International payment risk: what are the best ways to ensure that an importer in a territory new to your firm will honour its debts? Anthony Boczko explores the alternative methods.
This scenario is all too familiar for finance managers in many UK firms struggling to find a foothold in an unpredictable global market, where the search for profits, market share and shareholder value is rarely risk free.
The sources of risk in international trade can be divided into four categories:
* Country risk (see Technical matters, February), which relates to the acts of a nation's government.
* Credit/commercial risk, which relates to the possibility that the buyer will default on payment.
* Foreign exchange risk, which relates to movements in currency markets. This is often grouped with credit risk.
* Property risk, which relates to the possibility of loss or damage to goods in transit.
Country risk influences levels of risk in the other three categories and so affects the number of payment strategies you can use to limit your firm's credit risk. Although a range of methods exist (see panel, opposite page), their selection and use--while partly dependent on negotiation between the trading partners--is influenced largely by the levels of regulatory control and socio-economic uncertainty in the destination country. Such factors range from restrictions on the transferability of funds to currency devaluations as a result of a nationwide economic slowdown.
A firm seeking to establish a global presence must clearly exercise caution and use appropriate payment strategies, especially when trading with companies in high-risk destination countries. For example, the use of payment in advance would ensure that funds are cleared before the goods are exported and so minimise the risk of financial loss.
There may be instances where firms adopt payment strategies in higher-risk countries that are normally used only in low-risk countries, but such cases are rare. Even so, it's important to recognise that generalisations about countries can be dangerous. Even in well developed and politically stable nations, payment strategies may need to vary according to factors such as market sector differences, volume differences and certainly in larger countries such as China regional cultural variations as expressed in the form of local bureaucratic structures.
So which payment methods are typically used in which countries? Let's take a brief and highly selective tour.
In Kenya all the common forms of arranging payment are used. In South Africa most established importers use documentary collections varying from 60 to 120 days alter acceptance, but they also use confirmed irrevocable letters of credit. In Zimbabwe some payments are made on an open account, but it's becoming more usual to use bills of exchange and confirmed irrevocable letters of credit, as is the case in many other African countries.
In Hong Kong and Singapore most of the customary payment methods are used, while in Taiwan the general practice is to insist on confirmed irrevocable letters of credit, with more favourable terms available only after a number of successful transactions. The usual method in China is also confirmed irrevocable letter of credit against presentation of shipping documents. In Malaysia, India and Pakistan payment against an invoice is usual.
In Argentina confirmed irrevocable letters of credit are the norm, although they have become hard to obtain as a result of the country's financial crisis. Recent government measures have made it hard to trade on an open account even with long-term customers. They have also limited payments in advance to certain key products. Chilean importers usually expect to pay by letter of credit. although documentary collections are often preferred. Firms in Brazil are generally required to pay "at sight" or on account over a minimum of 90 days.
Confirmed irrevocable letters of credit and cash in advance are common in Hungary, although open accounts tend to be used once trading relationships have been established. In Bulgaria. while all the usual methods can be used, importers tend to avoid letters of credit and often prefer to pay on a proforma invoice basis before moving to credit terms. Although open accounts are becoming more favourable in Poland, the main methods are confirmed irrevocable letters of credit and cash up front. In the Ukraine only fully secured terms of payment are used, mainly because the banking system remains undeveloped and the country's debt management infrastructure is ineffective.
In all these countries money-transfer methods vary considerably. The most popular, despite its cost, is Swift Inter-Bank Transfer. Banker's drafts are also widely used. International money orders are becoming increasingly rare and payment by foreign cheque (buyer's cheque) is the least popular method, probably owing to its inherent riskiness.
What does all this say about the payment strategies of UK exporters? Significant variations clearly exist, but a broad picture can be drawn. First, although it may be the lowest-risk method, payment in advance is rarely used. Second, the most popular method by far is confirmed irrevocable letters of credit. Third, documentary collections and consignment payments remain popular in certain countries, while the use of open accounts is generally reserved for companies in low-risk countries that have established trading relationships. Lastly, although it's used in many countries, counter-trade is often subject to complex regulations.
No matter how carefully such deals are managed, payments may not be made for whatever reason. These are the risks of any market and, while they may be unavoidable, their impact can still be minimised by taking out insurance against, for example, non-payment of export debts or loss of goods in transit.
What would my advice be for the newly appointed finance manager whose firm is seeking a foothold in the international marketplace? Simple: be aware of the risks associated with the destination country and collect as much information as possible about the importing company, If in doubt, don't proceed. A risk-averse strategy today max well save your company tomorrow.
COUNTRY CREDIT RISK RATINGS A1 Stable political and economic environment. Very low probability of default. A2 Probability of default still low, but the payment record of companies is not as good as in A1-rated countries. A3 Adverse political or economic circumstances may lead to a worsening payment record. Probability of default remains low. A4 Patchy payment record could be further worsened by deteriorating political and economic environment. Probability of default still acceptable. B Unsteady political and economic environment likely to make a poor payment record worse. C Very unsteady political and economic environment could cause an already bad payment record to deteriorate. D High risk profile of the economic and political environment will further worsen a generally very bad payment record, Source: Coface, 2004. A SELECTION OF PAYMENT STRATEGIES Country risk Method Notes HIGH Payment in Payment is expected by the seller advance in full before the goods are shipped. This method is normally used where the seller has severe doubts about a customer's ability to pay, or where the seller's bank will not finance the transaction or extend existing credit arrangements. Confirmed A second assurance of payment irrevocable credit (usually a UK bank) prevents surprises and means that the issuing bank has been deemed acceptable by the confirming bank. This process imposes extra costs on the seller. Unconfirmed Credit can be changed only by irrevocable credit mutual agreement. It becomes an open account, with the buyer's bank as the collection agent. The foreign bank may experience problems making payments. Counter-trade Counter-trade can take many forms. Some of the more popular ones are counter-purchase, barter or compensation trade, buyback, offset, switch trading and evidence accounts. Documentary Documentary collections involve collections sending shipping documents through the banking system to a bank in the buyer's country. Depending on the terms agreed in the sales contract, these documents are released to the buyer only upon payment or acceptance of a bill of exchange. Consignment Payment on consignment is in payment essence the same as payment by open account, but ownership of the goods remains with seller until the payment is made. Open account This should be considered only when a seller is sufficiently confident that the customer can be trusted to make the full payment by the agreed date. Normally, open account terms are granted where the integrity of the customer is beyond question or the company has little or no security against LOW non-payment.
Anthony Boczko (firstname.lastname@example.org) is a lecturer in finance at the University of Hull.
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|Publication:||Financial Management (UK)|
|Date:||Mar 1, 2005|
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