One of the subjects of international business that I have a particular interest in concerns the different payment tools that importers and exporters use when selling goods. There is an added level of risk present when conducting transactions internationally. This risk is in the form of theft, fraud, non-payment, complications of multiple governing agencies, and the inability to meet time deadlines. There are many financial payment tools that are currently being used to combat the problem of international transaction risk. The most common payment types for an international transaction are a letter of credit, documentary draft for collection, open account, payment in advance, and barter.
Most of these transactions involve not only the importer and the exporter, but the respective banks of the parties involved, freight forwarders, and government customs agencies as well. The Role of an Importer An importer is a company that is bringing in, or importing, goods to their domestic market for sale or distribution. Importers benefit from this practice because they can acquire products at a higher quality, or lower price, than would be available domestically. The Role of an Exporter An exporter is a company that is shipping, or exporting, goods outside their domestic market for sale or distribution. Exporters benefit from this practice by making a profit with the sale or transfer of goods to international markets, or by expanding into new, international markets to broaden their customer base.
The Role of a Forwarding Company A freight forwarder is a company that ships goods, on a regular basis, to different locations around the world. An exporter will call a forwarder if that exporter wants to ship goods overseas without having to take on the responsibilities of logistics, customs, and paperwork by themselves. A freight forwarders main concern is the efficient shipment of goods all over the world. Another objective of the forwarder is to make money. They make their profits by streamlining shipments, increasing efficiency, and spreading out costs by moving a constantly high volume of products on a regular, routine basis (Hickman, p.138).
Regardless of the forwarders desire to make a profit off of the exporter, an exporter ends up saving a lot of money by using a forwarders services (Hickman, p.139). The money that a forwarder might charge to ship a product is miniscule compared to what an exporter would pay if they tried to ship the products without using a forwarder (Hickman, p.139). Forwarders know the customs regulations of all of the worlds countries. Forwarders handle the massive amounts of paperwork that is involved in exporting a product to a different country. Forwarders have good working relationships with the shipping companies that provide actual overseas transportation.
Forwarders have massive experience in all aspects of an import/export operation. The bottom line is that employing the services of a forwarding company is always a good idea for an exporter. The Role of Governing Agencies Customs agencies are powerful departments of a national government that regulate what comes in and goes out of that country (Weiss, p.171). Some of the tasks of a customs agency are: Check for the possibility of a contraband item entering or leaving the country. Collect duties, tariff fees, and enforce quota restrictions.
Ensure the proper specification/labeling of imported products are to the standard of that country. To account for products entering or leaving the country. They do this to get statistical information concerning domestic product flow to and from other countries, computation of consumption rates, and to help in computation of the domestic countrys GDP. Knowledge of the customs regulations of the importing and exporting country is absolutely critical in maintaining a successful import/export operation. The Role of a Bank The role of a bank concerning an import/export operation is structurally the same as a traditional, domestic banking relationship. Banks serve as a companys main financial resource by providing tools to raise capital, a place to store capital, and most any dimension concerning a companys money.
Banks also provide an importing/exporting company with risk reduction tools such as a letter of credit, documentary drafts for collection, and verification of an international trading partners financial credit and well being. Letter of Credit A very common payment method for a cross border transaction between two companies is a letter of credit. A letter of credit reduces most of the risk and uncertainty that is usually involved when goods are purchased from, or sold to a foreign, and sometimes unfamiliar, client (Sowinski, p.82). The reduction of risk with using a letter of credit comes from intensive bank involvement with the entire transaction process. Banks generally issue two distinctly different letters of credit; the first being a personal letter of credit, and the second is a commercial letter of credit. A personal letter of credit is issued to an individual who travels a lot, and wants to forward some money to a foreign bank for convenience, risk reduction, or exchange rate arbitrage.
A commercial letter of credit is what a company would use to make a foreign transaction (Weiss, p.101). I am only interested in, with respect to this observation, a commercial letter of credit, and will imply the transaction as simply a letter of credit. A letter of credit is a statement created by bank, and guarantees payment for shipped goods if the agreed conditions within the letter of credit are met (Luxton, p.93). Here is how a letter of credit works: Two companies decide to make an exchange of goods in the near future. A pro-forma agreement is made and the transaction process begins.
Both companies need to have a good working relationship with their respective bank for this to work. The importer of the goods, after reviewing the pro-forma contract, issues an application to the importers bank for a letter of credit. The importers bank reviews the terms of the proposed letter of credit, makes sure that the importer has sufficient credit to make the transaction, and finalizes the proposal. The importers bank sends the letter of credit to the exporters bank. The exporters bank also reviews the terms of the letter of credit, checks the financial position of the exporter, and because the letter of credit is a legally binding document, the exporter/exporters bank must carefully scrutinize the letter of credit on a word-to-word basis.
The exporter, upon approval of the conditions of the letter of credit, calls the freight forwarding company and has the goods picked up and readied for shipment. The freight forwarder ships the goods to the importers docking port for release to the importer once all of the conditions of the letter of credit are met. The exporters bank sends the shipping documents to the importers bank, which examines the documents for accuracy. After the examination takes place, the exporters bank will then take the money from the importers bank, subtract the fees for the letter of credit, and give the money to the exporter. At the exact same time the importers bank will debt the importers bank account.
On that same day, the Exporters bank will send the letter of credit and shipping release information to the importers bank. The importers bank looks over the final documents and gives the paperwork needed to release the goods from the docking port to the importer. The goods are picked up, and the transaction is complete. A letter of credit is used mainly by small to medium sized companies that are making transactions on an infrequent basis, or doing business with an unfamiliar client. A letter of credit, when compared to other international transactions, is a relatively complicated process.
Most very large companies do not use this type of transaction because they trade very frequently, with large volumes of goods, to partner businesses or subsidiary companies without much risk of payment default. Letters of credit are very flexible, and can take on many different forms, if needed, when negotiations between the importer and exporter require special instructions that would not be covered under the terms of a regular letter of credit. The importer can ask its bank to make any legal stipulation when applying for a letter of credit. If a letter of credit states that the exporter must personally load the goods on the ship while wearing nothing but a civil war flag and that the flag must be tied around his ankles, payment will not be made unless he presents documentary evidence of having done exactly that (Weiss, p.103). Nearly all letters of credit are “irrevocable” letters of credit, which means that they cannot be changed or canceled without the consent of all the parties involved (Weiss, p.103). Once an irrevocable letter of credit is issued, an importer cannot back out of a deal unless the exporter, and both banks, agree to let the importer do so.
A letter of credit is assumed irrevocable unless stated otherwise. Revocable letters of credit are very uncommon because, if the letter of credit is revocable, the assumed risk of the transaction would be as high as the other forms of payment. A confirmed letter of credit is a stipulation that the banks involved identify each other and confirm that the funds are available for the transaction (World Trade Staff, p.48). A confirmed letter of credit often occurs when an unfamiliar bank is involved in the transaction process. A negotiation letter of credit is a stipulation that does not require the payment to the exporter, form the importer, to come from a specific bank (Hickman, p.172).
A negotiation letter of credit is usually issued when commodity items are transacted, and may actually be financed by another source if the other source has a preferable cost of loaning the money. A standby letter of credit is a stipulation that spells out the conditions of the transaction. The standby letter of credit is usually issued to set time limits on the delivery or payment of transacted goods (Hickman, p.172). A revolving letter of credit is a stipulation that is used when there are multiple transactions taking place. If an exporter ships goods that may take several shipments to complete, a revolving letter of credit may be issued to avoid some of the redundancy with reapplying for a new letter of credit for each shipment. In addition, a revolving letter of credit may be used again if a repeat shipment for a product is desired (Hickman, p.173). There are other, less used stipulations for a letter of credit, but the most common ones are mentioned above.
The stipulations for a letter of credit are not limited to only one term. It is possible to have a commercial, irrevocable, confirmed, revolving letter of credit. Letters of credit are tools that made possible, promoted, and governed by an international entity called the International Chamber of Commerce (Maulella, p.77). The International Chamber of Commerce has very close ties with all of the major international trade sanctioning entities of the world, such as the WTO and EU. Since 1933 the International Chamber of Commerce has published a set of guidelines called the Uniform Customs and Practice for Document Credit 500, and also publishes a generally guide to commerce called Incoterms that is updated every ten years (World Trade Staff, p.49).
The International Chamber of Commerce sets these rules in an effort to promote small to mid-sized business participation in international trade through risk reduction legislation. Documentary Draft for Collection A documentary draft for collection is a less commonly used form of international transaction that is similar, but more risky, to a commercial letter of credit. Documentary draft for collection is a loose term that has several other descriptive names such as a documentary collection, sight draft, time draft, SD/DP, a bill of exchange, or a draft. A Documentary draft for collection is an unconditional order in writing, signed by the seller, and addressed to a foreign buyer to be paid when presented with the delivered goods (Weiss, p.96). A documentary draft for collection is a simple and inexpensive way to make an international transaction.
Here is how it works: Two companies decide to make an exchange of goods in the near future. A pro-forma agreement is made and the transaction process begins. The exporter fills out a documentary collection application at the exporters bank. The exporter sends the goods and the shipping documents to a freight forwarder. The freight forwarder sends the goods overseas. The exporter sends the completed collection documents to the exporters bank, and the exporters bank sends the collection documents to the importers bank The importer accepts the merchandise and gets the collection documents from the importers bank.
The importers bank sends the money to the exporters bank, and the exporter collects the money. There are different stipulations that can be attached to a documentary draft for collection. The two main categories of documentary drafts for collection are documentary drafts against payment, and documentary drafts against acceptance. A documentary draft against payment is when the exporter ships the goods and receives the proof that the title of the goods was transferred. The payment of the documentary draft will be made to the exporter upon the presentation of the proven documents (Hickman, p.96).
A documentary draft against acceptance stipulates that the payment will not be made until the importer actually accepts the title of the goods (Hickman, p.96). There are other, less used, stipulations for documentary drafts for collection such as sight drafts, arrival drafts, and time drafts. The purposes of these stipulations are to make payment under time constraints, or when certain conditions are met. A sight draft requires the importer to pay once the goods come in contact with a representative of the importers company or the importers company port (World Trade Staff, p.45). An arrival draft stipulates that payment will be made once the goods reach the final destination of the forwarders delivery (World Trade Staff, p.45).
A time draft stipulates that payment will be made on a particular time setting (World Trade Staff, p.45). These added stipulations are what make a documentary draft for collection unique. Without any stipulation used the document would basically resemble a simple bank check. Unlike a letter of credit, a documentary draft for collection does not require that cash for payment be on deposit when the transfer is initiated. A documentary draft for collection offers a stronger guarantee than a check, and is less time consuming, less intensive, and less expensive than a letter of credit.
The importer has comfort in knowing that the goods are already shipped, or have arrived, before the payment is made with a documentary draft for collection. The main disadvantage of a documentary draft for collection is that this method of payment by itself does not obligate the importer to accept and pay for the goods. This puts all of the risk of this type of transaction on the exporter (Weiss, p.97). The exporter runs the risk of shipping the goods, having the importer refuse acceptance of the shipment, and having to make a costly return shipment of the product back home to the exporter or simple abandonment of the goods altogether. Most of this risk is reduced if there is an underlying sales contract for the transfer of goods between the two companies (World Trade Staff, p.50).
Because of the apparent disadvantages of a documentary draft for collection, this type of transaction usually only occurs when a large company, with a good reputation, purchases goods from a small, possibly less reputable company. The predecessor to a documentary draft for collection, called a Bill of Exchange, has been in use for literally thousands of years as a result of differences in international currency, and as an alternative to bartering (Britannica.com Staff). During the early history of this type of transaction there were no laws, only reputation, to make the entire payment process work. England passed legislation in 1882, called the Bills of Exchange Act, followed by the United States in 1896 (Britannica.com Staff). International legislation for a documentary draft for collection was included in the Geneva Conventions of 1930 (Britannica.com Staff). The laws set forth in these conventions are still followed by most countries that participate in international trade Ope …