or hire an inspector to verify the standard and condition of the product, he ultimately has very little recourse. Although this is the riskiest sort of transaction it is nonetheless common in the trade of fresh produce.

Credit Card

Some banks now offer buyers special lines of credit that are accessible via credit card to facilitate even substantial purchases. While this can be very convenient for both parties the seller should confirm the discount percentage that the bank will charge him for using the service and bear in mind that the laws that govern domestic credit card transactions differ from those govern international use.

Countertrade and Barter

Countertrade or barter is most often used when the buyer lacks access to convertible currency or finds that rates are unfavorable or can exchange for products or services desirable to the seller. Countertrade indicates that the buyer will compensate the seller in a manner other than transfer or money or products. Barter is the exchange of goods or services between two parties.

A note on currencies and hedging

The U.S. dollar, followed by the British pound, the deutschemark, the French franc and the Japanese yen are the most popular and the most easily convertible currencies. Typically the seller will request payment in his own preferred currency. Where the transaction value is considerable -- typically in excess of US$50,000 -- there may be an opportunity to accept a foreign currency and hedge against the foreign exchange risk. While this may yield a better exchange advantage or provide an additional incentive for the buyer to participate in a transaction, it should not be attempted by novices without the support of an experienced international banker.

Source: Firstar Bank from www.ams.usda.gov/Pub.

Notes

1. Since banks deal with documents, not with products, they must pay an LC if the documents are presented by the seller in full compliance with the terms, even if the buyer never receives the products. Products lost during shipment or embargoed are some examples. Iraq for example, never received products that were shipped before its embargo but the LCs had to be paid anyway.
   
2. Although many LCs can typically be opened for .5% to 1%, application and processing costs especially for smaller LCs can add up.  Also see section 2.1C.
   
3. In most cases, LCs are channelled to the beneficiary's bank via an advising bank.
   
4. Confimation fees for some very risky countries can be as high as 25% of the LC (Patrick Lecoy, personal communication).
   
5. The bank's collateral signature on the draft functions as a guarantee

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