Export payment terms adjust the risk to exporters and the cost to importers

Business America, Oct, 1997 by F. John Mathis

There are a variety of payment forms for international trade that vary immensely in cost relative to risk. A cash payment is least risky to an exporter but is very expensive to the importer. An open account represents the greatest risk to an exporter but provides the importer with the lowest cost. As one increases the cost of the trade finance instrument to the importer and simultaneously lowers the payment risk to the exporter, the range of payment terms are: bank time draft, bank sight draft, irrevocable letter of credit, and confirmed irrevocable letter of credit. A letter of credit is a letter sent by the importer's bank to the exporter providing that it will pay for the goods when the proper documents are presented by the exporter. "Confirmed" means that a bank acceptable to the exporter adds a promise to pay if the importer's bank is unable to do so. The confirmed letter of credit form of trade financing is most commonly provided by banks and it captures country risk, company, and industry risk, thus reducing greatly the risk to the exporter. This instrument is the focus of this article.

A decomposition of the cost for a letter of credit indicates that, in general, there is currently about a one-eighth of 1 percent fee for negotiating the document, and that the most significant portion of the cost is the confirmation. Confirmation is based on the riskiness of the country or bank issuing the document. If funding is provided with the document, which occurs 30 percent to 40 percent of the time, the additional funding cost is based on Bankers Acceptances or the London Interbank Offered Rate (LIBOR).

The confirmation cost is the most variable component of the cost of a trade finance document, and presently may range from about 1 percent for a secure, low-risk country to 6 percent, or higher, for a high-risk country such as Russia. Which party to the transaction actually pays the cost is negotiable, and even when specified it is not clear since costs can be transferred by altering the price of the product traded.

One approach to this issue of cost and risk assignment is to examine the performance record on trade finance instruments, since the pricing on such instruments primarily reflects, among other factors, the performance or default record by a specific company, bank, industry, and country involved in the transaction. The higher the default rate, the more costly the trade finance instrument. In this respect, the Thunderbird International Trade and Finance Center initiated a study to compare loans losses by commercial banks on trade finance lending versus international term lending. The difference between the two is duration and purpose. Trade financing usually has a maturity of less than one year and is provided for exports and imports, while term lending is longer than one year and is used for the production and shipment of goods. Since 1990, the difference between the two has become increasingly blurred.

The results of this study suggest that trade financing, specifically the use of confirmed letters of credit, have a much lower incidence of losses, reschedulings, or restructurings than other normal term international loans, whether made to a government entity or to a company. This would suggest that this instrument has the lower overall cost for trade financing. The period covered by this study was from 1980 to the present. Of all the credit instruments used in international trade, the confirmed letter of credit has been found to be the safest and most secure form of international lending. Compared to other forms of international commercial loans, letters of credit enjoy a much lower loss record.

Performance Record and Risk

The objective of this study was to research the issue of default, loan loss, or non-performance on trade financing, specifically concerning the confirmed letter of credit. The criteria for defining a loss takes into consideration that the bank must have appropriate operational capabilities or professionals to perform the transaction and it must have the ability to analyze country risk as well as foreign bank or corporate risk. If the bank is unable to meet these performance assumptions, then losses on letters of credit are believed to be caused by poor credit decisions by unqualified lending officers. Several countries have defaulted on trade finance but banks had little trade finance exposure to these countries.

The hypothesis being tested was that as a credit instrument, a confirmed letter of credit, is a better (safer) instrument or has experienced a lower loss record or fewer restructurings than other international commercial loans -- particularly term loans. It is believed that there were no losses on confirmed letters of credit during the past 16 years (between 1980 to 1996) except for the Dominican Republic, Nigeria, and Iraq, which are all countries that failed to meet minimum country risk standards during the period under review.

The time period of particular interest for this study was 1982 and thereafter, when several heavily indebted developing countries went through a period of defaults, renegotiations, and restructuring/refinancing of their outstanding foreign debts. This period is often referred to as the period of the less-developed country (LDC) debt crisis.