Topic Category: Trade & Finance

If the exporter categorizes the product incorrectly, a common error, the importing country’s custom agent may reclassify the goods — often resulting in a higher duty rate. This could change the terms of the deal and cause the importer to reject it. Consequently, it is important that the exporter and banker understand the challenges, be familiar with the barriers to trade, and limit the risks from the beginning.

Tariff Barriers

Tariff barriers are taxes or duties levied on imports of foreign products. Originally, U.S. tariffs were established to provide revenue for the federal government, predating income or property taxes. Today, however, they are viewed differently. In effect, tariffs increase the product price which discourages its demand and thereby insulates, to a degree, domestic producers from foreign competition. Each country places higher tariffs on goods determined to be import sensitive.

The most common form of duty or tariff is the ad valorem: a tax assessed on merchandise value. If not specified, the duty or tariff applied is usually ad valorem. In many countries, ad valorem taxes are applied to the value of merchandise, plus the cost of insurance and freight. As a result, when issuing an invoice to the foreign buyer, it is important to itemize these individual costs.

In addition to ad valorem duties, other types exist. Specific duties are those charged by weight, volume, length or any other unit (e.g., charging 10 cents per square yard on fabric). If the duty is assessed by weight, it is important to know if the packaging weight is included in that figure. If so, packaging weight must be kept to a minimum. Compound duties call for both an ad valorem and a specific duty on the same product. Alternative duties are those in which the custom official calculates the ad valorem duty and the specific duty and applies whichever is higher.

Countries apply tariffs in different ways. In Mexico, for example, additional taxes are assessed on top of the duties. These include a processing fee and a value-added tax (VAT). The customs processing fee is similar to the U.S. customs user fee, also referred to as a merchandise processing fee. The VAT is similar to the Canadian Goods and Services Tax (GST). The United States does not assess a VAT. The following example illustrates how a 10 percent ad valorem duty and a customs processing fee are calculated, and their effect on the final U.S. exporter’s price to Mexico versus a local Mexican manufacturer’s price in the Mexican market. It is important to note that a Mexican customs processing fee is assessed on the cost, insurance and freight (CIF) value of the good. A national VAT of 15 percent is typically applied to the CIF value, duty and customs processing fee. In the past, Mexico has applied a VAT of 0 percent on basic foodstuffs, 6 percent on certain food items in specific regions, 20 percent on luxury goods and a general rate of 15 percent on all other goods.

The following compares the costs of U.S. exports to Mexico and Mexican domestic goods before and after tariffs:

  • Invoice value (including CIF on export): $ 10,000(U.S.), $ 10,000(Mexico)
  • Ad valorem duty (10%): $ 1,000 , n/a
  • Customs processing fee (.8%): $80, n/a
  • VAT (15%): $ 1,662, $ 1,500
  • Total cost: $ 12,742, $ 11,500

In addition to the above fees, an import processing fee, harbor tax, and other taxes, if assessed further, will increase the exporter’s costs. Also, it is wise to be careful when calculating the VAT, as the foreign customs service is likely to assess the VAT on top of the duty, effectively increasing the VAT rate.

Non-Tariff Barriers

Non-tariff barriers are often hidden, and are not necessarily quantifiable or measurable. They typically include quotas, boycotts, licenses, standards, local content requirements, restrictions on foreign investment, domestic government purchasing policies, exchange controls and subsidies. Non-tariff barriers often are used to inhibit the importation of products. In many sectors, it is predicted that environmental, labor, competitive policy and investment issues increasingly will be used in an abusive manner to discourage imports.

At a time when it appears that foreign government subsidies for industry are decreasing, assistance by other means may be increasing. According to Ron Brown, the late Secretary of the U.S. Department of Commerce, the Europeans, Japanese, and even the emerging markets are investing more and more of their resources to do battle with U.S. companies. In a sampling of about 200 overseas competitive projects tracked during an eight year period, it was estimated that U.S. firms lost approximately one-half of these due in part to government pressure — a hidden and non-quantifiable barrier to trade. And foreign governments may increase their efforts whenever they wish.

As a result, when calculating the total exporting costs, which is necessary to price a product, it is essential to consider the resources necessary to ensure that any non-tariff barriers applied to the exporter’s product are satisfied. If not, the exporter’s ability to perform may be adversely affected.

Quotas are a very common non-tariff barrier which are used extensively under the Multi-Fiber Arrangement (MFA). The importation of a product is limited to a specific quantity over a designated time period, usually a year. This method artificially stimulates consumption of the domestic substitute that may be more expensive and/or of lower quality. The domestically produced substitute becomes more attractive, preserving or attaining a greater share of the domestic market.

Three types of quotas exist: absolute quotas, tariff-rated quotas, and voluntary restraint agreements (VRAs). Absolute quotas effectively cut off further importation of a product into the host country when a specific quantity is reached. Quotas may apply to imports from all countries or certain countries. Tariff-rated quotas allow for a specific quantity of a product to be imported at a reduced duty rate. Once this quantity is reached, a higher duty becomes applicable. VRAs are informal bilateral or multilateral agreements in which exporting countries voluntarily limit the quantity of exports of a certain product to a particular country. This avoids the imposition of import restrictions, but effectively acts as a quota.

Government or industry boycotts against imports from particular countries have been implemented for political or economic reasons. For example, U.S. imports from Cuba are banned on political grounds; in the 1980s, the U.S. steel industry urged users to purchase domestic steel products and terminate imports. Licenses are required by importers in many countries prior to product importation. In the past, Mexico maintained license requirements on virtually every product; however, with the advent of the North American Free Trade Agreement (NAFTA), these demands have been drastically reduced or eliminated.

Standards are used to ensure a degree of quality in accordance with national regulations, including standards to protect health, safety and product quality. However, they are sometimes used in an unduly stringent or discriminating way for the sole purpose of restricting trade. The United States, Canada and Mexico all require many foreign products to meet the requirements set forth by each country’s respective regulatory bodies. For example, foreign electrical equipment requires authorization from the U.S. Underwriters Laboratory (UL), Canadian Standards Association (CSA), and Norma Oficial Mexicana (NOM) of Mexico prior to its importation.

Local content requirements dictate that a product must embody a particular percentage of local material or components prior to its importation. For example, under NAFTA rules of origin, a minimum product content requirement must exist in order for the good to be considered of U.S., Canadian or Mexican origin and enter with free trade status. If this content level is not obtained, the product normally will be allowed entry under a higher duty applicable to the newly defined country of origin.

Many countries inherently favor domestic suppliers over foreign suppliers. “Buy domestic” policies have been prevalent in many countries for years. In fact, as previously noted, in a sampling of about 200 overseas competitive projects tracked during an eight year period, it is estimated that U.S. firms lost approximately one-half of potential foreign contracts due partially to government pressure favoring non-foreign firms.

Subsidies are indirect forms of consideration granted by national governments to domestic producers for various reasons, which effectively enhance their product price competitiveness vis-à-vis foreign producers. Subsidies may be extended in the form of outright cash disbursements, reduced interest rates on bank loans, tax exemptions, preferential exchange rates, governmental contracts with special privileges, or any other form of favorable treatment.

The Case of Brazil

In some countries, the government may deny importers access to foreign currencies, effectively creating a non-tariff barrier for the purpose of reducing imports. Thus, when a country experiences either a temporary or prolonged severe balance of trade problems, its government has several options to remedy the situation. Three very effective measures include a gradual or abrupt devaluation of the currency in order to make imports more expensive, the tightening up on the issuance of import licenses, or the raising of duties. Brazil, which had been experiencing imbalances in its external trade for some time, decided on a different course of action. In an attempt to restrict Brazilian imports, in March 1997, the Brazilian government implemented measures that required Brazilian importers to provide advance payment for imports financed on credit terms of 360 days or less. Shipments to Brazilian importers on terms of up to 180 days required full payment in local currency upon arrival of the goods. Shipments on credit terms from 181 days to 360 days were required to be paid in local currency to a designated commercial bank 180 days prior to the instrument’s maturity date. At that time, a foreign exchange contract would be issued and foreign currency would be made available to pay the foreign creditor on the due date. Exemptions to these regulations included imports with repayment terms in excess of 360 days, oil imports, oil by-products, and imports valued at less than $10,000.

As a result, it was assumed that most Brazilian importers would have to come up with cash in advance. To achieve this, they likely would have to borrow from local Brazilian banks — an unlikely scenario for most Brazilian importers since local financing costs were often prohibitive.

The Impact of Trade Barriers

As foreign markets are liberalized, allowing firms to export more goods and services, domestic markets generally incur greater foreign competition. As this occurs, the tendency to protect an industry becomes heightened. Although this is beneficial in some instances for certain periods of time, numerous studies have indicated that this approach does have severe negative consequences.

Commenting on a report released in August 1993 by the General Agreement on Tariffs and Trade (GATT) depicting the true costs to consumers of protectionism, Peter Sutherland, former Director General of GATT, stated, “It is high time that governments made clear to consumers just how much they pay — in the shops and as taxpayers — for decisions to protect domestic industries from import competition. Virtually all protection means higher prices. And someone has to pay; either the consumer or, in the case of intermediate goods, another producer. The result is a drop in real income and an inability to buy other products and services.”

Mr. Sutherland continued, “Maybe consumers would feel better about paying higher prices if they could be assured it was an effective way of maintaining employment. Unfortunately, the reality is that the cost of saving a job, in terms of higher prices and taxes, is frequently far higher than the wage paid to the workers concerned. In the end, in any case, the job often disappears as the protected companies either introduce new labor-saving technology or become less competitive. A far better approach would be to use the money to pay adjustment costs, like retraining programs and the provision of infrastructure.”

To a large extent, the U.S. textile and apparel industry has been protected on a global basis by the Multi-Fiber Arrangement (MFA). Now being phased out, the MFA established quotas on behalf of industrialized countries and directed against textile and apparel exports from developing countries. The Institute for International Economics estimated that in 1986, the MFA raised textile and apparel costs in the United States by an average of 28 percent and 53 percent, respectively, with annual consumer losses of $2.8 billion and $17.6 billion. The net welfare cost to the nation, after subtracting the benefits to producers and workers, exceeded $8 billion. The consumer costs to maintain each U.S. textile and apparel manufacturing job, the study contended, were $135,000 and $82,000, respectively. As a result, the lowest 20 percent of U.S. households, ranked according to income, experienced a decline of 3.6 percent in their standard of living.

According to the GATT report released in August 1993, studies conducted during the 1980s indicated that protection costs a four-person household an additional $200-$420 per year in the United States, $130 per year in the U.K. and $220 per year in Canada.

Many leaders of industry and scholars alike have argued that even if protectionism were implemented to a greater extent, low technology jobs would still disappear. Robert Reich, former U.S. Secretary of Labor, stated that “Even if millions of workers in developing nations were not eager to do these jobs [low-technology jobs] at a fraction of the wages of U.S. workers, such jobs would still be vanishing. Domestic competition would drive companies to cut costs by installing robots, computer integrated manufacturing systems, or other means of replacing the work of unskilled Americans with machinery that can be programmed to do much the same thing.”

This appeared as Chapter Six in the book Trade and Finance For Lenders, 1999.
Topic: Trade & Finance
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In order for lenders to obtain a full appreciation of the exporter’s mindset, it is important to understand some of his/her considerations prior to obtaining an overseas order. One of the first issues confronting an exporter is deciding what markets to pursue. In doing so, exporters should determine each country’s market size, its rate of growth, U.S. market share and whether that market share is increasing or decreasing. In addition, he/she should calculate whether or not the firm can be competitive in the selected markets. Trade barriers (tariffs, as well as standards, regulations, quotas, labeling requirements, etc.) in each selected market must be identified. If excessive, these barriers may make the exporter’s product too expensive and limit his/her exports. If the barriers are deemed manageable, the next step would involve investigating whether any vested interests can bar the exporter’s product from the market.

The exporter must also conduct research to become informed about competitors’ products, prices, distribution methods and commitments to after-sale service, as well as target customers. If intense competition exists, the exporter may decide to look at smaller markets that may be unattractive for multinationals, but big enough for a small firm.

Sensitivity to foreign cultures is not only polite, it’s good business. As a result, the exporter also must be concerned with the customer’s culture and tastes. If the products and designs will not suit the target market, the exporter will need to make changes or choose another market. In addition, other factors to be considered include the degree of foreign intellectual property protection, environmental standards, an understanding of the legal system and how it works, and the comprehensiveness, or lack of, commercial legislation. The absence of civil, commercial and criminal codes can be a major constraint. And confusing and burdensome bureaucratic requirements can tie up valuable time. As a result of the effort up to this point, it is not uncommon for the exporter to grow fatigued, give up, or abandon the objective.

There are many strategies from which a company can choose to expand internationally. These include direct exporting, indirect exporting, establishing a joint venture or strategic alliance in a foreign market, acquiring a firm through direct investment, or licensing technology abroad. In order to understand the exporter’s needs, it is important for lenders to grasp these strategies. The benefits and risks associated with each method are contingent on many factors, including the type of product or service, the need for support, and the foreign economic, political, business, and cultural environment the exporter is seeking to penetrate. The best strategy will depend on the firm’s level of resources and commitment, and degree of risk it is willing to incur.

A number of questions must be answered before committing to a particular strategy. Experienced international executives often say the company contemplating international expansion must be very familiar with the environment it is seeking to penetrate and understand how to do business there. What it will take to be successful, to staff appropriately, integrate distribution, finance operations, and remedy currency risks should be analyzed ahead of time. A primary concern frequently expressed is the need to know how to terminate an agreement if the arrangement does not work. Additionally, seasoned executives indicate it is essential to determine the potential for political risk and the propensity for business disruption in each country under consideration.

Indirect Exporting

Should the client decide not to get involved in exporting, he/she may consider selling the product to an intermediary located in the United States. Indirect exporting demands little or no knowledge of foreign markets. The advantages to small- and medium-size firms are that indirect exporting requires less international experience, less commitment of resources, and less risk. In addition, firms often can enter foreign markets more quickly through indirect exporting. The disadvantages include less control over the marketing of the product, less information about the buyers and generally less profit because of the greater number of intermediaries involved. These intermediaries include foreign buying agents, brokers and agents, export management and export trading companies, piggyback marketing, and foreign trading companies.

Foreign buying agents, also known as commission agents, are locators and purchasers of merchandise for foreign firms or governments. They are compensated by the foreign entity. Brokers and agents, also known as import-export brokers, act as independent intermediaries who facilitate international transactions by coordinating activities of buyers and sellers of particular products. Brokers and agents receive commissions based on the value of the transaction. In some instances, a broker or agent may prefer to keep the identity of the buyer or seller confidential to prevent compromising his/her position in future dealings. In this case, the broker or agent would retain ownership of the merchandise for a limited period of time, receiving his/her compensation from the final price of the product. In some instances, a broker or agent will provide documentation, labeling, packaging, and marketing services.

Both export management companies (EMCs) and export trading companies (ETCs) serve as indirect exporting intermediaries by providing export-related services. EMCs act as the export department for one or several manufacturers of non-competitive products, pursuing overseas orders in the name of the manufacturer. A long-term contractual relationship typically exists between the EMC and manufacturer. Most EMCs can be viewed as manufacturers’ sales representatives for export. Compensation packages vary. EMCs may receive a commission based on sales, a combination of retainer plus commission, or they may purchase and mark-up the product for export. They usually specialize in particular products or country markets and work closely with well-established networks of foreign distributors. They are familiar with the necessary formalities in packaging, documentation and shipping.

ETCs typically act as independent brokers, international distributors or wholesalers, with no long-term obligation to the manufacturer. ETCs take title to the merchandise, paying the manufacturer directly. Both ETCs and EMCs can provide immediate access to foreign markets and are used extensively by many small businesses.

Piggyback marketing is an arrangement in which one manufacturer or service firm distributes another company’s product or service abroad. The most common example is when a manufacturer complements its product line with other non-competing, ancillary products, such as TVs and VCRs.

Foreign trading companies, also known simply as trading companies, were important in the colonial movement and still are important today. Trading companies are very popular in Japan and to a lesser extent in Korea, Taiwan, China, Germany, the Netherlands, Sweden, England, and the larger Latin American nations. They tend to focus on a particular market or product line. Dealing with a trading company is similar to dealing with a domestic distributor. Terms may include a limited or exclusive territory involving one, several or all foreign countries. The manufacturer may be expected to maintain a certain level of support in inventory, turnaround time, advertising, packaging, pricing, and financing. In turn, the trading company normally will agree to achieve a certain level of export sales in a specific time period.

Direct Exporting

Direct exporting offers several advantages over indirect marketing. These include:

  • Partial or full control over the foreign marketing strategy, including distribution, pricing, promotion, and product services;
  • Direct and unadulterated feedback from the foreign market, allowing the manufacturer improved insight and the ability to respond faster to changing market conditions to alter or improve the product;
  • Better protection of trademarks, patents and goodwill; and
  • Fewer intermediaries with which to share profits.

Although direct exporting involves greater risk, it often yields greater profits. Generally, it is the best choice for companies that expect international business to produce a significant portion of their profits.

Before commencing the export program, it is important to advise the exporter to meet with potential end-users, distributors, agents, and U.S. government trade representatives, including U.S. Export Assistance Centers (USEACs), (see Chapter Five). It is just as important to develop a first-hand insight into the country as it is to build a distribution network. Before committing significant resources, the exporter should test the market in order to determine product receptivity.

Foreign private sector import channels usually include direct sales, distributors, sales agents, and retail distribution. Direct sales to most foreign retail establishments, corporations, institutions or government agencies involve contractual terms and conditions often similar to those in the United States.

Distributors, also known as importing distributors or foreign distributors, play an important role for many U.S. exporters. Distributors in developing countries, for example, tend to purchase less sophisticated and less expensive products to complement their preferred, more expensive and sophisticated lines, which they then distribute, acting as agents for foreign firms. Factors that should be considered when choosing a distributor include the following: regions covered, lines handled, track record, rapport with local banks, after-sales service, firm size, knowledge of product, level of cooperation, reputation, relations with local government officials, willingness and ability to inventory, conditions of facilities, and average percentage added to product price.

A common method of selling is through agents who solicit business in the foreign country on behalf of their U.S. principals. Foreign sales agents, like U.S. sales representatives, do not take title of the goods. This method is well suited for the sale of capital goods directly to end-users. Contracts between exporters and agents in most countries usually are not subject to government regulations. However, the exporter’s relationship with the agent should be clearly defined so it is not misconstrued by the foreign government to be an employee-employer relationship, which could subject the exporter to tax and labor law obligations.

The agent relationship can be very beneficial depending on the exporter’s interests. Developing a close working relationship between the exporter and the foreign sales representative is crucial. Personal contact is vital to developing a foreign business relationship. Similar to a distributor, the factors that should be considered when choosing an agent are regions covered, lines handled, knowledge of product, track record, size and quality of sales staff, after-sales service, reputation, level of cooperation, length of contract, and commission required. On the downside, U.S. firms must also be aware of the commitment they incur when signing an agent or distributor agreement. Foreign regulations are different and can be more difficult to sever.

Over the past decade, foreign marketing techniques and distribution channels have become more sophisticated. Although small mom-and-pop retailers still dominate many foreign sectors in terms of numbers, larger retail chains and discount stores are playing an increasing role in the distribution of products to consumers. For example, in Mexico and in many other developing countries, large retail chains have been established. Many of them have adopted American-style marketing techniques, such as automated checkout systems. This has resulted in more efficient business operations and may require a reassessment of the agent/distributor expectations.

Joint Ventures and Strategic Alliances

A joint venture is a cooperative business venture established by two or more companies. Prior to commencing operations, partners usually allocate resources, consign risks and potential rewards, and delegate operational responsibilities to each other while preserving autonomy. Upon completion of the project, the joint venture is usually disbanded. However, it also may be a permanent relationship, maintaining, for example, a long-term production schedule.

An international joint venture enables a firm to establish a marketing or manufacturing presence abroad with the assistance of a local foreign partner. The partner may provide knowledge of government workings, regulations, internal markets and distribution know-how. This knowledge may be particularly valuable to an exporter in unfamiliar territory.

A strategic alliance is similar to a joint venture in many ways— yet very different. An alliance may be formed when one organization grants another the authority to exploit technology, research and development knowledge, marketing rights and so forth, but does not create a separate entity. A typical example of a strategic alliance is the basic manufacturer - foreign independent sales representative relationship. To solidify this informal arrangement, a handshake or simple written agreement may suffice. A strategic alliance, often less formal, is a preliminary step to creating a joint venture. Consequently, both allow a company quickly to respond to a changing environment and contribute complementary strengths to seize opportunities quickly. In some foreign markets, such as China, a joint venture with a Chinese partner may be the only legal way to enter the market, except under very special circumstances.

A small company with limited capital and manpower, and the need to reduce and share risks, may find a joint venture an ideal entry strategy in an overseas market. By utilizing the management skills, experience and knowledge of the foreign market by the local partner, a firm significantly can reduce its learning curve and share its risks with a partner that has a similar agenda. A joint venture is also safer than a full-scale acquisition should an unfamiliar host government legislate adverse policies affecting foreign investment. Or, as a result of social unrest, the host country becomes embroiled in violence, resulting in property damage and the disruption of business. Many smaller companies favor joint ventures over other methods of expansion because they allow companies to target the exact activity for which they are looking rather than tie up capital in areas in which they have no interest. And from a tax perspective, partners can form a structure so their income crosses the fewest possible borders.

While there are significant potential advantages associated with joint ventures, there are also limitations. For example, in a typical joint venture the profits are shared. Additionally, there are many factors that can lead to disagreements between the partners, such as a dispute over efforts and marketing strategies, differences in management philosophies, etc. The ability to compromise and work together is essential, regardless of cultural differences. A complaint often heard by veteran executives is that many smaller companies do not invest the necessary level of commitment to understanding the culture or developing a strong personal relationship with their joint venture or strategic alliance partners abroad. This, many say, is key to a successful partnership.

From the outset, the level of compatibility between potential partners is difficult to assess. Many auto analysts speculated that the joint venture between Toyota and General Motors that created New United Motors Manufacturing, Inc. in the United States in 1984 would not succeed due to differences in management styles. It appears, however, that the analysts’ predictions were wrong. Conflicts can often arise with regard to interests in second markets. For example, assume a U.S.-Mexican joint venture in Mexico sells its fabrics to Argentina. Should the U.S. partner wish to establish a second joint venture in Argentina with an Argentinean partner, the second joint venture would compete with the first. This can, and has, resulted in many disputes.

Jerald Blumberg, Executive Vice President for DuPont, Wilmington, Delaware, believes it’s imperative to have an operating and marketing presence in the markets one wishes to pursue. He stated that DuPont’s lycra spandex business, one of the company’s most global businesses, has 70 percent of its sales outside the United States. “We operate 10 plants in 10 different countries, and no region or country is favored. There is no ‘home region.’” Importantly, he said the business is able to provide customers with the product they need, when they need it, anywhere in the world.

The company has sought joint ventures and alliances as a way to expand abroad. “Many times we’ve found this to be the safest, best and most practical way to establish a presence and credibility in emerging and evolving markets,” Blumberg said. However, this approach may not work in places like Russia, where operating manufacturing plants and an understanding of the consumer are limited. Blumberg claims a diverse business team who can serve customers in local markets is vital. “It is simply not possible for a cadre of expatriates from the home country to master the language and cultural differences in this diverse world.”

Licensing Technology

Through a strategic alliance or joint venture, a U.S. producer may wish to license its technology, know-how or designs to a foreign company for use in a geographic area for a limited period of time. This may include patents, trademarks, production techniques, and technical, marketing and managerial expertise.

Licensing is particularly attractive to small- and medium-size firms because it affords international expansion while significantly limiting risks. It rarely requires capital investment and neither requires the parties to work closely together nor demands continuous attention. Generally, small firms do not have the expertise, staff or resources to satisfy requirements demanded by other methods of expansion. In many cases, licensing is the only viable strategy for any size firm to securely enter a foreign market that lacks hard currency, severely restricts the repatriation of profits and foreign direct investment, maintains unreasonable trade barriers, and/or is economically or politically unstable.

As with each market-entry method, licensing has its disadvantages. For example, the licensor loses control over the quality, distribution and marketing policies, as well as the essential support services employed for the purpose of selling the product or technology. If compensation is based on sales volume, the licensor must rely on the honesty of the licensee to report units sold. Additionally, earnings are usually less than those provided by most other entry methods.

A typical licensing agreement may call for an up-front fee, royalties based on a percentage of future earnings, and consulting and training assistance. Many licensing agreements evolve into joint ventures, while some joint ventures or strategic alliances are eventually converted to simple licensing agreements when one party’s interests diverge from the original purpose.

Foreign Acquisitions

Through foreign direct investment, a company can acquire an interest in another firm located abroad. This decision is often part of a company’s long-term strategy to strengthen its foreign presence. Most often, a company will complete a foreign acquisition once a market is proven, usually after years of exporting or when a high degree of success has been experienced through a preexisting joint venture.

The degree of ownership desired is often a choice of whether the foreign operation is to be wholly owned (either as a branch or separate subsidiary) or partially owned. If the investor or group of investors desire controlling interests, the stock purchase will range from 51 to 100 percent. If the company is successful, the revenue generated can often exceed profits obtained through other types of international expansion methods.

Controlling interests will provide full authority over all policies, including marketing strategies, financing, cost cutting, expansion programs, production, and quality control. A foreign acquisition can also position the investor to accept host government incentives. Although the greater degree of control may allow the new owners to dictate management policy, trade experts often advise clients to respect and value the input provided by existing managers. A very successful acquisition strategy is one where the new owners study preexisting management styles and seek to understand what management thinks of proposed policy changes, and then incorporate this input.

Nationalist consumers tend to favor goods produced in their country. As a result, it sometimes makes sense to establish a manufacturing presence in the host country through an acquisition to achieve this benefit. In addition to this, both acquisitions and joint ventures allow for more effective servicing of products in distant markets, often leading to more satisfied customers. Many Japanese automobile manufacturers, for example, service the European market through their manufacturing facilities in the United Kingdom. The savings in response time and shipping costs alone can make this type of venture worthwhile, ultimately benefiting the customer.

Establishing a foreign base to service a particular region is also beneficial for cultural reasons. For example, it’s predicted that more U.S. companies operating in Mexico will use the country as a base to service smaller Latin American countries. The cultural affinity among the Mexicans and Central and South Americans can make assimilation less difficult and sales easier.

Foreign acquisitions usually require an abundance of resources, and the exposure to risk is considerably higher, as compared to other methods of foreign market entry. As a result, large companies are usually better suited for this type of undertaking. Changes in government policy can subject these resources to great risk. For example, transfer risk, arising from adverse government policies can restrict the transfer of capital, payments, products, technology, and persons into or out of the host country. Operational risk can constrain the management and performance of local operations in production, marketing, finance, and other business functions. These types of risks, and others, can financially ruin a foreign acquisition.

This appeared as Chapter Five in the book Trade and Finance For Lenders, 1999.
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To entice a firm to export, get the products to foreign destinations and collect the international receivables, a number of additional intermediaries or resources other than lenders are needed. These intermediaries or resources include U.S. government agencies, foreign sales corporations, and U.S. freight forwarders.

Several U.S. government agencies provide assistance to level the playing field for exporters, and in many cases, counter export credit subsidies of foreign governments. For example, the U.S. Trade and Development Agency provides grant financing for projects and activities conducted by U.S. firms. The Overseas Private Investment Corporation provides specialized assistance to U.S. firms. The United States Small Business Administration (SBA) and the United States Export-Import Bank (Ex-Im Bank) offer programs that, among other things, address the financial needs of smaller exporters. And the Agency for International Development provides grants to developing nations that can be used to purchase U.S. goods and services.

Foreign Sales Corporations (FSCs), defined as foreign subsidiaries formed outside U.S. customs territory to transact export sales for their parent companies in the United States, offer generous tax advantages that can enhance export business. Freight forwarders tackle many of the logistics involved in getting the goods to their destinations.

In this section, the roles of some of these resources are reviewed in order to improve understanding of the export process so that the lender may better serve the exporter’s diverse needs. More information about specific organizations can be obtained from their internet websites.

United States Small Business Administration, Office of International Trade

The U.S. Small Business Administration (SBA) provides financial and business development assistance to encourage and help small businesses develop export markets. By participating in the SBA’s Export Working Capital Program (EWCP), lenders can help small businesses, yet minimize their own lending risks (See Appendix A).

Many small businesses invest the time and resources necessary to develop export leads, only to find that they can’t secure the credit to close the sales. The SBA’s EWCP gives lenders the comfort they need so that small businesses can get the financing they need. Under the program, the SBA backs up each loan request with a repayment guaranty of up to $750,000 or 90 percent of the loan amount, whichever is less. The exporter can finance a single export order or multiple sales under a revolving line of credit. For a single deal, the term is set to fit the transaction. The term for a revolving line is usually one year. The EWCP can help a small firm with its pre- and post-export financing needs. Under the program, the exporter can use the loan to:

  • Acquire inventory;
  • Pay manufacturing costs of goods for export;
  • Purchase goods or services for export;
  • Support standby letters of credit;
  • Finance foreign accounts receivable; and
  • Use standby language.

When exporters are competing for export orders, they need financing fast. The SBA understands this. As a result, the SBA provides simplified procedures with a quick turnaround. More than 200 experienced export lenders participate in the EWCP, some of whom have special approval authority under the EWCP — which means an even faster turnaround.

Small banks often view export sales as riskier than domestic ones and won’t provide the credit. Further, larger banks with international trade departments won’t make the smaller loans small firms routinely need. To help alleviate this problem, the SBA has developed the SBA Export Express. It takes the guesswork out of export transactions by providing lenders with the tools they need to assess the international risk involved in the exporter’s loan application.

The Export-Import Bank of the United States

The Export-Import Bank of the United States (Ex-Im Bank) guarantees the repayment of loans, makes loans to foreign purchasers of U.S. goods and services, and provides guarantees of working capital loans for U.S. exporters. As the Export Credit Agency (ECA) of the United States, it also provides credit insurance. Ex-Im Bank does not compete with commercial lenders, but assumes the risks they cannot accept (See details in Appendix B).

An exporter may reduce foreign risks by purchasing Ex-Im Bank export credit insurance through an insurance broker or directly from Ex-Im Bank. A wide range of policies is available to accommodate many different export credit insurance needs. Insurance coverage:

  • Protects the exporter against the failure of foreign buyers to pay their credit obligations for commercial or political reasons;
  • Encourages exporters to offer foreign buyers competitive terms of payment;
  • Supports an exporter’s prudent penetration of higher risk foreign markets; and
  • Because the proceeds of the policies are assignable from the insured exporter to a financial institution, it gives exporters and their banks greater financial flexibility in handling overseas accounts receivable.

Ex-Im Bank offers a short-term (up to 180 days) insurance policy geared to meet the particular credit requirements of smaller, less experienced exporters. Products typically supported under short-term policies are spare parts, raw materials and consumer goods. In addition, the government agency’s Umbrella Policy allows state agencies, export trading and management companies, insurance brokers, and similar agencies to act as intermediaries between Ex-Im Bank and their clients by assisting their clients in obtaining export credit insurance.

For those exporters who do not want to insure all their short-term export credit sales under a multi-buyer type of policy, the Short-Term Single Buyer Policy is available to cover single or repetitive sales. The policy offers 90 to 100 percent coverage for both political and commercial risks of default (depending on the type of buyer, terms of sale and product) and has no deductible. A special reduced minimum premium is available to small businesses.

Medium-term insurance is available for exporters of capital goods or services in amounts less than $10 million and terms up to five years. Ex-Im Bank offers 100 percent commercial and political risk protection. Although similar to the guarantee program, medium-term insurance applications will usually be decided in a more timely fashion because of their conditional nature. Ex-Im Bank also provides direct loans and guarantees of commercial financing to foreign buyers of U.S. capital goods and related services. Both programs cover up to 85 percent of the U.S. export value, with repayment terms of one year or more.

Ex-Im Bank’s Working Capital Guarantee Program assists small businesses in obtaining crucial working capital by guaranteeing loans in amounts greater than $750,000 to fund their export activities. (Note: The SBA guarantees the working capital needs of businesses for amounts under $750,000.) The program guarantees 90 percent of the principal and interest on working capital loans extended by commercial lenders to eligible U.S. exporters. The loan may be used for pre-export activities such as the purchase of inventory, raw materials or the manufacture of a product.

Ex-Im Bank will support the export of environmental goods and services through a short-term environmental insurance policy with coverage of 95 percent of the commercial and 100 percent of the political risks of default, without a deductible. Medium-term environmental exports will have enhanced guarantee coverage with local cost coverage equal to 15 percent of the U.S. contract price, and capitalization of interest during construction.

The organization has a special U.S. toll-free number, (800) 565-EXIM, to provide information on the availability and use of working capital guarantees, export credit insurance, guarantees, and loans extended to finance the sale of U.S. goods and services abroad. The toll number is (202) 565-EXIM.

State and Local Agencies

Numerous state and local governments offer export related services and financial support to small businesses. In fact, to better serve the needs of local firms, many states have established offices in foreign countries. Services range from education and counseling, to providing trade leads, to facilitating federal agency funding, loan guarantees and insurance.

The Case of the Erie County Industrial Development Agency

New York State’s Erie County Industrial Development Agency (ECIDA), through its Trade Assistance Program, provides export assistance designed to promote and enhance the exporting activities of Erie County businesses. To encourage exports, the ECIDA offers the exporter access to sources of financial support, market research, the facilities of trade missions to foreign markets and general export counseling. The organization seeks to play a facultative, awareness-raising role, resolving gaps in Western New York’s export infrastructure.

In attempting to achieve its goals, the ECIDA, a designated intermediary for SBA’s EWCP program, provides local exporters with an understanding of SBA and Ex-Im Bank programs, and helps facilitate the financing process, making it easy to obtain the necessary guarantees, insurance and loan solutions. In 1997, working closely with local banks, the ECIDA assisted local companies in obtaining 10 working capital loans totaling $6,943,000, of which 90 percent were guaranteed by either the SBA or Ex-Im Bank under the Export Working Capital Program. In addition, the organization helped facilitate several export credit insurance policies, and an Ex-Im Bank medium-term loan of $3,500,000.

Freight Forwarders

It is highly recommended that small business exporters work with freight forwarders. They act as the exporter’s agent or representative by advising on, and/or coordinating, a number of export related activities. These include:

  • Recommending the best type of packaging in order to protect the merchandise in transit;
  • Arranging for the goods to be packed at the port or containerized if necessary;
  • Coordinating and managing inland transportation from the exporter’s location to the ocean port, ocean transportation, foreign inland transportation, and warehousing along the way, if necessary;
  • Explaining and completing export and foreign customs documentation requirements;
  • Providing quotes for shipping, port charges, consular fees, costs of special documentation, insurance and handling fees; and
  • Reviewing financial documents, commercial invoices and other documentation.

Documents required in an export transaction differ depending on the destination and product category. Nevertheless, in addition to the required shipping and customs documents, it is wise to provide as much quality information as possible to help foreign customs agents and other foreign officials through the clearing process. According to several freight forwarders, this strategy can be very worthwhile.

Mexico is the United States’ second largest and growing export market. When dealing with Mexico, for example, the U.S. exporter usually will ship the merchandise to a U.S. freight forwarder located along the Mexican border. The Mexican importer generally then will handle all other transportation and customs requirements. Prior to this, however, U.S. exporters are advised to do the following:

  1. Send a proforma invoice in advance of the shipment to the U.S. forwarder to allow for any corrections;
  2. Provide catalogs or complete descriptions of the products to assist the appraiser in determining the accurate tariff product classification;
  3. Properly package the merchandise to allow for easy and secure loading and unloading;
  4. Speak with the U.S. freight forwarder to ensure all product restrictions, documentation requirements and fees are understood;
  5. Specifically determine well in advance whether or not an export permit is required; and
  6. Never ship products to the forwarder without prior notice.

The Mexican importer will usually be responsible for all broker and transportation fees south of the border, plus fees incurred by the U.S.-based forwarder. The following is an example of a routine shipment to Mexico City from Laredo, Texas with customs clearance in Nuevo Laredo, Mexico.

  • Day 1: The Laredo, Texas forwarder receives the merchandise and reviews the documentation.
  • Day 2: The merchandise appraiser determines the Mexican import duties, then reports this amount to the Mexican broker, who collects the funds from the Mexican importer.
  • Day 3: The funds are received or credit is arranged, and the freight forwarder is instructed to reload the merchandise (if previously unloaded). The freight forwarder then arranges to ship the merchandise across the border the following morning.
  • Day 4: The merchandise is received in Nuevo Laredo for inspection by Mexican customs officials. Delivery instructions are given to the Mexican carrier.
  • Day 5: The carrier picks up the merchandise and begins its two-day journey to Mexico City.

Prior to exporting, it is highly recommended that the exporter work closely with his/her freight forwarder to ensure all documents are in order and accurate. But that’s not all. According to Thomas Cook, Managing Director, American River International (FSI), Melville, New York, there are many issues related to trade where one often needs professional assistance to successfully steer the goods through the maze of legalities, customs documentation requirements, shipping considerations, political concerns, financial disputes, and language barriers, etc. These professionals (i.e., custom officials, freight forwarders, etc.) often rely on each other to manage the intricacies of an international transaction.

Cook says, “Documentation is always an issue because each country has different requirements that are not always in black and white, and change on a frequent basis.” As a result, the U.S.-based freight forwarder must have a strong presence or agency network in the exporter’s destination country, and have local knowledge and the necessary expertise to mitigate common problems. The key to successful exporting is understanding that logistics play a significant role in the exporter’s ability to deliver the goods and get paid.

Foreign Sales Corporations and Lenders

As a result of stiff competition among financial institutions, it is important for lenders to provide their customers with as much value as possible. Additionally, as a member of their customers’ financial advisory team, lenders need to be aware of special tax planning tools that can help exporters profit, and in turn, export more goods and services. Foreign sales corporations can accomplish this, while helping exporters save income tax on up to 30 percent on gross income from exporting.

Foreign Sales Corporations (FSCs), created under the 1984 Tax Reform Act, are foreign subsidiaries formed outside U.S. customs territory to transact export sales for their parent companies in the United States. Under the FSC program, when an export sale is made by the parent company, a commission is recorded to the FSC using an IRS-authorized formula. The commission expense can be deducted from the income of the parent company, while a portion of the commission is exempt from the federal tax of the FSC.

Although exotic locales are involved in forming FSCs, and certain tax compliance and management regulations exist and must be closely adhered to, FSCs were never meant to be complicated. In fact, according to James A. Sachs of the Buffalo, New York-based accounting firm of Freed Maxick Sachs & Murphy, P.C., the FSC program was designed as an incentive program to increase export trade by reducing the tax bill on foreign profits.

Sachs said, “FSCs were established by Congress to help balance U.S. trade deficits and increase the competitiveness of manufacturing companies throughout the world.” They can be formed by manufacturers, export intermediaries, or groups of exporters, such as export trading companies. An FSC can buy and sell for its own account, or serve as a commissioned agent. Its parent can be a manufacturer or an independent merchant or broker. Sales to an intermediary must be shipped outside the United States by the middleperson within 12 months of the original sale to qualify under the FSC rules. Shipments to Canada and Mexico qualify as foreign sales.

There are three primary types of foreign FSCs: small, large and shared. Although all are similar in terms of their fundamental operating procedures and tax benefits, they differ in some important ways.

Small FSCs really are not much more than a company through which bookkeeping entries are created to generate tax savings for both the parent company and the FSC. Annual maintenance costs for ensuring that an FSC meets tax code and local jurisdiction requirements can be in the $2,500-$3,000 range. Companies electing small FSC status can benefit only on export sales of up to $5 million annually. The basic procedures for setting up a small FSC are as follows:

  1. Establish a corporation in a qualifying U.S. territory or foreign jurisdiction. Countries qualified to maintain an FSC business office must have a reciprocity agreement with the U.S. Treasury. Although there are more than 35 qualified countries, the most popular FSC locations are the U.S. Virgin Islands (holding with 50 percent of the existing FSCs), Barbados, Bermuda, and Guam. FSCs incorporated under the laws of a qualified foreign country are also subject to the applicable tax laws and regulations of that particular country. Because an FSC cannot receive a foreign tax credit for foreign taxes imposed on its qualified income, it is most beneficial to have an FSC in a country where local income taxes and withholding taxes are minimized.
  2. File an election with the IRS within 90 days after the beginning of the FSC’s taxable year. The FSC, generally a wholly-owned subsidiary of the parent company, must have the same taxable year as the parent. Status cannot be changed during the tax year; therefore, some tax planning is important to ensure the most advantageous FSC arrangement.
  3. Maintain an office outside the U.S. and keep a duplicate set of tax records and books at that overseas office. The office does not have to be in the jurisdiction in which the FSC was incorporated; however, it must be within a qualified foreign county as governed by the 1984 Tax Reform Act. The FSC must also keep certain tax records, statements and tax returns at a location within the United States.
  4. Hire a non-U.S. resident to serve on the board of directors.
  5. Although a bank account is not necessary in most cases, it is required for an IRA-owned FSC (see below).

Small FSCs may not issue preferred stock or have more than 25 shareholders at any one time. The status of a small FSC must be elected, and can be as simple as writing a check. First, the exporter needs to decide if the tax savings from an FSC exceed the cost. If so, he/she needs to write the check to his/her professional advisor and the advisor will worry about the rest. The exporter’s bookkeeper will make journal entries and the advisor will prepare the return.

Companies wishing to benefit from export sales of more than $5 million annually must elect large FSC status. Although the operating procedures are basically the same as those required by small FSCs, a large FSC must fulfill some additional requirements. These include:

  1. Holding all meetings of the board of directors and shareholders outside the United States.
  2. Maintaining the principal FSC bank account in a qualifying country.
  3. Conducting the following disbursements through the principal bank: dividends, legal fees, accounting fees, officers’ salaries, and board of directors’ fees.

In addition to meeting the foreign management requirements, the large FSC must meet the “foreign economic processes” test. This test determines which of the foreign transactions will generate foreign trading gross receipts that will qualify for a tax benefit to the FSC. The foreign economic processes test is fulfilled if two requirements are met concerning (1) foreign direct costs and (2) foreign sales activities.

“The foreign economic processes test was designed to ensure that an FSC has a substantial role in export transactions,” Sachs remarked. “In essence, the large FSC must meet a certain burden of proof in order to take advantage of the tax break.” To fulfill the foreign direct costs requirement, the FSC or its agent must incur a certain percentage of transaction costs outside the U.S. For the purpose of this test, “direct costs” include: material consumed in the activity; labor costs directly associated with the activity; and incremental costs of facilities or services incidentally related to the FSC’s activities.

The activities tested are grouped in the following five categories: (1) advertising and promotion; (2) processing of customers’ orders and arranging for delivery of export property outside the U.S.; (3) transporting the export property to the customer; (4) determining and transmitting the final invoice or statement of account and receiving payment from the customer; and (5) assuming the credit risk.

An FSC meets this portion of the test if its foreign direct costs are either 50 percent or more of the total direct costs for these five activities, or 85 percent or more of direct costs incurred in each of any two of the five activities listed above. With respect to the portion of the test concerning foreign sales activities, the FSC or its agent must participate outside of the United States in any one of the following export transactions:

  1. Solicitation (other than advertising);
  2. Negotiation; or
  3. Contracting.

A shared FSC is one that is “shared” by 25 or fewer unrelated exporters who incorporate to receive the tax benefits and lower the managerial costs involved in establishing an FSC. States, regional authorities, trade associations, foreign trade zones, or private businesses can sponsor an FSC. The only element shared by companies engaging in this type of FSC is the cost; company benefits and proprietary information are not intermingled.

When determining an FSC’s profit, only a few basic decisions need to be made with respect to the profit allocation method. One method is a fixed 23 percent of the parent corporation’s combined taxable income relating to the foreign sales. Another method uses a fixed 1.83 percent of foreign gross sales to maximize savings when net profit is between 4 and 8 percent. Should the net profit drop below 4 percent, 46 percent of combined income can be allocated to the FSC.

Once the FSC profit number is determined, the exporter will need to compute the nontaxable amount of the FSC income. If a “C” corporation owns the FSC stock, the exclusion rate is 15/23rds of FSC income. If the shareholder is not a “C” corporation, 16/23rds of the FSC income will not be taxed. In both instances, the FSC is taxed on about one-third of its income at regular corporate tax rates.

As of 1997, changes in U.S. corporate tax regulations enable “S” corporations to take advantage of FSCs. Prior to that time, “S” corporations could not own subsidiaries, but could create an FSC and direct the tax exempt refunds to a corporate individual retirement account (IRA). An IRA investing in an FSC can produce non-taxable gains that may earn more than IRAs invested in publicly-traded securities. In addition, closely-held “C” corporations will find IRA-owned FSCs to be an appealing alternative for enhancing deferred income plans, since these profits post no immediate tax expense to shareholders.

It should be noted that a tax saving incurred as result of an FSC is permanent — it is not just a deferral. Therefore, a benefit to the financial statement is provided in addition to offering current tax savings.

An example of the FSC tax savings:

  • Profit from Export Sales: 300,000
  • Allocated to the FSC: 23% (69,000)
  • Exempt From Taxes: 15/23
  • Will Not Be Taxes: 45,000
  • Assumed Tax Rate: 34%
  • Tax Savings and Increased Cash Flow: 15,300

Role of the Lender

To date, approximately 6,500 companies have established an FSC, but there is room for more. According to U.S. Commerce Department statistics, less than one-half of eligible companies are realizing the tax benefits of FSCs. For the lenders, the opportunities for assisting customers within the FSC realm are immeasurable. In addition to obtaining a reduced rate of tax, a lender’s customers will benefit from an increase in cash flow, and may be encouraged to more fully participate in the financial benefits of international trade.

On a more practical level, lenders can assist their customers by alerting them to the existence of this tax incentive and guiding them to other members of their financial team, who can prepare a cost-tax benefit analysis to ensure that an FSC is the most beneficial option. “Watching a customer reap the dollar benefits from one of your suggestions is always a lift,” Sachs noted, “And it helps increase referral business. It is the essence of what financial advisors do and do well.”

This appeared as Chapter Four in the book Trade and Finance For Lenders, 1999.
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Experienced international executives indicate that a company seeking international expansion through investment must be intimately familiar with the market it chooses to penetrate, and the risks it may incur. For example, investors will need to understand the obstacles and risks involved in staffing, integrating distribution, financing operations, currency fluctuations, changing foreign investment legislation, and economic and social unrest. Likewise, exporters and their lenders must be cognizant of the inherent risks of exporting. These may be broken down into pre- and post-export risks. Pre-export risks, which are similar to domestic pre-shipment risks, primarily involve the performance capability of the seller. Post-export risk involves commercial and political risks.

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Managing international financial transactions is becoming more important, especially to the welfare of small exporters who generate a greater and greater share of their profits from international trade. Thus, the ability of the exporter to obtain export working capital and offer attractive credit terms to foreign importers can generate a much needed edge over the competition. And based on the exporter’s ability to obtain working capital and the method of payment he/she chooses to accept from the importer can mean the difference between financial success or failure. Consequently, working capital loans and terms of payment, including their obvious and hidden risks, are aspects of international trade that the exporter and lender must thoroughly identify and understand.

A typical trade cycle covers the period from the time a sale is made, through the time a company begins to outlay cash on design, raw materials, labor and other production expenses, until the point when the final payment is collected. In terms of overseas sales, this cycle has a critical mid-point at which the product is packaged, shipped to port and loaded on board a vessel or a plane. Thus, before the shipping point, financing required by the exporter is considered “pre-export financing.” Financing required after shipment to pay for the goods is considered “post-export financing.”

Pre-Export Finance

In many cases, a relatively large financial commitment is required to produce goods for overseas sales. Consequently, the exporter’s need for pre-export financing can be high. Pre-export financing generally refers to the manufacturer’s financing of materials and labor for export using working capital loans.

While the demand for export working capital is high, especially by small businesses, obtaining it can be very difficult. When exporters apply for working capital loans, the amount made available will be collateralized by a lien on their inventory and receivables according to a prescribed formula. Unfortunately, lenders generally exclude overseas receivables from the borrowing base, and consequently, deny export working capital loans.

In addition, many international contracts call for the development of specialized products the U.S. manufacturer cannot always unload in the domestic market if the export sale does not materialize. This added risk also works against the exporter. As an alternative, in an attempt to maintain a positive pre-export cash flow, the manufacturer may request that the overseas importer provides progress payments before the product is exported. This will enhance the exporter’s cash flow, but may exact an important commitment the buyer is unwilling to make. As a result, export working capital is an important component to export success.

Noted earlier, in a typical domestic transaction, receivables are considered collateral which helps obtain the needed working capital. For example, assume that ABC manufacturing company located in Texas obtains a $500,000 order from a New York City distributor to produce lamps. To complete the order, ABC purchases materials, which include metal housings, clamps, shades and light bulbs. As the materials arrive, the company assembles and ships the lamps in increments over a period of one year. Upon each shipment, ABC invoices the New York buyer on a 30 day open account.

When examining this scenario at a particular point in production, we find that ABC company has $100,000 in raw materials, $75,000 in finished goods, and $150,000 in accounts receivable. To calculate the borrowing base on collateral a lender is generally willing to incur on a working capital loan, it will use an internal method of computation often called a borrowing base certificate.

In our example, the borrowing base would be $197,500. This is determined by accepting 40 percent of raw materials ($40,000), 50 percent of finished goods ($37,500), and 80 percent of the value of receivables ($120,000). As the raw materials become finished goods, and the finished goods are converted in accounts receivable, the borrowing base would be adjusted to reflect the new situation and funds would be released from the bank based on a predetermined schedule.

On the other hand, if the buyer is located in Mexico City, instead of New York City, a lender would not consider the foreign receivables as collateral if the deal is simply based on open account terms. However, if the deal was structured as a letter of credit, or the receivables were insured by an acceptable insurance provider, the bank would consider the receivables as collateral and add it to the borrowing base. (Note: unlike most lender practices, the U.S. Small Business Administration Export Working Capital Loan program considers the receivables as collateral before they are created. In other words, before the goods are shipped.)

Insuring the exporter’s accounts receivable under open account terms is important for a variety of reasons. It not only protects the exporter and lender against the failure of foreign buyers to pay their credit obligations, but as stated above, it increases the exporter’s borrowing base, and in turn, improves his/her position to obtain often needed working capital. In addition, insuring foreign receivables encourages exporters to offer foreign buyers competitive terms of payment, supports an exporter’s prudent penetration of higher risk foreign markets, and gives exporters and their banks greater financial flexibility in handling overseas accounts receivable.

When the international receivables are insured, an export trade financing situation becomes very similar to a domestic trade financing situation in terms of risk. Thus, the primary difference becomes the location of the buyer.

Post-Export Finance

“Post-export finance” refers to the financing obtained by the foreign buyer to pay for goods imported. Once a shipment is en route to the customer, only one question usually consumes the mind of the exporter: When is pay day? But before asking this question, it is necessary to negotiate up front who will be responsible for payment. And the options are not always simple. For example, payment could come from the customer, the customer’s bank, the exporter’s bank, a forfaiting company, or from the proceeds of an Ex-Im Bank guaranteed loan to the foreign buyer.

Depending on the exporter’s need for control, certain methods of payment may be demanded. For instance, a principal function for payment through the use of a letter of credit is to ensure control of goods so the buyer cannot clear the product through foreign customs without paying the seller.

Three categories of financing — short, medium and long-term — are used to define the length of time post-export financing, or “after the sale” financing, will extend. Thus, short-term financing generally extends over a period of six months to one year. (Note: In addition to its use in the post-export phase, short-term financing is typically used for export working capital in the pre-export phase.) Based on the circumstances (reputation of buyer, destination country, etc.), U.S. exporters may wish to finance specific transactions on behalf of their customers to make deals more attractive, or in many cases, possible. This may by a accomplished by various methods. The exporter may:

  • Ship on open account terms, carry the receivables and, perhaps with export insurance in place, borrow from a domestic bank to achieve this;
  • Draw a bill of exchange on the importer, ask the importer’s bank overseas to avalize the draft (see details later in this chapter), and then sell it to a third party;
  • Send the goods on collection under documents against acceptance (see details later in this chapter). When the overseas buyer has accepted the draft and the collecting bank has advised a maturity date, the exporter can ask his/her bank to purchase the acceptance;
  • Draw a draft and present documents under a usance letter of credit (see details later in this chapter).

Medium-term financing extends from the short-term period up to five years. It is very uncommon for small businesses to carry a medium-term debt on their balance sheets when domestic U.S. banks do not accept foreign receivables as collateral for working capital. For sales requiring financing during this period, exporters will often resort to:

  • The forfait market (see details later in this chapter), where the exporter draws a draft or a series of drafts with varying maturities which are guaranteed by a bank in the importer’s country and then sold, without recourse, in the international forfait market;
  • Ex-Im Bank guaranteed loans (see Chapter Four), where Ex-Im Bank protects a U.S. lender or an overseas bank against commercial and political risks arising from the import of U.S. goods;
  • Ex-Im Bank medium-term single buyer policy, insuring loans repayable over a period of one to five years.

Long-term financing is generally considered financing from five to seven years, up to a period of 20 to 30 years. This length of financing is uncommon for small firms. Nevertheless, the forfait market may be helpful in financing beyond five years for certain countries. And, the more politically and economically stable a country, the better the chance that long-term obligations will be acceptable to the forfait market.

Post-Export Payment Mechanisms

In any foreign or domestic transaction, cash in advance of shipment is the least risky and, therefore, the most preferable to the exporter. Conversely, it is to the advantage of the importer to delay payment as long as possible. Both parties desire to keep cash available to service non-related accounts payable, earn interest, and/or finance other projects. As a result, both must negotiate terms to achieve a level of mutual satisfaction. In order to remain competitive, the exporter may need to extend some credit. However, as the terms of payment become more beneficial to the importer, the exporter’s risks grow.

Borrowing money in most developing countries is often difficult and expensive. If the exporter can extend more liberal payment terms, he/she may be able to seize a competitive advantage. However, the exporter and lender must always weigh the risks against the benefits. Even if the buyer is a well known entity and considered trustworthy, there are more factors to consider if one is extending credit terms. Difficulties with foreign banking systems, local customs officials and practices, and political instability can result in the exporter not getting paid — ever. Customs documentation in developing countries is often confusing and changes frequently. Seemingly simple issues, such as required documents, language used, number of copies, inspection requirements, and signatures can lead to problems that delay payment.

Several factors must be considered in determining what level of risk the exporter and lender are willing to incur regarding accounts receivable. These include bank and other supplier references, the depth and experience of the business relationship, the buyer’s financial position and creditworthiness, number of years in business, etc.

Various methods of payment that accommodate the needs of the exporter and importer. These include the following, from least risk for exporter to most risk:

  • Cash in advance
  • Letter of credit (L/C)
  • Open account (with insurance)
  • Documents against payment (D/P)
  • Documents against acceptance (D/A)
  • Open account (without insurance)
  • Consignment

Cash in Advance

Cash in advance is the most desirable method of payment for the exporter since the exporter is relieved of collection and gains immediate use of the funds. This method, however, poses the greatest risk to the importer and is only likely to be acceptable if the purchase is very small, or the buyer is highly motivated to obtain a unique product and is confident of the supplier’s ability to deliver.

Documentary Collections

Documentary collections is a method of obtaining payment for goods where the exporter ships the goods and instructs his/her bank in writing to collect payment from the importer in exchange for the transfer of title, shipping and other documentation allowing the importer to take possession. Documentary collections include documents against payment (D/P), documents against acceptance (D/A), and letters of credit (L/Cs).

Documentary collections involve the use of drafts. A draft, a common version of a bill of exchange, is an unconditional order in writing prepared by one party (drawer) and addressed to another (drawee), directing the drawee to pay a named person (the payee) a specified sum of money. A draft can be clean (one that has no documents attached and is usually handed to a bank for collection in a foreign country) or documentary (one that is accompanied by documents needed to complete an export transaction).

In general, there are two categories of drafts: those that are payable immediately, and those that are payable at some time in the future. A sight draft, which is payable immediately when presented to the paying party, is an example of the former category. The latter category inclues time drafts and date drafts, also known as usance drafts. Time drafts are payable at a specified number of days in the future (i.e. in 30 days after sight). Date drafts are payable on a specific date in the future (i.e., March 25).

Another common version of a bill of exchange is a promissory note. It is a transferable, negotiable instrument that is evidence of a debt contracted by the borrower to the creditor, whereby the borrower or issuer promises to pay a certain amount by a specific date, and at a particular interest rate.

Letters of Credit (L/C)

A letter of credit (L/C), formerly known as a documentary credit or documentary letter of credit, is by far the most common and mutually secure method of payment in international trade. Similar to documents against payment, the exporter receives payment prior to the importer receiving the goods. For all practical purposes, the L/C shifts the risk from the foreign buyer to the buyer’s bank. Small business exporters tend to use L/Cs at sight.

The L/C is issued by the importer’s bank, known as the issuing or opening bank, which promises to pay the exporter (beneficiary) against documents stipulated in the L/C. This payment is directed through a U.S. bank, known as the advising bank. When an L/C is issued, the issuing bank is effectively substituting its creditworthiness for its customer, the importer. If the exporter presents documents in compliance with all terms and conditions of the L/C, the issuing bank must legally pay the exporter, whether or not the importer has paid. Therefore, before an issuing bank issues an L/C for a customer, it must ensure that its customer has access to the required funds, or it will insist that the funds be deposited in the bank prior to issuing the L/C.

The advising bank has a duty to the exporter to authenticate the L/C and to advise the exporter of its receipt. However, it does not assume any responsibility for payment should the importer’s bank default. The issuing bank usually will designate a U.S.-based correspondent bank as the advising bank unless otherwise requested by the exporter.

A confirmed letter of credit is the most secure L/C for the exporter. The confirming bank in the United States, usually the advising bank, will guarantee payment to the exporter, then seek reimbursement from the issuing bank. If the issuing bank defaults, the confirming bank must still cover payment to the exporter under the L/C. All letters of credit are irrevocable unless they state otherwise.

For the sake of familiarity, the U.S. exporter may deal directly with his/her local bank, which may not be the advising bank, and instruct the local bank to deal with the issuing bank usually through the U.S. advising bank. This being the case, the local bank would be called the negotiating or paying bank. Otherwise, the advising bank likely would assume these titles.

If stated in the L/C, the exporter may assign all or a portion of proceeds (but not the right to present documents) to a second and/or third party. This ensures that all parties (i.e., a U.S. manufacturer, export broker and lender) will be paid what is owed to them. Prior to the exporter receiving payment or the importer gaining possession of the merchandise, several documents called for in the L/C must be furnished (i.e., bill of lading or airway bill, commercial invoice and packing list), proving the goods have been shipped as ordered.

Revolving, Transferable, Back-to-Back, Standby and Red Clause Letters of Credit

A revolving L/C is designed to satisfy the needs of the exporter and importer whose transactions are repetitive. It allows a single revolving L/C to cover several regular transactions. For example, it covers the exporter who may ship products every two weeks for a period of three months to the same importer. A revolving L/C may indicate a maximum dollar amount that may be available at any one time.

In many circumstances, a small U.S. exporter is not able to finance a high-value purchase from U.S. suppliers for shipment abroad. In response, he/she may request a transferable letter of credit. This is a documentary letter of credit that is marked as transferable. It will be issued in favor of the exporter and transferred to the ultimate supplier. If it allows partial shipments, it may be transferred to one or more beneficiaries, where each party receives its own portion of the proceeds. The second beneficiary, however, is not allowed to transfer to a third beneficiary unless specified in the L/C. When using a transferable L/C, the buyer is made aware of the supplier. This can cause a problem for the exporter if, in the future, the buyer attempts to buy directly from the supplier. Transferable L/Cs often are used when:

  • The first beneficiary is unable to supply some or all of the merchandise called for in the letter of credit;
  • The first beneficiary acts as agent of, or principal supplier to, the applicant (i.e., importer). Such L/Cs are usually issued for a large amount where the first beneficiary is responsible for distributing portions of the L/C to various suppliers; or
  • The first beneficiary is unable to secure back-to-back letter of credit facilities from bankers.

Underlying any transferable L/C is the request of the beneficiary to have it made transferable. This indicates to the applicant that the party supplying the goods is not the original supplier.

A back-to-back letter of credit is a documentary letter of credit opened at the request of an exporter who is also the beneficiary of an export letter of credit (the master L/C). Banks usually open these for a middleperson who first proves that he/she is able to perform. This type of letter of credit is popular because it allows a middleperson with limited financial resources to purchase goods from a supplier who only will sell on L/C terms. The middleperson opens the back-to-back L/C, or baby L/C, in favor of the seller for a smaller amount than the master L/C. The difference between the two is the middleperson’s gross profit. Confidentiality is another reason why these instruments are popular. It is possible to deny the name of the original supplier of the goods from the ultimate buyer and vice versa, which protects the middleperson.

In back-to-back L/C operations, the shipping documents tendered by the supplier under the baby L/C usually are used by the middleperson to obtain payment under the master L/C. Documents submitted by the middleperson would normally include the commercial invoice and bill of exchange. The terms and conditions of the baby L/C usually are similar to those of the master L/C.

Standby letters of credit, or more commonly called performance or bid bonds, are very popular in the United States for domestic transactions, and usually are issued for the purpose of guaranteeing payment in the event of non-performance by the applicant. They are becoming more popular in the international arena. Standby L/Cs differ from commercial L/Cs in several ways: the beneficiary’s statement or claim of default suffices to draw funds under the L/C (in contrast to the detailed export documents under commercial L/Cs). This has the effect of making the standby L/C a tangible security as safe as cash. Consequently, the discrepancy rate in standby letters of credit is non-existent. Therefore, any applicant wanting a bank to issue a standby L/C may be asked to collateralize the transaction at 100 percent of face value.

These flexible instruments are useful in many circumstances. For example, they may be used to:

  • Support an importer’s frequent, small, open account purchases;
  • Cover a brokerage firm’s margin requirement;
  • Serve as bid and performance bonds in the construction and service contract industries;
  • Cover advance payments and/or performance bonds;
  • Provide insurer’s agents worldwide reimbursement of claims paid; or
  • Enable corporations issuing commercial paper to obtain a better borrowing rate.

A red clause letter of credit is used to provide the exporter with a portion, or all, of the funds in advance of a shipment. In essence, the red clause extends financing to the exporter prior to shipment, against a simple receipt presented to the issuing bank.

Tips for Using Letters of Credit

Seemingly simple errors will negate an L/C. As a result, it is essential that all the terms and conditions of an L/C be scrutinized closely. In an attempt to eliminate costly errors and ensure that the exporter and importer understand each other, the importer often will issue a proforma letter of credit, which is a draft L/C with all the documents, terms and conditions spelled out. In turn, the exporter should insist that the terms of the L/C are agreed upon before the sales contract is signed. Importantly, a bank with little in-house international experience should consider having an experienced bank scrutinize the L/C.

Upon review of the proforma L/C, all names and addresses, for example, must be spelled correctly. If the exporter’s name and address are misspelled on the L/C, but not on the exporter’s invoice, the issuing bank may deem this as a discrepancy and refuse payment of the documents without referral to the importer. Experience indicates it is well worth the effort to get such minor details ironed out before signing the sales contract.

In addition, shipping dates, presentation periods and L/C expiration dates should all be reviewed carefully to determine whether or not they can be met. Each L/C always will specify a shipment date. If the bill of lading date is not on or before that shipment date, the exporter’s documents will be deemed discrepant by the issuing bank (for late shipment) and the exporter may be denied payment. Of course, it is entirely possible that the importer will accept the date and other discrepancies in order to obtain the documents covering the shipment. It is also true that under the rules for L/Cs, the issuing bank must pay the exporter in the event that shipping documents are released, whether the documents are discrepant or not.

It is also highly recommended that the exporter have a freight forwarder check all the details of the proforma L/C to ensure both the exporter and the freight forwarder understand the implications and can satisfy the documentary requirements. Very often, shipping, insurance, freight forwarding and other fees must be included in the L/C if the importer is to pay these expenses. If not included in the L/C amount, the exporter may be unable to recover the money from the customer.

Documents Against Payment (D/P)

A document against payment (D/P), also referred to as cash against documents, necessitates the use of a sight draft. It is less risky than documents against acceptance, which typically involves a time or date draft. Since a sight draft is a bill of exchange payable immediately upon presentation of the documents, the bill is paid, then the goods are released to the importer.

When using a document against payment, which is similar to a collect-on-delivery (COD) shipment, a downside exists where the buyer has the prerogative to refuse the documents. Should this occur, the goods can sit on the docks and accumulate demurrage charges (fees assessed for freight detained beyond the normal time permitted). The risk of theft also rises. If not claimed, the goods may be moved to a government warehouse where they will accrue warehousing fees. In any event, the exporter would have to arrange and pay for the return of the merchandise, or expeditiously find a second buyer for the goods, probably at a significant discount.

Documents Against Acceptance (D/A)

Documents against acceptance (D/A), also referred to as drafts against documents, bear great risk due to the fact that the seller relies on the buyer’s good intentions to pay for the merchandise after the buyer has possession. This method, however, provides greater documentation than open account since it involves banks as intermediaries. This enhances the seller’s chances of collecting what is owed. The paper trail is similar to that of documents against payment.

In the normal course of events, the exporter will prepare documentation (i.e., commercial invoice, packing lists, bills of lading) proving the merchandise has been shipped, and present it to his/her bank along with the time or date draft. The exporter’s bank will then forward the documents to the importer’s bank. If the exporter wishes, he/she may request that the bank prepare the draft. Upon receipt, the importer’s bank will notify the importer that documents have been presented for collection. If accepted by the importer, he/she acknowledges the stated responsibilities and agrees to abide by the terms. The importer’s bank then releases the documents, allowing the importer clear access to the goods, which would likely be in the possession of the importing broker (not having entered customs). When the funds are due (i.e., in 30 days or on a specific future date), the importer’s bank should receive payment from the importer, then forward the funds to the exporter’s bank, which will pay the exporter.

Open Account

International sales on open account (i.e., payment within 30, 60 or 90 days after receipt of goods) are executed only after long-term relationships have been established between the exporter and importer, or in sales to well-known multinationals. In the case of default, the exporter likely will be forced to file suit in the foreign country. If one is unfamiliar with foreign laws and judicial process, legal proceedings can become very time consuming, expensive and frustrating. Consequently, considerable steps must be taken to ensure the creditworthiness and integrity of the buyer. Nevertheless, honesty may be inconsequential to the importer’s ability to make payment. For example, the importer may have every intention of paying the exporter, but may be incapable due to an unforeseen financial crisis. As a result, the open account method bears tremendous risk to the exporter and only should be contemplated for sales to customers of indubitable standing.

Stated earlier, open account is less risky when export insurance is obtained. Importantly, this not only will protect the exporter and lender up to a designated percentage (i.e., 90 percent of export sale price), but will also allow the international receivables to be added to the borrowing base, essentially becoming an asset.

Consignment

Consignment calls for the importer (who is in possession of the goods, but does not retain title) to pay for the goods when they are legally sold. Because the exporter retains ownership and does not receive payment until the foreign agent or distributor sells the goods, this method carries enormous risk for the exporter. Overall, this method of collection is rarely used in international trade for the following reasons: 1) foreign laws are not always clear about when ownership ends for the U.S. exporter and begins for the foreign importer; 2) it is difficult for the U.S. exporter to track sales thousands of miles away; 3) exchange rates are likely to fluctuate over time, making it difficult for the buyer to meet his/her obligation; and 4) the date of payment to the exporter is not discernible, forcing the exporter to rely on the importer’s word.

Other Payment Mechanisms

Discounting of Drawings Under a Usance Letter of Credit

A usance letter of credit allows the exporter to obtain payment for goods at an earlier date than expressed in the letter of credit. As a result, the exporter may grant the importer more liberal terms (i.e., payment due in 180 days), yet collect payment, at a discount, sooner. This can make a deal much more attractive to the importer while greatly increasing the exporter’s level of international competitiveness.

Upon issuing a usance letter of credit, the issuing bank promises to pay the exporter, against conforming export documents, a certain number of days after sight (after the issuing bank sights the documents, usually 10 days to three weeks), or a specified number of days after the bill of lading date (the date the steamship takes on the goods). From the exporter’s perspective, it is preferred that payment be made a predetermined number of days after the bill of lading date, since this date is easier to ascertain.

Collecting under a usance letter of credit is simple. After shipment, the exporter presents documents per the L/C to the negotiating bank. The negotiating bank will then check the documents carefully to verify that they comply with the L/C terms. If they do, the negotiating bank will advance funds immediately, less the discount representing an interest rate. The exporter will be paid less money than he/she would have collected at maturity, but his/her cash flow will benefit.

Forfaiting

Forfaiting is derived from the French term, “a forfait,” which denotes the surrendering of rights, or when used here, the forfeit of future payments for cash today. It has been used in Europe for more than 30 years. Forfaiting is very popular among the Italians and Germans, and is becoming more familiar to the British, Spanish, and French. It also is becoming more attractive to U.S. and Canadian traders as an alternative method to traditional export trade finance.

Forfaiting is the selling of notes, usually bills of exchange, promissory notes or other negotiable instruments, on a non-recourse basis. In a typical situation, four parties are involved. These include the exporter, the importer, the forfaiting house and the guarantor, which usually involves a bank that may offer the guarantee by using an aval (discussed below). Thus, the exporter transfers payment collection to a third party, the forfaiter, and in turn receives immediate cash, less a fee paid in terms of interest or a discount. The “non-recourse” basis indicates that should the importer fail to pay, the exporter cannot be held liable. An attractive advantage of using forfaiting is the ability to deal with a less complicated negotiable instrument instead of a contract.

Forfaiting is usually used for deals that range from $100,000 - $250,000 on the low end, and not exceeding $8 - $10 million on the high end. Terms commonly range from 1 - 10 years. Both U.S. and European forfaiting houses are active in the U.S. market. To complete the transaction, the forfaiter usually must know the identity of the buyer, the buyer’s nationality, the goods that are being sold, details regarding the contract value and currency used, the date and duration of the contract, the credit period, number of payments and maturity dates, the evidence of debt (usually promissory notes or bills of exchange), and the guarantor’s identity.

Factoring

Factoring is the discounting of a foreign accounts receivable that does not involve a draft. It has been used in the United States to finance domestic sales for decades. Its use in the international arena began in the 1960s, and has become more popular only in the last 15 - 20 years.

When factoring, the exporter transfers title of its foreign accounts receivable to a factoring house (an organization that specializes in the financing of accounts receivable) for cash at a discount from the face value. Factoring products and services, however, are not limited to this. In addition to basic collection services, they offer credit protection and financing. Although factoring is often done without recourse to the exporter, the specific arrangements should be verified by the exporter.

According to Kal Kaplan, Senior Vice President and Project Manager, Current Asset Management Group of Heller Financial, Glendale, California, in 1995, $23 billion in international trade was made possible by international factoring. This represents an increase of 17 percent over 1994. He recommends that when choosing a factoring house, exporters should ensure the house offers complete credit risk protection, an established network of overseas affiliates, an up-front statement of fees, use of experts in the export destination country, and a U.S.-based point of contact to make transactions as convenient as possible.

The Case of ABC Furniture Company

(Provided by James C. Shelley, Vice President and General Manager, International Department, The CIT Group/Commercial Services.)

As explained throughout this publication, export markets offer endless marketing opportunities, but also harbor numerous risks. Unfamiliar languages, laws, and accounting practices make gathering and analyzing credit information difficult, time consuming and costly. In today’s competitive domestic market, however, many manufacturers are finding that in order to expand their customer base and increase their sales volume, it is imperative to look for opportunities abroad.

This was the case for ABC Furniture Company, a $20 million Georgia-based manufacturer of upholstered furniture, established in 1990. ABC entered the global marketplace cautiously and has been exporting goods to Europe for more than three years. Their export sales have grown by 10 percent each year and are currently $1 million annually. This success, coupled with the fact that European customers reacted very favorably toward their products, encouraged ABC to continue to expand its business abroad.

ABC historically restricted sales terms to confirmed letters of credit or cash in advance of shipment. Its local bank had been able to handle the financing of these receivables, but ABC’s European customers complained that the terms of sale were too expensive. Many of its customers told ABC that even though they liked the product, unless more attractive terms were offered, they would discontinue buying more product. As a result, ABC was faced with a situation in which it must offer its customers 60 day terms or risk losing its export business.

ABC had neither the track record nor the confidence in exporting under open account terms. This presented a major problem. The company’s credit department had little experience in evaluating the foreign credit risk, as its expertise was solely in the domestic market. ABC also faced concerns regarding the collection of export invoices and dealing with unfamiliar languages, laws and customs. Additionally, its bank’s policy was not to accept foreign receivables as eligible loan collateral; therefore, the bank would not finance this type of transaction. The bank also lacked experience in evaluating the credit risk of ABC’s foreign customers, whose financial statements were in an unknown language and whose accounting principles differed from those in the U.S. In order to continue growing its export business, ABC and its bank turned to factoring.

Factoring is a complete financial package that combines credit protection, accounts receivable bookkeeping and collections services. It is an agreement between the factor and the seller (the factor’s client) where the factor purchases the seller’s accounts receivable and assumes responsibility for its customers’ financial ability to pay. In the case of ABC, the factor evaluated the credit risk of the foreign customers and established a line of credit for ABC in order to sell to them. It also managed the accounts receivable bookkeeping and collection functions, guaranteed payment on all of ABC’s approved shipments, and paid 100 percent of any bad debts.

ABC assigned its rights to the factoring contract to its bank, so that if a credit loss occurred, the bank’s loan against ABC’s accounts receivable would be protected. This allowed the bank to finance ABC’s receivables, because the U.S.-based factor guaranteed the creditworthiness of ABC’s customers.

ABC and its bank found that factoring best suited their needs. Now that the exporter has a factor managing its foreign accounts receivable, the company is able to focus its attention on its core competency — manufacturing furniture and growing sales — rather than checking credit and collecting receivables. ABC’s bank is pleased with the arrangement because it was able to retain its relationship with ABC and meet the company’s needs for accounts receivable financing.

Avals

Obtaining guarantees on foreign receivables also can be accomplished through the use of an aval draft. This allows the exporter to extend credit with the assurance that he/she will get paid. This instrument, however, does not provide documentary protection. As a result, certain related risks do exist.

Aval drafts can be cost effective and represent an alternative export finance method. Essentially, it is a draft where payment is guaranteed by the importer’s bank through the following steps:

  1. The importer draws up a draft declaring that he/she owes the exporter money for goods received, and will pay at a future date.
  2. The importer takes the draft to his/her bank and obtains a guarantee confirmed by an official banker’s signature and the term “per aval” stamped on it. The importer then sends the exporter the draft.
  3. The exporter obtains a quote from his/her bank on discounting the aval draft. If acceptable, the exporter then delivers the draft to his/her bank for authentication and collection on the due date.
  4. Once authenticated, the bank confirms the transaction with the importer’s bank. Then, on the due date, the exporter’s bank pays the exporter, and bears any risk of default by the buyer or his/her bank. The drafts can be discounted, if prearranged.

This appeared as Chapter Two in the book Trade and Finance For Lenders, 1999.

Topic: Trade & Finance
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Change Is Occurring at Warp Speed

Several decades ago, as Albert Einstein monitored an exam for a graduate level physics class, a student raised his hand and said there was a problem: the questions on the exam were the same as the previous year’s test. Einstein agreed. The questions were indeed the same, but in a year’s time the answers had changed completely. Given the accelerated pace of change today, the “answers” in business are not just different from those of last year. They are different from those of last month, last week, and, in many cases, those of yesterday.

As we enter the 21st century, new dynamic global trends are taking hold that are dramatically impacting business. As a result, many economic assumptions no longer seem to apply — yet new realities still need to be defined. And basing decisions on old assumptions undoubtedly will lead to undesirable outcomes.

One example is the new trend in rapid capital movements. Today, new sophisticated technology allows investors to transmit capital to all corners of the world at historically unprecedented speed. This is affecting assumptions about financial controls. Thus, the belief that governments or central banks still can manage their capital outflows or currency fluctuations to the same degree as in the past is dangerous and has resulted in extensive economic instability. This is exemplified by the recent Asian financial crisis, Mexico’s peso crisis that began in December 1994, and to a lesser extent, Great Britain’s and Italy’s withdrawal from the European Exchange Rate Mechanism in September 1992. And, as the speed of capital flows accelerates, foreign exchange and international business transactions that today exceed $1.3 trillion daily will continue to soar, further limiting government control.

An even more extensive trend well under way is the trend toward globalization. It is so massive that it is affecting almost every aspect of our lives. From a business perspective, globalization is forcing companies to seek markets outside their domestic arena. For many years, the United States’ enormous internal market more than satisfied the needs of U.S. industry. Globalization has changed this. The world quickly is becoming economically integrated, forcing unprecedented changes at every level of industry. U.S. companies need not look beyond their own backyard to realize they are in a very serious contest against experienced foreign companies. As a result, U.S. firms, both small and large, are facing record levels of foreign competition. For companies to survive and remain competitive in this environment, it takes more than a quality product or service at an attractive price. Today, it requires firms to expand internationally. And this demands access to capital.

For many small businesses, expansion will be achieved through exporting. However, in order to do this, businesses need the help and support of their financial institutions. Now, and to a greater extent in the future, an exporter’s ability to obtain working capital in a timely manner and offer attractive financing to foreign buyers will provide an important competitive advantage. And, in an increasingly competitive business environment, every advantage is vital.

In addition to globalization, other trends already have changed the nature of competitive advantage. New paradigms are emerging as old ones fade. For example, for centuries an abundance of natural resources was known to secure a nation’s competitive advantage. This is no longer the case. Japan, a country of much wealth and few natural resources, clearly has disproven this. Today, knowledge and information has become the new generator of competitive advantage. This is becoming more evident in every industry. Thus, many of our largest corporations, who for decades dominated the economic landscape, are being pushed aside by leaner, more knowledge-intensive companies. And since knowledge and skill are infinite resources, obtainable by both large and small companies alike, smaller companies are not disadvantaged by their size. As a result, a real sustainable competitive advantage is the ability of a small company’s workforce to learn faster than the competition.

Over the next decade, if a worker’s skill level is highly competitive, he/she can anticipate much opportunity and a higher level of income. However, if his/her skill level is not competitive, compared to workers anywhere in the world, this level of opportunity is likely to decrease. In today’s global economy, employment is increasingly tied to educational attainment and skills. According to the Bureau of Labor Statistics, in 1995, although the total unemployment rate averaged 5.6 percent, the rate was 12.8 percent for those without a high school diploma, 5.8 percent for those with only a high school diploma, 3.5 percent for those with associate degrees, 2.6 percent for those with college degrees, 2.3 percent for those with Master’s degrees, and 1.9 percent for those with doctoral degrees.

Change, which is often accompanied by fear and disorganization, is not always easy. But with change comes new challenges and exciting opportunities. Importantly, embracing these challenges and seizing new opportunities will help position employees, companies and lenders to succeed well into the future.

Lending and Trade Finance Has Changed Forever

The business of lending is no longer “business as usual.” Globalization, coupled with tremendous advances in technology, is having a profound effect on the financial sector. As a result, the old days of doing business solely in the domestic arena are over. And because many businesses today are contemplating nothing less than global expansion, their financial institutions must be able to satisfy their financing needs. To achieve this, lenders are taking steps to obtain a greater understanding of international trade and finance.

Like most industries, the banking industry is undergoing major changes at rapid speed. With the introduction of “nonbank” lenders (i.e., brokerage and investment houses, mutual fund companies, consumer credit operations), and acquisitions and mergers, the fewer banks that exist today are experiencing shrinking margins and eroding market share. To cope, banks are diversifying and offering more services in an attempt to generate larger market shares. From 1972 to 1998, the number of U.S. banks decreased from approximately 17,000 to 9,000. However, the number of international departments, which number approximately 300, has remained about the same, even though the number of customers and their needs has changed.

As international trade has increased, so, too, has the need for trade finance tools among exporters of all sizes. Thus, for many seasoned exporters, trade finance has become a regular treasury function, where accelerating international receivables and managing international credit risk are increasingly viewed as a variation on domestic collections and credit management. Many of these firms now use trade finance as “just another tool” to sell their goods — often providing an increasingly important advantage over European and Asian competitors.

Traditionally, domestic U.S. lenders have been very conservative with respect to financing the working capital needs of exporters. Thus, when payment was guaranteed by a letter of credit and confirmed by a well known U.S. bank, the domestic lender often would doubt the exporter’s ability to fulfill an overseas order and effectively collect on it, and refuse to incorporate the guarantee of payment as security for a working capital line. Even when the exporter was confident and exhibited a successful track record in selling to a particular customer, many banks were inhibited by their own lack of information of a particular overseas market.

More recently, however, the picture has changed. Spurred by programs offered by the SBA and Ex-Im Bank, and driven by competition, financial institutions have developed global networks and are more amenable to incorporating overseas sales in their customers’ working capital lines.

Within the international trade environment, banks have taken on a variety of roles. For example, they:

  • Provide working capital funds, with or without the guarantee of a department of the U.S. government, to the exporter;
  • Collect funds on behalf of the exporter, under a letter of credit or on documentary collection basis (see Chapter Two);
  • Buy the foreign currency received by the exporter and sell U.S. dollars to the exporter;
  • Provide funds, with the guarantee of the Export-Import Bank of the United States to the buyer (see Appendix B).

The Growth of U.S. Exports Benefits Lenders

Many U.S. firms have come to understand that in order to maintain a high standard of living in the United States, it is imperative that we develop strategies designed to support worldwide exportation. In fact, in just the last decade, the number of companies exporting — especially small and medium-size companies — has increased significantly. According to President Clinton, “Exports now account for almost one-third of real U.S. economic growth and are expected to grow faster than overall economic activity for the remainder of this decade.”

From 1990 through 1998, U.S. exports of goods and services increased from $394 billion to $931 billion, an increase of 137 percent. This supported approximately 12 million American jobs. What’s more, according to the Office of the Chief Economist, Office of International Macroeconomic Analysis, Department of Commerce, workers in jobs supported directly by exports earn 20 percent more than the average national wage. Workers in jobs supported directly in high-technology industries receive 34 percent more. And workers in jobs supported both directly and indirectly by exports are paid 13 percent more.

The non-traditional export of services also will become a major generator of economic growth in the future for many U.S. sectors. Typically, services now account for 60 to 70 percent of gross domestic product (GDP) for industrial members of the Organization for Economic Co-operation and Development (OECD). And because services are not yet internationally traded on a large scale, the benefit to their trade balances is not yet evident. Thus, in 1965, services accounted for 24 percent of total exports; in 1998, services accounted for 28, just slightly more. This, however, is anticipated to rise significantly. Currently, international trade in services is growing at a faster rate than trade in goods. As this trend continues, service exports will have a greater and greater positive impact on a company’s and country’s trade balance.

Most politicians, scholars and business people agree that exports are very good for the United States and participating companies. But just how good has been difficult to determine. And the impact on U.S. workers has been questionable for some time. Over the past few years, however, more data has been collected and analyzed. And the quantifiable results are very positive. Additionally, selling products in diversified markets, located throughout the world, not only raises corporate sales figures, but also spreads the risk, should a particular country or region experience a period of slow or negative economic growth. But that’s not all. According to the report, Why Exports Matter: More!, published by the Institute for International Economics and The Manufacturing Institute, “in U.S. plants that export, worker productivity is higher, jobs are compensated better and technologies are adopted more aggressively than among non-exporters.”

The report contends that since the late 1980s, plants and firms that have sustained an export commitment, or that have initiated exports, experienced almost 20 percent faster employment growth than those that never exported or stopped exporting. Additionally, these plants and firms were 9 percent less likely to go out of business in an average year. During the period of 1987 through 1992 (latest available statistics), employment at a typical plant fell 2.5 percent, while employment at exporting plants grew approximately 18 percent, indicating better corporate performance. In fact, the report states that communities that hosted exporters benefited from a stable, growing, high-performance workforce and tax base.

Many companies in foreign countries already have learned the lessons of globalization and have adapted. For example, a relatively large percentage of Canadian gross national product (GNP) is dependent on exports. In order for Canada to maintain its high standard of living, Canadian companies must operate on economies of scale that necessitate larger markets than are provided by its domestic population base of only 30 million. As a result, Canadian exports are of extreme importance to Canadian companies and to the overall well-being of the Canadian economy. Very simply, many Canadian companies must export or go out of business. Companies located in many areas of the world, specifically in Belgium and Hong Kong, also have small domestic markets and need to export in order to maintain their high standards of living. In many cases, imported goods are further processed, adding value, and are then exported.

In 1998, world merchandise exports were $5.5 trillion. According to the World Trade Organization (WTO), the United States was the leader, with 12.7 percent of world merchandise export share — up from 11.6 percent in 1995. However, on a per capita basis, the United States ranked low as compared to other developed countries. Germany was second with 10 percent; followed by Japan with 7.2 percent; France with 5.7 percent; the United Kingdom with 5.1 percent; Italy with 4.5 percent; Canada with 4 percent; and the Netherlands with 3.7 percent. Interestingly, in tenth place was Hong Kong with 3.2 percent of world export market share; in ninth place was China with 3.4 percent.

How did Hong Kong, with a population of under six million, rank almost equal to China, with a population of 1.3 billion? In order to survive, Hong Kong has no choice but to export on a massive level. Because “necessity is the mother of invention,” in 1998, Hong Kong exported $174.1 billion in goods globally. Of this, only $24.3 billion were domestic exports, or exports originating in Hong Kong. Due to necessity, many small companies worldwide and in nearly every industry are exporting or teaming up with foreign partners as a way to expand internationally. “Going global” has become a basic fundamental of business. And if banks wish to remain competitive, they increasingly will have to serve these new needs of business.

Export Participation by Small U.S. Firms Is Rising

Export participation by small and medium-size companies is significantly higher than at any time in the past, according to the Institute for International Economics and The Manufacturing Institute report. And according to the United States Small Business Administration (SBA), small businesses provide virtually all net new jobs, represent 99.7 percent of all employees, and provide 55 percent of innovations. Their international success has numerous implications for every industry — especially the financial industry.

Many small firms new to exporting are unfamiliar with international receivables and managing international credit risk, while those familiar with exporting often cannot obtain the financial tools they need. Consequently, lenders have an opportunity to increase their value to small businesses that export. To do so, however, first requires an understanding of the obstacles that small businesses face.

For instance, one of the obstacles small firms regularly face when exporting to developing countries is the foreign buyer’s difficulty and expense in obtaining financing to pay for imports. The banker’s ability and willingness to provide the exporter with a flexible financing structure, contingent on the level of risk, enables the exporter to offer more attractive and competitive liberal payment terms. This strategy is becoming more important due to the exponential increase in global competition.

The bottom line: exporters who can manage risks and move quickly to arrange financing at attractive rates win the business benefiting themselves and their banks. In order for banks to defend and increase customer market share, they need to be proactive in meeting the needs of business. As such, it is important to understand the dynamics of international trade from the exporter’s perspective; help him/her identify and assess opportunities, risks, and finance needs; and deliver timely, cost-effective solutions. Therefore, effectively managing international financial risk is becoming essential for export-oriented firms and a mainstream need in the marketplace.

While many small companies are already very successful internationally and have contributed to United States export figures, most will need to adjust their strategies just to keep up with changing environments. And many others, still unfamiliar with the international landscape, will need to act. Exporting can be more difficult and costly than selling in the next U.S. state — but also far more financially rewarding! Small companies often approach exporting with a great deal of trepidation. At first, pursuing global markets may appear overwhelming. However, by taking a step-by-step approach, companies will find it no more difficult than any new undertaking — an important lesson for both exporters and lenders new to international finance.

This appeared as Chapter One in the book Trade and Finance For Lenders, 1999.
Topic: Trade & Finance
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Mexico’s gross domestic product (GDP) growth rate has made impressive gains as the economy recovers from the financial crisis that struck the country in December 1994. During the first six months of 1997, Mexico's GDP grew by a very strong annual rate of 7% which was well above expectations. Its climb to 5.1% in 1996 also surprised many analysts after it dipped 6.2% in 1995. As the economy continues to expand, many new Mexican trade and investment opportunities are emerging.

The Mexican Demand for U.S. Products Is Rising

As the Mexican economy builds momentum, U.S. companies are once again finding lucrative markets there. In fact, a larger percentage of U.S. goods are now being sold south of the border racking up impressive numbers. Mexico now accounts for 10% of U.S. worldwide exports of agricultural crops; 23% of U.S. apparel and other textile products; 21% or rubber and plastic products; 17% of fabricated metal products; and 13% of electronic and electric equipment.

From Mexico's perspective, U.S. goods are securing a greater share of their individual import markets. For example, since NAFTA went into effect, Mexico has imported more textiles from the United states than any other country. As a result, the U.S. share of Mexico's textile import market jumped 17.2 percentage points to 86.4% — the largest of any U.S. gain.

U.S. exports of transportation equipment also acquired a significant increased of the Mexican transportation import market by rising 19.2 percentage points to 83.1%. And impressive gains were made in the electronic goods and appliances sector, where U.S. market share rose by 7.5 percentage points to 74.3%. On average, U.S. suppliers' share of total Mexican imports grew from 69.3% to 75.5%.

Despite the recession, increases in sectoral bilateral trade have also become significant. From 1993 through 1996, U.S.-Mexican automotive bilateral trade jumped 185.6%; textile and apparel trade increased by 119%; and agricultural exports plus imports rose by 44%, benefiting both U.S. and Mexican businesses.

Overall, U.S. merchandise exports to Mexico are up significantly. In 1996, they reached almost $57 billion, a 23% increase since 1995, with 44 out of 50 U.S. states experiencing export growth. The prospects this year are even better. In the first four months of 1997, U.S. exports to Mexico virtually equaled U.S. exports to Japan, the United States' second largest export market, even though Japan’s economy is 12 times larger than Mexico’s.

As Mexico's economy continues to grow, its demand for U.S. goods, especially the following ten, will continue to offer U.S. exporters opportunity. These include: automotive parts and equipment, franchising services, building products, pollution control equipment, chemical production machinery, telecommunications equipment, apparel, management consulting services, aircraft and parts, and electronic components.

NAFTA's Impact Thus Far

It is difficult to accurately measure the short-term impact NAFTA, which was implemented only three years ago, has had on the United States for several reasons. For one, many Mexican and U.S. tariffs are still in the process of being phased out, but not yet eliminated. Complicating this is the negative effect Mexico's deep economic and financial crisis, steep fall in output, increase in unemployment, and drop in real wages has had on bilateral trade. Nevertheless, an overall performance of the accord has been made by the Clinton administration and private organizations with similar conclusions.

According to a recent study released by the Clinton administration, “NAFTA had a modest positive effect on U.S. net exports, income, investment and jobs supported by exports.” Several other studies have concluded that NAFTA has resulted in a modest increase in U.S. net exports, controlling for other factors. A new study by DRI estimates that NAFTA boosted real exports to Mexico by $12 billion in 1996, compared to a smaller real increase in imports of $5 billion, controlling for Mexico's financial crisis.

An earlier study by the Dallas Federal Reserve finds that NAFTA raised exports by roughly $7 billion and imports by roughly $4 billion. The relatively greater effect on exports partly reflects the fact that under NAFTA Mexico reduced its tariffs roughly 5 times more than the United States.

DRI estimates that NAFTA contributed $13 billion to U.S. real income and $5 billion to business investment in 1996, controlling for Mexico's financial crisis. These estimates suggest that NAFTA has boosted jobs associated with exports to Mexico between roughly 90,000 and 160,000. The Department of Commerce estimates that the jobs supported by exports generally pay 13 to 16 percent more than the national average for non-supervisory productions positions.

Without the Mexican recession, U.S. exports to Mexico would undoubtedly be higher, generating greater benefits to the United States. Mexico has made deeper cuts in its average tariff rate applied to U.S. products. Since the agreement was implemented, Mexico has reduced its trade barriers on U.S. exports significantly and dismantled a variety of protectionist regulations. Before NAFTA was signed, Mexican tariffs on U.S. goods averaged 10%. Since then, Mexico has reduced this by 7.1 percentage points. This has increased the attractiveness of U.S. goods over European, Japanese, and other foreign country products.

In comparison, U.S. tariffs on Mexican goods averaged only 2.07% and more than half of Mexican imports entered the United States duty-free. Since then, U.S. duties have come down 1.4 percentage points.

This article appeared in The Exporter, November 1997.
Topic: Trade & Finance
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Service export opportunities are booming — in industries and countries that may surprise you. And global trade in services is now at an all time high, exceeding $4 trillion annually.

In 1995, the United States exported $211 billion, resulting in a trade surplus of $68 billion. And since 1985, exports of services rose by 189% — faster than exports of goods. As a result, many companies who didn’t feel they could export their services are changing their minds.

Tremendous Growth and Opportunities Ahead

The service sector is the largest component of the U.S. economy. In 1995, it sustained 78 million U.S. jobs and is expected to account for the entire net gain in employment over the next decade. This boon is overwhelmingly led by small, entrepreneurial firms.

The service industry is growing in other countries as well. In fact, it now accounts for half to three-quarters of GNP for many industrial countries. However, because services still aren’t traded globally on a large scale, the benefit to nations’ trade balances are not yet evident. This will change — soon.

New Service Exports Are In Demand

The export of services has become a major generator of economic growth for many industries. As this trend continues, service exports can have a very significant impact on your profits, depending on your business.

In addition to the most common — like travel, transportation, financial, entertainment, telecommunications and health care — a whole new group of industries are in demand.

Service Exports You Should Consider

Business, professional and technical services are now the second most popular service export. This includes accounting, advertising, engineering, franchising, consulting, public relations, testing and training. Major markets you may want to consider for expansion include the European Union, Japan and Canada.

From 1987 to 1994, exports of business, professional and technical services have grown by 391% to Europe, 189% to the Western Hemisphere, and 244% to Japan.

GATS Agreement Makes Exporting Services Easier

The recently implemented General Agreement on Trade in Services (GATS) covers 150 service sectors and involves more than 100 countries. It reduces or eliminates service export barriers, forces countries to treat most U.S. service providers the same as it does its own, and provides for the free flow of payments and transfers. Now that the walls are coming down worldwide, it’s easier to export your services — creating new opportunities that can be extremely profitable for your business.

This article appeared in January 1997. (PN)
Topic: Trade & Finance
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During the last decade, U.S. exports have increased significantly. In fact, from 1985 through 1995, on a balance of payments basis, U.S. exports of goods and services increased from $288.8 billion to $786.5 billion—an increase of more than 172 percent. This pace is expected to accelerate.

"Exports now account for almost one-third of real U.S. economic growth and are expected to grow faster than overall economic activity for the remainder of this decade," said President Clinton. And export participation by small and medium-size companies is significantly higher, according to a recently published report by the Institute for International Economics and The Manufacturing Institute, research organizations both based in Washington, DC.

According to the report, exporting manufacturing plants:

  1. Are larger than non-exporting plants, on average four times larger in employment and six times larger in sales;
  2. Adopt new technologies more frequently;
  3. Had an annual failure rate of 3 percent, compared to 9 percent for non-exporters, on average for the period of 1976 to 1987;
  4. Have a small advantage in avoiding shut downs compared to non-exporting plants of the same size, capital intensity and industry; and
  5. Avoided employment shrinkage to a greater extent than other similar manufacturing plants during the period of 1976 through 1987.

As international trade has increased, so too has the degree of sophistication in trade finance among exporters of all sizes—so much so that trade finance has become a regular treasury function for many companies. More and more U.S. firms now use it as “just another tool” to sell their goods—often providing an increasingly important advantage over European and Asian competitors. Effectively managing international financial risk has become essential for export-oriented firms and a process that has already become streamlined by many.

As growth in exports accelerates, the demand for new, more creative financing by companies of all sizes will continue to increase. Assessing their needs can be difficult, especially those of firms that have not yet fully developed their international strategies. Understanding their global opportunities and risks, providing the right tailored solutions, and finding the appropriate delivery channel can be challenging.

In an effort to effectively compete in the ever-changing and increasingly dynamic financial services environment, banks must first focus on niche markets and develop the necessary international expertise. And identifying the right niche market is not always an easy task—especially since each market is more like a moving target.

Focus on the Markets Best for You

Markets can be identified in a number of ways. Companies, for example, can be classified by their size (small, medium or large), or by their geography (i.e., those located in Southeastern states). They can be categorized by their industry (i.e., producers and sellers of automobiles and parts), or by their needs (i.e., companies new to international trade requiring simple solutions and much personalization). They can even be categorized by their target export markets (i.e., industrialized or developing countries).

If many of your customers sell into developing countries, and you wish to increase your value to these companies, it’s vital that your organization understands the obstacles they face and can provide the right solutions to overcome them. For example, a real impediment to selling to companies in developing countries is their inability or difficulty in obtaining financing to pay for imports. And obtaining medium and long-term financing can be especially burdensome for small and medium-size companies there. By assisting developing country importers with liberal payment terms, U.S. exporters can often export more of their products.

This strategy is becoming more important due to the exponential increase in global competition. Exporters that can manage risks and move quickly to arrange financing at attractive rates can seize new opportunities—not only benefiting themselves, but their banks as well.

Whatever markets you choose to target, keep in mind that companies that export have demonstrated certain advantages over companies that don’t.

An Understand of Global Trends Will Help You to Better Understand What Your Customers Are Up Against

A new economic era is upon us. Many of our old realities are being replaced by new ones yet to be defined. For hundreds of years nations with an abundance of natural resources were considered to have the competitive edge. Today, this is no longer the case. Human skill has taken front seat.

The world is quickly becoming economically integrated, forcing unprecedented changes at every level of industry. U.S. companies, small and large, are facing record levels of foreign competition for domestic market share. In addition to this, the world landscape is changing as never before. And the proliferation of trade agreements and trade blocs among countries are not only increasing the complexity of international trade, but also heightening the level of competition.

In an effort to gain secure and preferential access to foreign markets, and in turn achieve a higher degree of economic security while maneuvering into the 21st century, many countries have entered into trade agreements with one another. From 1947 through 1994, a total of 108 regional trade agreements were notified to the General Agreement on Tariff and Trade (GATT), the international body that governs approximately 90 percent of world trade. Some of these agreements are between two countries; others are among many, creating trade blocs.

Banks Need to Understand the Implications of Trade Agreements on their Customers’ Businesses and Provide Appropriate Solutions

The 15-member European Union (EU) encompasses Belgium, Britain, Denmark, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain. On January 1, 1995, Austria, Sweden and Finland became members. In years to come, it is likely that East European countries join the 350 million population of the EU, expanding the market to include 850 to 900 million consumers.

The implosion of Soviet Communism and the fall of the Berlin Wall have exposed East Europeans to a free market economy for the first time in several decades. In an attempt to shift from central planning to a free market, the economies and political systems of many East European countries have experienced chaos to various degrees. And the eruption of ethnic conflict in former Yugoslavia and elsewhere in Eastern Europe has accelerated economic deterioration.

Much of the EU's vested interest in allowing East European countries to eventually become full members is primarily aimed at preventing a potentially large mass migration westward. By integrating East European economies with the EU, the economic and political stability of the region will likely improve. Very importantly, as the degree of cohesion and internal support increases in Europe, outsiders will be at a competitive disadvantage.

In recent years, trade among East Asian nations has increased at a much faster pace than trade outside the region. Through the development of several trade agreements, such as ASEAN, with a population of 325 million comprising Malaysia, the Philippines, Singapore, Thailand, Brunei and Indonesia, the region is becoming more trade-cohesive. However, economic integration is mostly influenced by Japanese investment in the region, which is creating an informal trade bloc. According to trade analysts, Japan appears to be the only major industrial country whose domestic market remains protected from both foreign trade and direct investment. They conclude that with Japanese expansion in East Asia, North American firms may increasingly lack access to an East Asian bloc.

According to the late Secretary of Commerce Ron Brown, “The European and Japanese, and even the emerging markets themselves are investing more of their leaderships’ energy and resources to do battle with U.S. Companies... and foreign governments’ efforts to increase this will likely continue.” This does not exclude foreign government export financing programs that can give their companies a competitive edge. With an understanding of this, U.S. bankers can appreciate the degree of competition facing U.S. exporters and their need to obtain globally competitive financing solutions.

In an effort to increase the competitiveness of North America, the North American Free Trade Agreement (NAFTA), which built on the achievements of the U.S.-Canada Free Trade Agreement, was implemented on January 1, 1994. Preferential access to Mexico and Canada, guaranteed by NAFTA, has put U.S. companies at a competitive advantage relative to rapidly expanding European and East Asian trade blocs. The Agreement not only opens up the Mexican market of 92 million customers, but creates a trade area of 360 million consumers ensuring secure markets for U.S., Canadian and Mexican products to each other's markets. In the decade ahead, NAFTA is expected to expand south to include Central and South America in the Free Trade Agreement of the Americas (FTAA).

Since NAFTA was implemented, there has been a proliferation of joint ventures and strategic alliances between U.S., Mexican and Canadian companies. This, the development of the FTAA, and other factors leading to greater cohesiveness in the hemisphere will result in greater hemispheric trade. In fact, former U.S. Trade Representative Mickey Kantor says that by the year 2010, the United States will export more goods to Latin America than to Japan and Europe combined. More creative finance solutions will be demanded as U.S. exporters seek opportunities offered by Latin American firms—developing country firms that need access to creative financing solutions.

The GATT Uruguay Round Agreements (URA), implemented on January 1, 1995, by the United States and over 100 other countries, further integrate trade policies among its members. It phases out quotas and cuts tariffs by about one-third on most products traded globally.

GATT, now known as the World Trade Organization, is responsible for reducing international tariffs from an average of 40% in 1947 to 5% in 1990, and has permitted international trade to expand enormously, national incomes to increase substantially and international competition to flourish. This resulted in higher quality, lower priced goods. As a result of this agreement, global trade is expected to increase significantly—benefiting many U.S. industries while generating more risk for some.

The dynamics of NAFTA, the increasing cohesiveness of EU and East Asian trade blocs, and the impact of the GATT agreement on U.S. business is profound. Unraveling the complexities of these agreements and understanding their implications can be a very difficult, time consuming and expensive process for U.S. exporters. This is especially true for smaller firms that do not have the available staff nor resources. Understanding these global trends will greatly assist you in assessing your customer’s needs, realistic abilities, and help you to provide the right solutions. Importantly, by offering knowledge and expertise in these matters, banks can significantly increase their value to their customers.

Solutions to Consider

The Export-Import Bank (Ex-Im Bank) of the United States and private insurers, like FCIA Management and American International Underwriters, are well positioned to meet many of the challenges presented by the projected growth in international trade.

As international trade has increased, so too has the number of Ex-Im Bank programs and transactions. In over 60 years, the independent U.S. government agency has supported more than $300 billion in U.S. exports. Their incentives to banks to work with fledgling exporters and provide programs like Working Capital Guarantees are steps in the right direction.

Many U.S. firms, however, cannot take advantage of Ex-Im Bank's programs because some of their positions are policy driven and can be too restrictive. For example, in order to utilize Ex-Im Bank finance solutions, at least 50 percent of a product's content must be of U.S. origin. Not all companies can achieve this.

Like other U.S. government agencies, Ex-Im Bank must adhere to U.S. foreign policy directives that can terminate or restrict Ex-Im support to various countries without notice. This can make planning difficult for a company if they are relying on Ex-Im Bank support. For example, on March 1, 1996, President Clinton decertified Colombia as a beneficiary of U.S. aid because Colombia was not found to be fully cooperative in the effort to stem the drug trade. Consequently, Ex-Im Bank support for Colombia has been terminated. In April, directed by the U.S. State Department as a result of alleged violations of intellectual property protection, Ex-Im Bank terminated support for China. Within one month, however, a U.S. government policy reversal resulted in agency re-establishing support. And government shutdowns for unspecified periods of time can throw a wrench into the most well-laid plans.

Additionally, Ex-Im Bank support is either limited or not available on guarantee programs, export credit insurance and loans to Bolivia, Brazil and Venezuelan.

Private providers are not subject to the same government policy restrictions and often have a different criteria for determining risk. FCIA Management Co., a subsidiary of Great American Insurance Co., American International Underwriters, a subsidiary of American International Group, and Trade Underwriters Association owned by Reliance, for example, offer very competitive insurance products.

Four Steps to Meeting Our Objectives

As international trade increases, exporters are requiring more sophisticated financing solutions—especially medium-term. To keep up and, more importantly, be proactive, it’s essential to constantly develop new strategies to satisfy these needs. In doing so, we believe it’s important to:

  1. Target the best niche markets where your bank demonstrates a competitive advantage;
  2. Understand how international trade agreements, emerging trade blocs and global trends will impact your customer base;
  3. Identify and assess your customers’ needs and abilities, opportunities and risks in this environment; and
  4. Provide the best solutions and delivery channels to satisfy customers’ growing needs for creative finance.
This article appeared in Bankers Magazine, November 1996.
Topic: Trade & Finance
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U.S.-Latin American trade is steadily increasing and is projected to grow significantly in the next decade. In fact, U.S. Trade Representative Mickey Kantor says that by the year 2010 the United States will export more goods to Latin America than to Japan and Europe combined. As a result, finance solutions that satisfy growing customer needs will be in greater demand.

Borrowing money in Latin American countries can be difficult to obtain and expensive. Stated by Kathy Sifer, Director of International Banking for Barnett based in Miami, Florida, "Medium and long-term financing may be difficult for small and medium-size Latin American companies to obtain." By assisting Latin American trading partners with liberal payment terms, U.S. companies can export more of their products south of the border and seize a sometimes much-needed advantage over European and Asian competitors.

Managing financial risk is becoming more important, especially to the success of U.S. small and medium-size exporters who generate a greater and greater share of their sales and profits from international trade, added Sifer. And obtaining pre- and post-export financing is not always an easy task, she says.

The Export-Import Bank (Ex-Im Bank) of the United States and private insurers, like FCIA Management and American International Underwriters, are well positioned to meet many of these challenges and those presented by the projected growth in north-south trade. Ex-Im Bank's programs are designed to enable U.S. exporters, especially small and medium-size firms, to finance their exports, offer attractive credit terms to their buyers, and insure foreign receivables. "Ex-Im bank is part of the solution," says Sifer. Their rates to exporters are very competitive, they offer many incentives to banks to work with fledgling exporters and provide very good programs like Working Capital Guarantees that are unique to Ex-Im Bank, she says.

As growth in U.S.-Latin American trade accelerates, the need for creative financing will continue to increase. Unraveling and understanding the sometimes seemingly complex set of options can be difficult, especially to those new to international trade. Those companies that can manage risks and move quickly to arrange financing at attractive rates can take advantage of new opportunities.

The Dynamics of International Trade Are Rapidly Changing

In an effort to gain secure and preferential access to foreign markets, and in turn achieve a higher degree of economic security while maneuvering into the 21st century, many countries have entered into trade agreements with one another. From 1947 through 1994, a total of 108 regional trade agreements were notified to the General Agreement on Tariff and Trade (GATT), the international body that governs approximately 90 percent of world trade (now known as the World Trade Organization). Some of these agreements are between two countries; others are among many, creating trade blocs.

Three agreements, however, have emerged to encompass countries with massive economic might to the extent that they have already come to dominate continents. These include the European Union, currently involving West European countries and likely to expand into Eastern Europe; the North American Free Trade Agreement among Canada, the United States and Mexico and likely to expand into Central and South America; and an informal bloc in East Asia dominated by Japan. Based on past trade patterns and policies, and anticipated policies, these blocs will continue to develop, gaining increased strength and influence. Within each bloc free trade has and will likely continue to become more entrenched. However, future trade among blocs is not so clear.

Fear that trade blocs will become inwardly focused and protectionist, not allowing cost-efficient, non-member producers to sell their products on the basis of competition, has promoted a race among nations to achieve the largest and most powerful trade area. Even if protectionism does not become a reality, many believe that trade diversion could have a similar effect. Trade diversion occurs when members of a trade group buy more goods from each other due to the elimination of internal trade barriers, displacing non-member goods.

It is a fact that intra-regional trade has increased. For example, in 1928, 50.7 percent of Western European trade was with Western European countries. By 1993, this increased to 70 percent. During this period, internal Latin American trade only increased from 11% to 19.4%. Due to preferential access made possible by the European Union and other regional incentives, the French are likely to buy more goods from the Germans at the expense of United States.

The Free Trade Agreement of the Americas Will Extend the Benefits of NAFTA Throughout Latin America — Increasing Hemispheric Trade

As intra-European trade increases as a result of the European Union's trade agreement, so too is intra-North American trade as a result of the North American Free Trade Agreement (NAFTA). NAFTA, which was implemented on January 1, 1994, and built on the achievements of the U.S.-Canada Free Trade Agreement, guarantees U.S. companies preferential and secure access to Mexican and Canadian markets.

One of the primary goals of NAFTA is to encourage expansion of business partnerships among North American firms, to promote greater efficiency and more successfully counter the fierce competition generated from the Far East and Europe. So far, evidence shows this strategy is bearing fruit. Since NAFTA was implemented, there has been a proliferation of joint ventures and strategic alliances between U.S., Mexican and Canadian companies. The benefits derived from this teamwork will continue to make North America more globally competitive — at a time when regional trade alliances are becoming increasingly important in the world economy.

Continuing direct investment also reflects an important trend in North American trade — the growth of production partnerships. Production sharing, also referred to as co-production — where manufacturing is divided-up to take advantage of local efficiencies — is an increasingly significant business strategy for improving global competitiveness. By establishing alliances and combining strengths and resources to a greater extent through production sharing, U.S. and Mexican firms are becoming more competitive compared to European and Japanese firms. The concept of "Team North America," a primary objective of NAFTA, has become a reality and is more vital to our economic interests in light of the rapidly changing global environment.

U.S.-Mexican co-production and other types of alliances are anticipated to increase under NAFTA. Predicted in 1992 by Bob Broadfoot, Managing Director of Political & Economic Risk Consultancy, Ltd. located in Hong Kong, unless the majority of their markets are in East Asia, many American manufacturing firms operating there are likely to relocate their plants to Mexico. He indicated that many U.S. manufacturers based in Singapore, for example, produce electronics products primarily for the U.S. market. Many of these firms, he said, will likely relocate to Mexico.

On December 9, 1994, the leaders of 34 Western Hemisphere nations met in Miami for the Summit of the Americas. The goal: to establish a free trade area of the Americas by the year 2005, further building on the achievements of NAFTA. During the Summit, Chile was invited by the United States, Canada and Mexico to begin negotiations to accede to the trade bloc. Although efforts to achieve this goal have become stalled, a revival is likely to be seen after the U.S. presidential election.

Since 1990, some 27 bilateral, trilateral and multilateral agreements have been signed in Latin America, according to the Inter-American Development Bank. These agreements are playing a more important role in providing vital foundation blocks for the building of the Free Trade Agreement of the Americas. This will make the Western Hemisphere the largest trading area in the world, with a combined gross domestic product of more than $7.7 trillion and a market of more than 745 million people. And more trade will increase exporter's needs for competitive financing.

Steve Jenner, Consulting Director for International Executive Programs at the University of California at San Diego, predicts that with the advent of the Free Trade Agreement of the Americas, U.S. manufacturing and sourcing will shift from East Asia to Latin America. "All the benefits derived from NAFTA, including the proliferation of alliances, will be extended throughout Latin America making the Western Hemisphere more competitive globally," he says. Additionally, as U.S.-Latin co-production accelerates, U.S. suppliers will export more components to Latin America where they will be assembled or incorporated in finished products. "Latin America has come a long way in their economic and political development. The region has a great deal more to offer the United States in terms of export markets, investment opportunities and a low-cost manufacturing base."

U.S.-Latin trade will increase for many reasons unrelated to preferential access. Lower wages in Latin America and the Mexican peso devaluation has made manufacturing in the region even more competitive against the Europeans and East Asians. Another advantage offered by Latin America is the proximity. Jenner says the great geographical distance between the United States and East Asia often results in control problems. "With Mexico as our neighbor and the rest of Latin America in the same time zone — and still much closer than East Asia — getting there is easy. And shipping costs are less expensive." As a result, U.S. exports to Latin America, especially of intermediate goods (those used in finished products), will increase.

A third advantage cited by Jenner is the ability of U.S. and Latin partners to work together, not engaging in competition against one another. East Asian entrepreneurs, especially the Chinese, Jenner says, are not often content in supplying a U.S. customer. They have a tendency to become direct competitors and manufacture under their own brand name. Latin Americans on the other hand do not have this same tendency, he says.

Ex-Im Bank Offers Creative Trade Finance Solutions that Satisfy Growing Demands

In order to insure that U.S. companies remain globally competitive, "Ex-Im Bank offers excellent solutions," says Denise Gaudy, Group Senior Vice President and International Sales Manager for Barnett. As trade has increased, so too has the number of its programs and transactions. The independent U.S. government agency helps finance the overseas sales of U.S. goods and services. In over 60 years, Ex-Im Bank has supported more than $300 billion in U.S. exports.

The bank's mission is to create U.S. jobs through exports. Importantly, it has undertaken a major effort to reach more small business exporters with better financing facilities. The bank provides guarantees of working capital loans for U.S. exporters, guarantees the repayment of loans, or makes loans to foreign purchasers of U.S. goods and services. It also provides credit insurance. Ex-Im Bank does not compete with commercial lenders, but assumes the risks they cannot accept.

Ex-Im Bank's Working Capital Guarantee program is particularly attractive. It covers 90 percent of the principal and interest on commercial loans to creditworthy small and medium-size companies that need funds to buy or produce U.S. goods or services for export. The agency's Export Credit Insurance policies protect against both the political and commercial risks of a foreign buyer defaulting on payment. Importantly, they encourage exporters to offer competitive terms and supports prudent penetration of higher-risk markets. And because the proceeds of the policies are assignable from the insured exporter to a financial institution, it gives exporters and their banks greater financial flexibility in handling overseas accounts receivable. Policies may be obtained for single or repetitive export sales or for leases.

The Bank's Guarantees of commercial loans to foreign buyers of U.S. goods or services cover 100 percent of principal and interest against both political and commercial risks of non-payment. Direct Loans provide buyers and/or their banks with competitive, fixed-rate financing for their purchases from the United States.

Gaudy is positive toward some Ex-Im Bank's programs that are unique to the organization, including the short-term multi-buyer, short-term single buyer, umbrella, and small business policy. She is also impressed with the agency's efforts to improve. "Ex-Im Bank is trying to be more flexible and has added another level of delegated authority to banks, and state and local agencies that assist exporters," she says. It is considering the establishment of a medium-term delegated authority program, she adds.

Ex-Im Bank's Activity in Latin America Is Increasing

According to Ex-Im Bank, there has been a significant increase in their volume of transactions in Latin America, particularly since the debt crisis of the early 1980s. In fiscal year 1994, Ex-Im Bank recorded $5.2 billion in financing and insurance shipments to support $5.7 billion in exports to Latin America.

Ex-Im Bank's increased activity in Latin America is a reflection of events there. Less than two decades ago most Latin American countries were run by military generals or dictators closely aligned to the military. For the first time, freely elected governments rule in just about every Latin American and Caribbean country. The so-called “lost decade” in Latin America is a fading memory. These once closed markets have become bustling, dynamic economies that resemble the development process encountered by the Asian tigers of the 1970s. Like the East Europeans, Latin Americans have learned that protectionist policies only result in an inevitable loss in standard of living.

Latin America’s political and economic reforms are working well. Investment is growing and the middle class is on the rise. In fact, Chile and Colombia have received investment grade credit ratings on financial risk by Moody's, a financial rating agency. The transition to open markets has not only benefited Latin companies and workers, but also U.S. companies and workers who owe much of their success to exports and investments in the region. In fact, Latin America has become the fastest-growing region in the world for U.S. exports. Last year, U.S. exports there reached $95 billion. And from 1993 to 1995, exports to Argentina more than doubled; climbed 86 percent to Brazil; were up 96 percent to Chile; rose by 137 percent to Colombia; and increased by 39 percent to Mexico, despite the economic crisis.

Ex-Im Bank's Programs May Not Be Right For Everyone

Tom Jaskolka, Regional International Trade Services Manager for Barnett Bank based in Miami, says many U.S. firms cannot take advantage of Ex-Im Bank's programs because some of Ex-Im Bank's positions are policy driven and can be too restrictive. For example, in order to utilize Ex-Im Bank finance solutions, at least 50 percent of a product's content must be of U.S. origin. This, Jaskolka says, cannot be achieved by some companies.

Ex-Im Bank follows U.S. foreign policy directives that can add an element of unpredictability making long-term planning difficult for a company if they are relying on Ex-Im Bank support, Gaudy says. For example, in April, directed by the U.S. State Department as a result of alleged violations of intellectual property protection, Ex-Im Bank terminated support for China. Within one month, a U.S. government policy reversal resulted in Ex-Im Bank re-establishing support.

Effective May 1, 1996, the agency revised its country limitation schedule. According to the schedule, Ex-Im Bank support, for example, is not available on guarantee programs, export credit insurance and loans to the Bolivian public sector exceeding seven years, to the Brazilian public sector for any length of time, or to the Venezuelan public sector exceeding seven years or the private sector for any length of time.

Private companies, such as FCIA Management Co, a subsidiary of Great American Insurance Co., American International Underwriters, a subsidiary of American International Group, and Trade Underwriters Association owned by Reliance offer competitive insurance products not subject to the origin requirements imposed by Ex-Im Bank, says Jaskolka. Additionally, he says, "they are not subject to political considerations." For example, on March 1, 1996, President Clinton decertified Colombia as a beneficiary of U.S. aid because Colombia was not found to be fully cooperative in the effort to stem the drug trade. This decision, Jaskolka says, does not affect the products or services provided by the private sector. Additionally, the private sector uses an independent criteria to determine country and corporate risk and may provide solutions where Ex-Im Bank does not.

On the downside, Gaudy says, the private firms only offer short-term multi-buyer insurance policies. They do not offer working capital guarantee programs nor medium-term policies, she says. Additionally, she adds, some of the minimum premiums can be expensive for small and medium-size companies.

If private or public insurance and guarantee programs do not meet all the exporters' needs, companies may wish to consider aval financing (the discounting of drafts bearing a guarantee from the buyer's bank). This can be obtained from banks or forfait firms.

Choose the Financial Policies and Political and Commercial Risk Insurance Programs that Are Best for You

As political - economic events and new trade agreements increase U.S.-Latin American trade, timely and attractively priced financing solutions will be essential for companies to remain competitive and win new business. Ex-Im Bank, private political and commercial risk insurers, and aval financing are some of the available solutions which should be considered.

This article appeared in Latin Finance magazine, September 1996.
Topic: Trade & Finance
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