1. CHAPTER 8
AN INTRODUCTION TO TRADE FINANCE
The absence of an adequate trade finance
infrastructure is, in effect, equivalent to a barrier to
trade. Limited access to financing, high costs, and
lack of insurance or guarantees are likely to hinder
the trade and export potential of an economy, and
particularly that of small and medium sized
enterprises.
As explained in Chapter 1, trade facilitation aims at
reducing transaction cost and time by streamlining
trade procedures and processes. One of the most
important challenges for traders involved in a
transaction is to secure financing so that the
transaction may actually take place. The faster and
easier the process of financing an international
transaction, the more trade will be facilitated.
Traders require working capital (i.e., short-term
financing) to support their trading activities.
Exporters will usually require financing to process or
manufacture products for the export market before
receiving payment. Such financing is known as
pre-shipping finance. Conversely, importers will need
a line of credit to buy goods overseas and sell them
in the domestic market before paying for imports. In
most cases, foreign buyers expect to pay only when
goods arrive, or later still if possible, but certainly not
in advance. They prefer an open account, or at least
a delayed payment arrangement. Being able to offer
attractive payments term to buyers is often crucial in
getting a contract and requires access to financing for
exporters.
Therefore, governments whose economic growth
strategy involves trade development should provide
assistance and support in terms of export financing
and development of an efficient financial
infrastructure. There are many types of financial tools
and packages designed to facilitate the financing of
trade transactions. This Chapter will only introduce
three types, namely:
• Trade Financing Instruments;
• Export Credit Insurances; and
• Export Credit Guarantees
1. Trade Financing Instruments
The main types of trade financing instruments are as
follows:
a) Documentary Credit
This is the most common form of the commercial
letter of credit. The issuing bank will make payment,
either immediately or at a prescribed date, upon the
presentation of stipulated documents. These
documents will include shipping and insurance
documents, and commercial invoices. The
documentary credit arrangement offers an
internationally used method of attaining a
commercially acceptable undertaking by providing for
payment to be made against presentation of
documentation representing the goods, making
possible the transfer of title to those goods. A letter
of credit is a precise document whereby the importer’s
bank extends credit to the importer and assumes
responsibility in paying the exporter.
A common problem faced in emerging economies is
that many banks have inadequate capital and foreign
exchange, making their ability to back the
documentary credits questionable. Exporters may
require guarantees from their own local banks as an
additional source of security, but this may generate
significant additional costs as the banks may be
reluctant to assume the risks. Allowing internationally
reputable banks to operate in the country and offer
documentary credit is one way to effectively solve this
problem.

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60 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE
b) Countertrade
As mentioned above, most emerging economies face
the problem of limited foreign exchange holdings.
One way to overcome this constraint is to promote
and encourage countertrade. Today’s modern counter
trade appears in so many forms that it is difficult to
devise a definition. It generally encompasses the idea
of subjecting the agreement to purchase goods or
services to an undertaking by the supplier to take on
a compensating obligation. The seller is required to
accept goods or other instruments of trade in partial
or whole payment for its products.
Some of the forms of counter trade include:
• Barter – This traditional type of
countertrade involving the exchange of
goods and services against other goods and
services of equivalent value, with no
monetary exchange between exporter and
importer.
• Counterpurchase – The exporter undertakes
to buy goods from the importer or from a
company nominated by the importer, or
agrees to arrange for the purchase by a third
party. The value of the counterpurchased
goods is an agreed percentage of the prices
of the goods originally exported.
• Buy-back – The exporter of heavy
equipment agrees to accept products
manufactured by the importer of the
equipment as payment.
c) Factoring
This involves the sale at a discount of accounts
receivable or other debt assets on a daily, weekly or
monthly basis in exchange for immediate cash. The
debt assets are sold by the exporter at a discount to a
factoring house, which will assume all commercial and
political risks of the account receivable. In the
absence of private sector players, governments can
facilitate the establishment of a state-owned factor;
or a joint venture set-up with several banks and
trading enterprises.
d) Pre-Shipping Financing
This is financing for the period prior to the shipment
of goods, to support pre-export activities like wages
and overhead costs. It is especially needed when
inputs for production must be imported. It also
provides additional working capital for the exporter.
Pre-shipment financing is especially important to
smaller enterprises because the international sales cycle
is usually longer than the domestic sales cycle.
Pre-shipment financing can take in the form of short-
term loans, overdrafts and cash credits.
e) Post-Shipping Financing
Financing for the period following shipment. The
ability to be competitive often depends on the trader’s
credit term offered to buyers. Post-shipment
financing ensures adequate liquidity until the
purchaser receives the products and the exporter
receives payment. Post-shipment financing is usually
short-term.
f) Buyer’s Credit
A financial arrangement whereby a financial
institution in the exporting country extends a loan
directly or indirectly to a foreign buyer to finance the
purchase of goods and services from the exporting
country. This arrangement enables the buyer to make
payments due to the supplier under the contract.
g) Supplier’s Credit
A financing arrangement under which an exporter
extends credit to the buyer in the importing country
to finance the buyer’s purchases.
2. Export Credit Insurance
In addition to financing issues, traders are also subject
to risks, which can be either commercial or political.
Commercial risk arises from factors like the
non-acceptance of goods by buyer, the failure of buyer
to pay debt, and the failure of foreign banks to
honour documentary credits. Political risk arises from
factors like war, riots and civil commotion, blockage
of foreign exchange transfers and currency
devaluation. Export credit insurance involves insuring
exporters against such risks. It is commonly used in
Europe, and increasing in importance in the United
States as well as in developing markets.
The types of export credit insurance used vary from
country to country and depends on traders’ perceived
needs. The most commonly used are as follows:

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CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE 61
• Short-term Export Credit Insurance –
Covers periods not more than 180 days.
Protection includes pre-shipment and
post-shipment risks, the former covering the
period between the awarding of contract
until shipment. Protection can also be
covered against commercial and political
risks.
• Medium and Long-term Export Credit
Insurance – Issued for credits extending
longer periods, medium-term (up to three
years) or longer. Protection provided for
financing exports of capital goods and
services.
• Investment Insurance – Insurance offered to
exporters investing in foreign countries.
• Exchange Rate Insurance – Covers losses as
a result of fluctuations in exchange rates
between exporters’ and importers’ national
currencies over a period of time.
The benefits of export credit insurance include:
• Ability of exporters to offer buyers
competitive payment terms.
• Protection against risks and financial costs
of non-payment.
• Access to working capital.
• Protection against losses from foreign
exchange fluctuations.
• Reduction of need for tangible security when
borrowing from banks.
Export credit insurance mitigates the financial impact
of the risk. There are specialized financial institutions
available that offer insurance cover, with premiums
dependent on the risk of the export markets and
export products.
3. Export Credit Guarantees
Export credit guarantees are instruments to safeguard
export-financing banks from losses that may occur
from providing funds to exporters. While export
credit insurance protects exporters, guarantees protect
banks offering the loans. They do not involve the
actual provision of funds, but the exporters’ access to
financing is facilitated.
An export credit guarantee is issued by a financial
institution, or a government agency, set up to
promote exports. Such guarantee allows exporters to
secure pre-shipment financing or post-shipment
financing from a banking institution more easily.
Even in situations where trade financing is
commercially available, companies without sufficient
track records may not be looked upon favourably by
banks. Therefore, the provision of financial
guarantees to the banking system for purveying export
credit is an important element in helping local
companies go into exporting. The agency providing
this service has to carefully assess the risk associated
in supporting the exporter as well as the buyer.
4. The Role of Governments in Trade
Financing
The role of government in trade financing is crucial
in emerging economies. In the presence of
underdeveloped financial and money markets, traders
have restricted access to financing. Governments can
either play a direct role like direct provision of trade
finance or credit guarantees; or indirectly by
facilitating the formation of trade financing
enterprises. Governments could also extend assistance
in seeking cheaper credit by offering or supporting
the following:
• Central Bank refinancing schemes;
• Specialized financing institutes like
Export-Import Banks or Factoring Houses;
• Export credit insurance agencies;
• Assistance from the Trade Promotion
Organisation; and
• Collaboration with Enterprise Development
Corporations (EDC) or State Trading
Enterprises (STE).
a) Central Bank Refinancing Schemes
Under this type of schemes, the Central Bank will
rediscount the commercial bills of exporters at
preferential rates. This will provide the cheap
post-shipment financing necessary for exporters to
quickly turn around funds for further export business.
Here, the government is subsidizing the cost of funds
that exporters have to pay if they rediscount their bills
with commercial banks.

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62 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE
In a similar scheme, government could also offer
factoring services at subsidized rates.
b) Export-Import Bank (EXIM Bank)
The Export-Import Bank (EXIM Bank) specifically
caters to the needs of exporters and importers and
those of investors in foreign markets. It offers various
services, including long-term direct loans to foreign
buyers for loans and equipment sales of sufficient
sizes.
Several countries, including developed nations, have
EXIM banks. For example, the United States EXIM
Bank was created in 1934 and established under its
present law in 1945. Its primary role is to aid in
financing US exports, and for medium-term
(181 days to 5 years) transactions, it co-operates with
US commercial banks by providing export credit
guarantees. In setting up the EXIM Bank, the US
recognized that job creation is a consequence of
exports. Its main customers are SMEs in the United
States.
c) Export Credit Insurance Agencies
Export credit insurance agencies act as bridges
between banks and exporters. In emerging economies
where the financial sector is yet to be developed,
governments often take over the role of the export
credit insurance agent. Governments traditionally
assume this role because they are deemed to be the
only institutions in a position to bear political risks.
Several countries in Asia and Africa have such an
organization. However, the viability of such an
organization depend on the volume of business and
income from insurance premium. In that context,
credit insurance policies vary according to the type
of exports. For example, short term policies on the
sale of raw materials on 180 days terms are covered
up to 95 per cent for commercial risk and 100 per
cent for political risk. Such trades are considered
relatively secure. Nonetheless, it is good practice to
get the exporter to bear a certain portion of the risk.
d) Support from Trade Promotion Organisations
(TPOs)
As explained earlier, banks are often reluctant to lend
to exporters because of their lack of knowledge about
the creditworthiness of the traders, and as a result may
raise interest to compensate for the risks taken. TPOs
are in a position to know the strengths and weaknesses
of the individual trading houses and exporters, and
could share information with financial institutions to
facilitate access to financial services.
TPOs are the government agencies that are most
directly involved with the trading community, often
supporting promising trading and exporting
enterprises. The support and assistance given by the
TPOs could act as a signal to banks as to which
companies are creditworthy companies. In addition,
TPOs could establish network of financial
institutions, identify their credit requirement, and
match trading enterprises and financial institutions
based on these requirements.
e) Export Development Corporation and State
Owned Enterprises
In most emerging economies, there are a few key
conglomerates with a diverse range of products,
substantial export capacity and sustainable financial
resources. They could be private sector export
development corporations (EDCs) or state-owned
enterprises (SOEs).
Governments could harness these enterprises as
mechanisms to assist other local firms, especially
SMEs, to export their products or import goods.
Unlike the SMEs, the EDCs and the SOEs have the
financial resources and trade expertise needed to
participate in trading activities. Smaller exporters
could sell their products to the EDCs and SOEs and
receive payment earlier than if they exported directly
by themselves. Small importers could also purchase
goods from the EDCs and SOEs, which have the
financial strength to bulk purchase from abroad.

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CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE 63
5. Conclusion
This Chapter has explained the need for trade finance
and introduced some of the most common trade
finance tools and practices. A proactive role of
governments in trade finance may alleviate the lack
of trade finance in emerging GMS economies and
contribute to trade expansion and facilitation.
However, the best long-term solution in resolving the
constraints in trade financing is to encourage the
growth and development of a vibrant and competitive
financial system, comprising mainly private sector
players. This point is important as some of the
government-supported trade financing schemes may
Box 8.1 Trade Finance Trends in Asia
The recent economic slowdown is making the need for sound trade finance policies and strong financial
systems more acute. Many companies are trying to preserve cash by delaying payment and the number of
SMEs in emerging Asian economies with high credit risk is growing.
This is partly the result of a regional trend toward unsecured, open-account type transactions. Large
Western buyers are asking that their Asian suppliers sell goods on open-accounts terms, instead of using
guarantees like letters of credit (LCs). These buyers simply do not want to bear the extra cost of payment
guarantees and will source their goods from somewhere else if they are not given open-accounts. These
open-accounts allow the buyers to delay payments as needed, rising the need for credit for Asian companies
who choose to supply them.
The economic slowdown also has made many companies rethink their commitment to electronic trading
and payment systems. While these systems may cut significant costs out of the labor-intensive trade finance
process, they also make payment delays more difficult to justify.
Large Western buyers are not the only ones delaying payments. In fact, many companies prefer dealing
with these buyers than with the thinly capitalized buyers commonly found in many emerging Asian
economies, mainly because these large buyers remain relatively punctual and have very low credit risk
(i.e., even if they delay payment a little, they will pay).
With the internationalization of supply chains, a Hong-Kong, China based transformer manufacturer may
sell its products to Chinese buyers sub-contracted by Dell or IBM to manufacture PCs. The Chinese
sub-contractor may ask to buy from the manufacturer on open-account terms on the basis that payment
from Dell or IBM is a sure thing. This kind of arrangement increases the financial risk exposure of the
transformer manufacturer, and typically results in payment delays measured in weeks and sometime months.
Because LCs or factoring in China and many other countries in Asia are not yet commonly used or available,
Asian suppliers can often do very little to protect themselves in regional cross-border transaction, increasing
the cost of regional trade transactions relative to that of direct transactions with Western companies.
Source: Moiseiwitsch, J., CFO Asia, Trade Finance – Time Bandits, November 2001, http://www.cfoasia.com/archives/200111-03.htm
increasingly be challenged by competing countries as
unfair export subsidies under existing and future
WTO rules.
The role of the government and other parties involved
in trade finance will need to evolve along with the
country’s economy. Underlying the functions
provided by the different players is the need for a clear
and effective legal environment. The commercial
legal system must be transparent. Laws of property,
contract and arbitration must be clear. The
commercial legal environment must be integrated
with the financial infrastructure framework in order
for it to be effective.

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64 CHAPTER 8: AN INTRODUCTION TO TRADE FINANCE
6. For Further Reading...
• One illustration of government’s proactive role
in trade finance in Asia and the Pacific is the
creation by the Australian government of the
Export Finance and Insurance Corporation
(EFIC) in 1991. (http://www.efic.gov.au).
• A well-developed domestic financial system can
go a long way toward facilitating trade by
making trade financing easier. The issue of
mobilizing domestic finance for development is
addressed in the joint ESCAP-ADB report
available at: http://www.un.org/esa/ffd/escap-
rpt2001.pdf.
• The International Trade Center (ITC), a joint
initiative of UNCTAD and the WTO, is a
source of practical guides and manuals on
international trade finance issues (http://
www.intracen.org/tfs/docs/overview.htm).