Before entering into international trade, it is important for an exporter to prepare for the risks involved with different payment methods.
The Electronics and Computer Software Export Promotion Council (ESC) had estimated India’s electronics hardware exports in 2011-12 to be Rs 444.5 billion, while for the same period, computer software, services and ITES exports were a whopping Rs 3265 billion. Clearly, India has a long way to go in hardware exports. It is, therefore, important for Indian electronics companies to actively pursue exports and also get a bigger share of the international market.
However, entering the business of exports requires a lot of preparation in terms of market research, sourcing finance, documentation, etc. One of the most important concerns of exporters is how to choose a mode of receiving payment for goods sold to a buyer in the international market. This can be done by carefully evaluating various options and the risks involved with each of them.
Government support
In order to assist exporters in the payment process, Government of India has established the Export Credit Guarantee Corporation of India Ltd (ECGC), which aims to provide a range of risk covers including political risk, business risk and financial risk against the loss of goods, or the loss of export orders for goods and services due to factors beyond their control. It offers guarantees to banks and financial institutions to enable exporters to obtain better facilities from them. It also provides overseas investment insurance to Indian companies investing in joint ventures abroad in the form of equity or loans. However, insurance is only risk calibration and mitigation, and not the answer for commercial payment risks. Hence, it is always advisable to carefully evaluate the various payment options available for international trade. Here are some guidelines to follow before embarking on this journey.
Different methods of payments
There are three main ways of payments for exports—the clean payment method, payment collection of bills, and letter of credit.
The clean payment method is a relatively cheap and uncomplicated method of payment for both importers and exporters. Here, shipping documents, including title documents (documents of ownership of the goods being shipped), are handled directly between the trading partners. The role of banks is limited to clearing the required amounts. There are two types of clean payments—advance payments and open accounts. In the advance payment method, the exporter ships the goods after receiving the payment from the importer. In the open account method, the importer pays the exporter after receiving the goods. The main drawback of this second method is that the exporter assumes all the risks, while the importer is not responsible for the risk associated with goods during transportation.
In payment collection of bills, also called uniform rules for collections, the exporter gives the commercial and financial documents to the bank, which gives these documents to the importer. This is considered one of the most cost effective methods of transacting business across borders. There are two methods of collections of bill—documents against payment (D/P), and documents against acceptance (D/A). While in D/P, documents are released to the importer only when the payment is made, in D/A, the buyer does not have to pay immediately, but is given a credit period, and pays on the maturity date of the accepted bill of exchange, which may range between 30 to 90 days.
Letter of credit (L/C), also known as documentary credit, is a written undertaking by the importer’s bank on behalf of its customer, promising to effect payment in favour of the exporter up to a stated sum of money, within a prescribed time limit and against stipulated documents. There are various types of L/Cs, which include the revocable and irrevocable types. A revocable L/C can be cancelled without the consent of the exporter, whereas an irrevocable L/C cannot be cancelled or amended without the consent of all parties, including the exporter.
Shares Sanjiv Narayan, managing director, SGS Tekniks Manufacturing Pvt Ltd, an EMS company, “While most companies in the electronics industry prefer the advance payment method, this is seldom the method used because the buyer cannot trust an exporter and pay in advance for the order. Therefore, a better arrangement for both the exporter and the buyer is to go for part payment of the consignment in advance. For example, when a company gets an order to supply test equipment to a buyer in a particular country, the exporter has to invest in manufacturing or acquiring the equipment. Therefore, the most viable option is to take part payment in advance from the buyer so that in case the deal fails, due to any reason, at least the full loss is not borne by the exporter.”
Criteria for selecting a payment method
According to Rajit Pal Singh and Anil K Chopra, consultants, Foundation for Business Competitiveness (FBC), which provides consultancy to SMEs on exports, the most important thing to consider before selecting a payment method is the safety of the payment.
“The title of goods lies in the bill of lading (BL), a legal document between the shipper of the particular goods and the carrier, which details the type, quantity and destination of the goods being carried. This gets transferred to the buyers the moment the BL is endorsed in their favour. Therefore, it is better to go for a sight L/C or post sight L/C, where payment is guaranteed through banks, rather than the D/A method where the bank is not liable to pay the exporter till the buyer pays,” they point out.
Agrees Sanjiv Narain, “The security of payment is the main criteria for selecting a payment method. For our new customers, we prefer the letter of credit payment method, as the importer’s bank guarantees the payment. However, to our trusted customers, we allow a 30 day credit period for making the payment.”
S Nair, deputy general manager (commercial), Himachal Futuristic Communications Ltd, a manufacturer of high technology telecom equipment and optical fibre cables, says that the most secured method is the 100 per cent irrevocable L/C, in which payment is guaranteed against the receipt of documents, while the least secured mode is the D/A as the payment here is not guaranteed and the importer can give any excuse for non-payment.
Protection against non-payment
International trade leads to several payment challenges for exporters. It usually takes longer to get paid for exports than for sales within the country.
According to Rajit Pal Singh and Anil K Chopra, one should take precautions by insisting on firm, irrevocable L/Cs from prime banks and get them confirmed by your bank. Getting a report on the credentials of the client from ECGC, getting ECGC credit risk insurance against loss during export of goods and services, and getting insurance cover even if the contract does not need it, are some other ways of being cautious. There are companies like Dun & Bradstreet which check the credentials, history and financials of overseas companies for a fee.
“It is important to note that the bank deals with papers and not goods. As long as the papers conform with the opening bank’s (bank of the exporter) requirements, the confirming bank (bank of the importer) has to pay to the opening bank. Any trade dispute or commercial dispute between the buyer and seller that may crop up later is not within the purview of the bank transaction and has to be dealt with as a commercial dispute,” says Rajit Pal Singh.
Managing foreign exchange risks
One of the risks associated with foreign trade is the uncertainty of the future exchange rates. The relative value between the two currencies could change between the time the deal is concluded and the payment is received. If the exporter is not properly protected, a devaluation or depreciation of the foreign currency could cause the exporter to lose money. This is a problem most of the exporters face, given the volatility the US dollar is exposed to.
Informs S Nair, “Exporters should put in specified clauses in the trade agreement between the buyer and seller as a cover for foreign exchange risks. They should also mention the upper and lower limits of foreign exchange fluctuations, and also the time period the agreement is valid for.”
Here are some financial tools that help in minimising this risk.
A forward exchange contract is an agreement between the exporters and their bank, in which the bank agrees to buy or sell a certain amount in foreign currency at a fixed rate of exchange, up to a particular date. When exporters enter into an export contract in a foreign currency, a forward exchange contract allows them to determine (at the time they sign the contract) the exchange rate that will apply to future payments from their buyer.
Foreign currency options enable exporters to set a lower limit on the amount of dollars that they will receive in exchange for payment in foreign currency from the buyer.
A foreign bill negotiation is an advance by the bank for the amount and currency that an exporter will receive when the overseas buyer makes a payment. The bank provides within a short term, a post-shipment advance by buying a bill of exchange that the exporter has issued in a foreign currency in a documentary collection transaction.
A foreign currency account enables the exporters to deposit in their bank export contract payments they receive in a foreign currency and to use those funds to pay expenses invoiced in the same currency and, therefore, there isn’t any exposure to changes in exchange rates.
A foreign currency loan can help to manage exchange risks for export contracts.
—By Nitasha Chawla
