International trade transactions between an exporter (seller) and an importer (buyer) are complicated by concerns that one party might not fulfil its obligation to the other. The exporter is typically concerned about receiving payment from the importer. There’s also a risk that the importer’s government could impose exchange controls preventing payment. Conversely, the importer may not trust the exporter to ship the ordered products. Financial managers must be aware of the methods available to ensure product delivery or payment in international trade.
Generally, there are five basic methods of payment used to settle international transactions, each carrying a different degree of risk for the exporter and the importer. These methods are:
- Prepayment
- Letters of credit
- Drafts
- Consignment
- Open account
These methods range from relatively simple to more complex approaches. International trade activities have grown over time due to increased globalization and the availability of trade finance from the international banking community.
Let’s explore each method in detail:
1. Prepayment
Under the prepayment method, the exporter does not ship the products until payment has been received from the importer. Payment is typically made via an international wire transfer to the exporter’s bank account or a foreign bank draft. Electronic payment systems also allow firms to make electronic credits and debits through an intermediary bank.
- Risk Characteristics: This method provides the most protection for the exporter.
- Usage: Exporters often require prepayment when dealing for the first time with importers whose creditworthiness is unknown or whose countries face financial difficulties.
- Importer’s Perspective: Most importers are typically unwilling to prepay due to concerns that the exporter might not ship the products ordered.
- Risk to Exporter: None.
- Risk to Importer: The importer relies completely on the exporter to ship products as ordered.
- Product Availability to Importer: After payment.
- Usual Time of Payment: Before shipment.
2. Letters of Credit (L/C)
A letter of credit (L/C) is a written obligation from the importer’s bank (the “issuing bank”) to pay the exporter once the bank receives documentation proving the products have been shipped. It serves as a written commitment on behalf of the importer.
- Process: The importer requests their bank (issuing bank) to issue an L/C. The issuing bank makes a written commitment to pay the exporter upon receiving shipping documents confirming shipment. The L/C is typically sent to the exporter’s bank, which then notifies the exporter. The exporter ships the goods and presents the shipping documents and a time draft to their bank. The exporter’s bank presents these documents to the issuing bank. The issuing bank examines the documents and, if they comply with the L/C terms, pays the exporter’s bank. The exporter’s bank then pays the exporter. The issuing bank then presents the documents to the importer, who pays the bank and receives the documents needed to claim the goods.
- Benefit for Exporter: The exporter benefits because they may trust the importer’s bank more than the importer themselves to make payment. It assures that the amount mentioned in the LC will be paid if the submitted papers fulfill the terms and conditions of the agreement.
- Benefit for Importer: The importer is assured that shipment has been made but relies on the exporter to ship the products described in the documents.
- Key Documents: The primary document in an international shipment under an L/C is the bill of lading (B/L). The B/L acts as a receipt for the shipment, summarizes freight charges, and, most importantly, conveys title to the merchandise. Depending on the mode of transport, it’s an ocean bill of lading (for shipment by boat) or an airway bill (for shipment by air). The carrier gives the bill to the exporter, who presents it along with other required documents to their bank.
- The B/L usually includes: a description of the merchandise, identification marks, evidence of loading ports, names of exporter and importer, status of freight charges, and the date of shipment.
- Other documents presented with the B/L might include certificates of origin, inspection certificates, commercial invoices, consular invoices, and insurance documents.
- Types of L/C mentioned:
- Revocable Letter of Credit: Can be modified or revoked by the issuing bank without notice. It is rarely used in modern international trade.
- Irrevocable Letter of Credit: Cannot be revoked or modified without the consent of the issuing bank, the beneficiary (exporter), and the confirming bank. This is the type used in international trade and cannot be cancelled or amended without the exporter’s consent. It is a safer option for the exporter.
- Confirmed Letter of Credit: Another bank adds its guarantee to the LC. This provides added assurance to the exporter but increases the cost of the LC.
- LC at Sight: Requires the issuing bank to make payment on demand or upon presentation of documents.
- Usance Letter of Credit: Also known as deferred LC or time/term LC. It is payable at a predetermined or future point, subject to conditions and presentation of documents.
- Back to Back LC: Consists of two distinct LCs – one from the buyer’s bank to an intermediary (broker) and another from the intermediary’s bank to the seller.
- Transferable Letter of Credit: Used when a middleman or a company selling another’s product is involved. The first beneficiary (middleman/company) can ask the bank to transfer all or part of the payment to a second beneficiary (the producer/seller).
- Standby Letter of Credit: Similar to a bank guarantee and is more popular in the US. It allows the exporter to get paid by the bank if the applicant (importer) fails to perform as per the agreement.
- Freely Negotiable Letter of Credit: Allows any willing bank to become a nominated bank for negotiation (payment, acceptance, incurring deferred payment undertaking, or negotiation). The LC must state it’s not restricted to a specific bank or can be negotiated at any bank.
- Revolving Letter of Credit: The amount is reinstated after payment, reducing the need for a new LC. Used for trade involving diverse or repeated goods over a specific period.
- Standards: L/Cs are usually issued in accordance with the provisions of the “Uniform Customs and Practice for Documentary Credits,” published by the International Chamber of Commerce.
- L/Cs as Financing: L/Cs are not only a payment method but can also be a source of financing. Many L/Cs are payable at a future date (Usance LC), meaning the exporter effectively provides financing to the importer until payment is made. The importer’s bank also extends credit to the importer when it issues an L/C if the importer doesn’t have sufficient funds, as the bank is obligated to make the payment.
- Risk to Exporter: Very little or none, depending on credit terms.
- Risk to Importer: Is assured that shipment has been made, but relies on the exporter to ship products described in documents.
- Product Availability to Importer: After payment.
- Usual Time of Payment: When shipment is made.
- Assignment of Proceeds: An arrangement allowing the original beneficiary (exporter) to pledge or assign L/C proceeds to an end supplier.
3. Drafts
Drafts are also known as bills of exchange. In the context of international trade payment methods, drafts are typically used in conjunction with other mechanisms like Letters of Credit or documentary collections. Documentary collections are trade transactions handled on a draft basis.
- Definition: A draft is an instrument in writing containing an unconditional order, signed by the maker (drawer), directing a certain person (drawee) to pay a certain sum of money only to, or to the order of, a certain person (payee) or to the bearer.
- Types of Drafts in Trade:
- Sight Draft: Requires payment upon presentation (“at sight”).
- Time Draft: Requires payment at a specified future date. When a shipment is made under a time draft, the exporter instructs the importer’s bank to release the shipping documents when the importer accepts (signs) the draft. This acceptance signifies the importer’s promise to pay at the specified future date. The time period (tenor) for time drafts typically ranges from 30 to 180 days. An accepted time draft is also known as a trade acceptance.
- Documents Against Acceptance (D/A): This payment method is associated with time drafts. The importer’s bank releases shipping documents to the importer only after the importer has accepted (signed) the draft.
- Documents Against Payment (D/P): Not explicitly detailed as a separate payment method in the same list as the five basic ones, but is a common method under documentary collections. The importer obtains the documents required to take possession of the goods only after paying the draft. The sources mention documentary collections offer no verification process and limited recourse for non-payment, making them less secure than L/Cs for the exporter.
- Drafts vs. L/Cs: Drafts are generally less expensive than letters of credit.
- Drafts and Banker’s Acceptances: A time draft, once accepted by a bank (typically the importer’s bank), becomes a banker’s acceptance (B/A). A B/A is a negotiable money market instrument. The exporter can hold the B/A until maturity or sell it at a discount in the money market. The process of a typical foreign trade transaction often involves creating a B/A from a time draft. A banker’s acceptance can be beneficial to the exporter, importer, and the bank.
4. Consignment
Consignment in international trade is a variation of open account. Under consignment, the exporter ships the goods to a foreign distributor who receives, manages, and sells them. The exporter retains title to the goods until they are sold to the end customer. Payment is sent to the exporter only after the goods have been sold by the foreign distributor.
- Risk Characteristics: This method involves high risk for the exporter. The exporter has little control once the goods are shipped and relies entirely on the foreign distributor’s honesty and ability to sell the goods.
- Risk to Exporter: Very high (relies completely on importer/distributor).
- Risk to Importer: Very little or none.
- Product Availability to Importer: Before payment.
- Usual Time of Payment: After products are sold by the importer (distributor).
5. Open Account
In an open account transaction, the exporter ships the merchandise and expects the importer to send payment according to agreed-upon terms. The exporter relies fully upon the importer’s financial creditworthiness and integrity.
- Risk Characteristics: This method is risky for the exporter as payment is not guaranteed. It offers minimal risk to the importer.
- Usage: This method is typically used only when the exporter and importer have established mutual trust and significant experience with each other. Despite the risks, it is widely used, especially among industrialized countries in North America and Europe.
- Trade Credit: Trade credit can take the form of open account or bills payable. When a firm buys goods on credit and isn’t required to pay immediately, the debt outstanding to the supplier is trade credit, recorded as accounts payable by the buyer and accounts receivable by the seller. Small and new firms may be more dependent on trade credit as they might find it harder to get funds from other sources.
- Risk to Exporter: Very high (relies completely on importer’s promise to pay).
- Risk to Importer: Very little or none.
- Product Availability to Importer: Before payment.
- Usual Time of Payment: After shipment.
Comparison of Payment Methods Risk and Payment Time:
| Method | Usual Time of Payment | Products Available to Importers | Risk to Exporter | Risk to Importer |
| Prepayment | Before shipment | After payment | None | Relies completely on exporter to ship products as ordered |
| Letter of Credit | When shipment is made | After payment | Very little or none | Is assured shipment made, relies on exporter for products described |
| Drafts | When shipment is made | After payment | Moderate | Is assured shipment made, relies on exporter for products described |
| Consignment | After products sold by importer | Before payment | Very high | Very little or none |
| Open Account | After shipment | Before payment | Very high | Very little or none |
Note that the “Drafts” row in the table in source indicates “Moderate” risk to the exporter and importer. This is likely because payment is handled through banks, offering some level of structure compared to open account or consignment, but without the bank’s guarantee of payment inherent in an L/C.
Trade Finance Methods
Beyond the basic payment methods, several methods are used to finance international trade transactions. These include:
- Accounts receivable financing
- Factoring
- Letters of credit (as discussed above, also a financing tool)
- Banker’s acceptances (as discussed above, derived from drafts)
- Medium-term capital goods financing (forfaiting)
- Countertrade
Let’s look at the methods not already covered:
1. Accounts Receivable Financing
An exporter might ship products on an open account or time draft basis without bank assurance of payment. If willing to wait for payment, the exporter extends credit to the importer. To get funds sooner, the exporter can use accounts receivable financing. This involves borrowing funds from a bank using the accounts receivable as collateral. The bank lends a percentage of the value of the receivables, and the exporter is responsible for collecting payment from the importer and repaying the bank. This is usually done with recourse to the exporter; if the importer doesn’t pay, the bank can seek payment from the exporter.
2. Factoring
Factoring involves an exporter selling its accounts receivable to a third party, known as a factor. Factors are financial institutions or companies that specialize in purchasing accounts receivable. The factor buys the receivables at a discount from their face value. Factoring can be done with or without recourse to the exporter.
- Without Recourse: The factor assumes the risk of default by the importer. If the importer doesn’t pay, the factor cannot seek payment from the exporter.
- With Recourse: The exporter retains the risk of non-payment by the importer.
- Benefit for Exporter: Allows the exporter to receive funds immediately instead of waiting for the importer to pay. It can also shift the collection responsibility and credit risk (if without recourse) to the factor.
- Risk to Exporter: Lowered significantly if factoring is done without recourse.
3. Forfaiting (Medium-Term Capital Goods Financing)
Forfaiting is a type of medium-term trade financing used for the sale of capital goods, which are often expensive and may require longer payment periods than typical short-term trade credit.
- Process: In a forfait transaction, the importer issues a series of promissory notes to the exporter, promising to pay for the imported products over a period that generally ranges from three to seven years. A note in the series typically matures every six months. The promissory notes are often guaranteed by a reputable international bank (which could be the importer’s bank). The exporter then sells these notes at a discount to a financial institution (the “forfaiter”), which is usually a bank.
- Key Feature: The notes are sold “without recourse” to the exporter. This means the exporter has no liability for the payment of the notes; if the importer defaults, the forfaiter cannot seek payment from the exporter.
- Benefit for Exporter: The exporter receives payment for the export immediately and does not have to carry the financing or bear the risk of default by the importer.
- Risk for Exporter: Eliminated, as the risk of non-payment is transferred to the forfaiter.
- Usage: Typically used to finance capital goods transactions for amounts of $500,000 or more.
- Denomination: Forfait transactions are often denominated in Swiss francs, euros, and U.S. dollars.
- Origin: Forfaiting began in Switzerland and Germany and has spread throughout Western Europe and into the United States.
- Forfaiter: The forfaiter buys the notes at a discount and can hold them until maturity or sell them to other investors.
4. Countertrade
Countertrade refers to international trade transactions in which a seller provides goods or services to a buyer in return for a reciprocal promise from the buyer to purchase goods or services from the seller. These transactions don’t always involve the use of money. Countertrade has gained renewed prominence as a way to conduct international trade.
- Forms of Countertrade:
- Barter: A direct exchange of goods or services of approximately equal value without the use of money. It is described as a primitive way to do business that flourished until the Bretton Woods system established currency convertibility and fostered free trade.
- Compensation (Buy-back): Involves the sale of plants, machinery, or technology on credit, with the seller agreeing to purchase products manufactured by the buyer as repayment. For example, selling a power plant in exchange for purchasing a percentage of the plant’s output over time.
- Counter purchase: An agreement where the seller agrees to purchase goods or services from the buyer’s country within a specified period. The goods exchanged are usually unrelated. An example is Morocco selling phosphate to France in exchange for France purchasing a specific amount of fertilizer from Morocco.
- Switch Trading: A complex form involving at least three parties. It usually arises when a country has countertrade obligations that it cannot or does not want to fulfil directly, and it sells its right to a third party (a switch trader) at a discount. The switch trader then finds a market for the goods.
- Reasons for Countertrade: Often used when a country lacks sufficient hard currency or credit to finance imports. It can also be driven by government policy to stimulate exports or protect domestic industries.
- Risk: Can be complex and risky, requiring expertise to value the goods and manage the exchange.
- Pros and Cons: The sources mention discussing the pros and cons of countertrade from a country’s and a firm’s perspective.
Additional Related Concepts:
- Documentary Collections: As mentioned earlier, these involve handling trade transactions on a draft basis. They offer no verification process and limited recourse for non-payment compared to L/Cs.
- Promissory Note: A formal document signed by the buyer promising to pay the amount to the seller at a fixed or determinable future time. It is a short-term credit tool. Essentials include being in writing, not being a bank or currency note, containing an unconditional undertaking, being signed by the maker, promising to pay on demand or at a fixed/determinable future time, promising a certain sum of money, and being payable to a certain person/order/bearer. Commercial paper is an unsecured short-term promissory note.
- Trade Credit: The credit given by one business firm to another arising from credit sales. Recorded as accounts receivable by the seller and accounts payable by the buyer. Can take the form of open account or bills payable.
- Bills Discounting: A scheme where a seller of equipment raises a bill accepted by the buyer. The seller gets immediate funds by discounting the bill with a commercial bank, which might then rediscount it.
- Commercial Bills: Short-term, negotiable, self-liquidating instruments used for financing working capital. Arise when goods are bought on credit and enhance the liability to pay on a fixed date. Can be inland or foreign. Foreign bills are drawn outside India or drawn on a person not resident in India.
- Commercial Paper (CP): An unsecured short-term promissory note, negotiable and transferable, issued by large, creditworthy companies to raise funds for short periods (e.g., 15 days to 1 year in India). Issued at a discount to face value. Purchased by commercial banks, money market mutual funds, and other financial institutions. Cost is often lower than prime lending rates, plus placement fees. Can be issued physically or in dematerialized form. Euro-commercial papers are similar short-term money market securities issued in Europe.
- Bank Loans: Direct loans from banks are another source of short-term funds for MNCs. MNCs maintain credit arrangements with banks globally. During a credit crisis, banks may reduce lending due to repayment concerns.
- Negotiable Instruments: The Negotiable Instruments Act, 1881 contains the law relating to negotiable instruments. A negotiable instrument is a written document transferring a right in accordance with the Act’s provisions. Key characteristics include free transferability and the holder in due course obtaining good title. Examples include promissory notes, bills of exchange, and cheques. They can be bearer/order, inland/foreign, or demand/time instruments.
- SWIFT: Society for Worldwide Interbank Financial Telecommunication, a messaging system used by foreign exchange dealers/traders for business transactions, including communicating fund transfers. It uses 3-letter codes for currencies.
In summary, the modes of payment in international trade involve varying degrees of risk for the parties involved. Prepayment offers maximum security to the exporter, while open account and consignment place the most risk on the exporter. Letters of credit provide a structured, bank-backed mechanism that significantly reduces risk for the exporter upon presentation of conforming documents. Drafts are used in conjunction with other methods and can become negotiable instruments like banker’s acceptances, which can also be used for financing. Beyond basic payment, trade finance methods like accounts receivable financing, factoring, forfaiting, and countertrade offer ways to manage credit risk, liquidity, and facilitate complex international transactions, especially for capital goods or in environments with currency restrictions.