Managing payment risk in International Trade

There is a growing number of exporters in Kenya that are falling prey to unscrupulous importers of their goods and services. A rising number of new exporters have indicated that they have not received payments from importers after delivering a consignment. This has led to losses amounting to hundreds of millions leading to closure of businesses. Many of these enterprises had borrowed loans from banks to support working capital needs but they were unable to service them. Consequently, banks resorted to repossessing and auctioning securities pledged against the loan to cover default risk.  

Majority of these exporters are small and medium enterprises that are new to international trade. These businesses are eager to participate in international trade but are ill prepared to navigate inherent risks that come with it. As small businesses pursue cross border trade, they need to map out the entire process together with the risks associated and formulate realistic mitigation measures to implement throughout the export journey. This paper focuses on methods of payment in international trade together with their inherent risks and propose measures to mitigate them. The essence of this article is to present to you the available payment methods and choose the most appropriate when negotiating a sale agreement with your buyer.

Methods of payment in international trade

Complete guide to trade finance for export business

1. Open account

Open account terms transaction refers to a sale where the goods are shipped and delivered before payment is due, which in international trade is typically in 30, 60 or 90 days. This method of payment is the most disadvantageous to the seller/exporter because the seller needs to part with the goods before they get paid.  The seller may therefore have to plan for financial resources to fund working capital needs such as supply and production, prior to receiving payment at a later date.

Additionally, some countries may have country risk, whereby for political or economic reasons the importer’s government or central bank may block payment out of the country. In this case the buyer may be ready and willing to pay but the country in which they are located may not have enough hard currency e.g. US Dollars or Euros, to facilitate the international trade transaction.

For the importer this payment method is the most advantageous. It gives the importer:

1. Security – the buyer knows the goods are in transit and may be           able to         inspect them before having to make payment.
2. Cash flow – the buyer does not have to part with their money until they      receive the goods, or even later, in case credit           terms apply. This is          highly advantageous for the                 importers working capital.

Small businesses that intend to venture in cross border trade should only consider open account trading terms when they are confident of receiving payment. This confident is built on the following factors:

1. The buyer is large well-known company
2. Buyers credit reference rating- An exporter should carry out a detailed credit reference check on the buyer to confirm that they are in good financial standing.
3. Having an established trading history with the buyer repeatedly making payment on time.
4. Purchase credit insurance against the risk of non-payment.

It is important to note that in many cases large buyers who place big orders tend to only accept open account terms, particularly when dealing with SME exporters. In addition, large buyers in developed regions generally demand credit terms as well. Such buyers are considered to have buying power – they are desirable customers for SMEs, and they usually do not have trouble finding suppliers who want to work with them.

1. Advance payment/ cash in advance

In this method of payment is received from the buyer or importer prior to goods being shipped. Payment is usually made via electronic transfer, credit card, or escrow service. Once payment is received the goods are shipped to the buyer. With cash-in-advance payment terms, an exporter can avoid credit risk because payment is received before the ownership of the goods is transferred.

This is the most secure method for the seller (exporter), and consequently the least attractive for the buyer. Cash-in-advance is recommended in high-risk trade relationships or export markets, particularly for small export transactions for which other payment methods may not be cost-effective. Cash-in-advance is also less burdensome than a letter of credit and has less risk for the exporter than an open account. However, requiring payment in advance is the least attractive option for the buyer. Exporters who insist on cash-in-advance as their sole payment method for doing business may lose out to competitors who are willing to offer more attractive payment terms. Depending on the sales opportunity, an exporter may also need to consider other terms of payment.

Exporters should consider cash I advance method of payment when:

1. The importer is a new customer or has a less-established purchasing history. the importer’s creditworthiness is doubtful or unverifiable
2. There is little or no confidence in the ability of the buyer to pay.
3. If the political, commercial, or economic situation in the buyer’s country increases the risk of non-payment.
4. The seller has a unique, market-leading product, not available elsewhere, or in heavy demand. 
5. The goods are being customised to the buyer’s specifications, resulting in increased cost of manufacturing.

Businesses that export to developing countries often demand advance payment terms, due to uncertainties over non-payment and country risk.

It’s important to note that open account and advanced payment are the two extremes on the payment risk ladder in international trade. In practice, neither may be suitable should the buyer or seller feel they are giving up too much control.

Letters of credit

A Letter of Credit is a contractual commitment by the foreign buyer’s bank to pay once the exporter ships the goods and presents the required documents to the exporter’s bank as proof of shipment.

Letters of credit are trade finance tool designed to protect both the exporter and importer. They can be very helpfull in winning and signing business deals with new clients in foreign markets. A letter of credit gives the exporter guarantee of payment while offering the importer reasonable payment terms.

Letter of Credit is the most secure method of payment provided that its terms are met (i.e. the documents are presented in order and on time). There are strict guidelines around the issuance of Letters of Credit, which are governed by UCP 600 (Uniform Customs and Practice for Documentary Credits, established by the International Chamber of Commerce).

Letters of credit are recommended for use in higher-risk situations for instance when the importer’s credit rating is unacceptable or not available, when dealing with a new or less-established trade relationship, when extended payment terms are requested or to provide added security for high-value export transactions where any delay in payment or non-payment would be catastrophic for the exporter.

The required documents are detailed and prone to errors and discrepancies. To avoid payment delays and extra fees, documents required by the Letter of Credit should be prepared by professionals such as freight forwarders. The exporter should consult with their bank before the importer applies for the Letter of Credit. An exporter should enquire

1. What type and size of export transactions are suitable for a Letter of Credit?   
2. How much does a Letter of Credit cost? Who pays the fees?
3. How are disputes resolved between importer and exporter?

Documentary collections

Documentary collections payment method is an approach preferred for merchandise and commodity exports. This method of payment is recommended in situations where there is an established and ongoing trade relationship with a trusted buyer. Documentary collection payment method can simplify your export transaction, offer faster payment, and reduce costs compared to Letters of Credits. 

In ddocumentary ccollection transactions, the exporter’s and the importer’s banks facilitate the export sale by exchanging shipping documents for payment. It is important to note that the banks do not verify the accuracy of the documents. They also don’t guarantee payment as they do with Letters of Credit. Should the buyer not pay or not accept the bill of eexchange, the exporter retains title to the goods. This is better than in open account terms as the exporter ends up not getting paid and losing the goods. Since the exporter retains ownership of the goods they may choose to transport the goods back or sell them in the open market in the target market. Thus, while Documentary Collection provides the exporter with control of their goods, it does not guarantee payment from the buyer.

Documentary collections payment method is only recommended for established trade relationships in economically and politically stable markets. Before an exporter opts for this method of payment it is recommended that they consult their bank.