Is export factoring a superior choice to other forms of export credits?

International trade offers remunerative opportunities to the traders but also demands resilience and strategically planned execution from them. Out of a multitude of stumbling blocks that exporters face, procuring finance and mitigating payment risks are the most cumbersome for them.

According to a trade and finance report in 2016 by the ICC, almost 80% of the global trade functions with the strong support of export finance. Exporters, until now, have always been dependent on the traditional export credit methods extended to them by the banks, private financial institutions, and government agencies for their short-term, medium-term and long-term needs, against collateral or assets.

What is the export credit?

Financial loan acquired by the exporters through banks or financial institutions against collateral or security has always been the prevalent methods of procuring export credit.

Lack of assets or collateral to be presented to the banks as security to procure credit by the small companies gradually made way for a relatively newer method of accessing financial support. This method is known as export factoring.

Though it is yet to be accepted by the Indian exporters without apprehensions, it is undoubtedly gaining momentum around several countries in the world as a complete financial package.

What is export factoring?

Export factoring is a tool, which enables the exporters to procure short-term financial assistance against the bills of exchange, to be received by them, under open account payment terms from the importer, after they have delivered the goods.

It is not a pre-shipment but post-shipment finance for the exporter. And the factors contributing credit cover three services under it, i.e., finance, credit protection, and follow-up services.

Critical factors of export factoring:

  • A tool to raise short-term finance
  • A seller sells his receivables to a factor for immediate cash
  • After deduction of the fees and charges the exporter receives up to 90% of total receivables immediately once the factor approves the papers, the rest of the amount goes through clearance once the shipment is complete to the satisfaction of both parties.
  • The credit is an open account receivables system and can extend beyond six months.

How to qualify for export factoring?

There are no qualification criteria for export factoring. First-time exporters or SMEs can avail export factoring without any cumbersome documentation process, yet there are certain criteria that exporters applying for export factoring should meet –

  • The factor considers the importer’s credibility with whom the exporter is dealing.
  • No bank has secured the accounts receivable.
  • The payment terms are under open account credit term.
  • There is a valid contract between the buyer and the exporter.
  • The seller sells his receivable to a third party, i.e. the factor

An exporter dealing in gems and jewelry cannot opt for export factoring, as these items are not amenable to factoring. The exporters mandatorily have to share each detail regarding the agreement, debtor, sales agreement, the term of payments and the exporter’s performance history to acquire financial assistance through export factoring.

How is export factoring different from traditional export credit?

Traditional export credit is not available without collateral or security whereas the only major requirement under export factoring is a valid agreement between the exporter and the importer under open account payment terms.

Banks or financial institutions under the traditional export credit do not provide credit protection, collection facility or unsecured finance to the exporters, unlike export factoring.

Unlike the traditional methods of procuring credit, finance is available in the invoice currency and is actually cheaper for the Indian companies as the interest rate is based on London Inter-Bank Offered Rate, i.e. LIBOR, which is significantly lower than the Indian interest rates.

Factoring, however, is not a replacement to procuring finance through banks but instead acts as a supplementary method to garner working capital.

When taking credit through traditional export credit methods, the exporters have to protect themselves against importers default by taking an insurance cover from an agency. It involves cumbersome documentation process for two separate institutions whereas export factoring provides a complete financial package to the exporters.

Why is export factoring a preferred choice?

Export factoring presently is a recognized and accepted method of open account receivables financing all across the globe. A systemic and methodical set of rules and procedures is applicable for governing it. It assists exporters to avoid credit losses by mitigating their collection and credit risks to a third party.

There are several reasons why export factoring is gradually becoming a preferred choice of procuring short-term finance all around the globe. These reasons include –

  • Elimination of the risk of non-payment as it is against accounts receivable.
  • It helps exporter to avail immediate cash.
  • It charges interest only against the funds provided. There are no hidden costs.
  • Operating costs become minimal as the factor takes over the risk of collection debts
  • It is not a kind of credit instead is an advance against the bills receivable
  • Immediate liquid cash becomes available within 24 hours against presentation of accounts receivable
  • Does not require any assurance from any bank or other financial institution
  • It does not put the financial burden on the exporters like traditional financing methods.
  • The process of procuring credit guarantee through export factoring is straightforward and simple
  • It enables the exporter to cover his payment risk and have adequate cash flow
  • It assists those small exporters or MSMEs that do not have the back up of assets to procure immediate cash without any collateral security

Export factoring in India

Export factoring in India has still to gain recognition. Some exporters are unaware of it being a method to procure cash against accounts receivable. Some are apprehensive about its process and its expenses. According to estimates, there are only 30 to 35% exporters in India who are aware of export factoring. Countries like China, Germany, France, Brazil, Taiwan, and Italy have well recognized the advantages of export factoring. Though, it still has to be accepted by the Indian exporters.

India presently has seven institutions that are members of FCI [Factors Chain International], the global association for providing factoring services. Germany has 190 such institutions, yet India is poised to take off on it.

An endnote

Trade finance is an integral part of international trade. Thus, export factoring has emerged to be the most lucrative alternate for exporters. It is for those who want to avail liquid cash, an advance against their invoice without any risk.

How MSME exporters can benefit from India’s FTAs?

Free Trade Agreements are immensely beneficial to the MSMEs operational in the country. They result in increased export revenues and investment flow on the one hand and strengthen harmonious trade relations on the other.

Over the last five decades, Indian MSMEs have dynamically emerged to become the most empowering sector of the economy. They are the most stabilizing sector generating consistent revenues by providing employment opportunities at the widest scale.

Thus, MSMEs in India play a significant role as the catalyst for the transformational changes in the economic development of the country.

The deep-rooted role of MSMEs in the economic development of the country can be well-perceived by the NSSO survey of 2015-2016, which indicates that there are a total of 6.3 crores MSME’s in India generating employment for over 111 million people. They contribute over 45% to the total industrial production and almost 40% to the export revenues and also account for 30% GDP of the country.

MSME exporters

All micro, small and medium enterprises involved in the export of goods and services from India are MSME exporters. The MSME Act in India became functional on 2nd October 2006. They are classified into two categories namely manufacturing enterprise and service enterprise.

Challenges faced by the MSME exporters
Even though MSME exporters have contributed substantially to the country’s revenue and have had remarkable growth, they have had to resiliently face certain challenges that have limited their growth quite a bit, over the years. Some of the problems that became a hurdle for the MSME exporters are:

  • Lack of implementing innovative technology in the quality and packaging of the products as per the international market
  • Lack of awareness of the existent international trade agreements
  • No knowledge about the export promotion and assistance programs initiated by the Indian government
  • No familiarity with the regulatory framework of the countries sought to be traded with

A strategic action plan is already being implemented to remove all limitations that are hindering the progress of MSME exporters. But besides this, it is also essential that MSME exporters utilize the benefits offered by India’s FTAs to increase their financial returns.

FTAs

Free Trade Agreement is a deal or an agreement between two or more countries or a trading bloc that taxes, regulatory laws, quotas and preferences on goods and services to be traded between them will be reduced or eliminated to foster better trading relations and returns.

FTAs may also include clauses with respect to intellectual property rights (IPRs), investments, government procurement, etc.

Important features of FTAs

Under FTAs, markets are opened completely, and the FTA partners get advantageous reciprocal trade.

  • Removal of Import and export duties on several products
  • The partner countries are treated equal even if they are at a disparity on socio-economic levels.
  • Partner countries cannot discriminate between their domestic companies and foreign exporters.

Benefits of FTAs

Countries that enter into FTA agreements benefit in a number of ways. The countries that enter into FTA get easy access to each other’s market due to the reduction or removal of tariff and non-tariff barriers. Other beneficial aspects of FTAs for countries are-

Easier access to markets

The low prices owing to tariff cuts place the products of the partnering countries more advantageously thus bringing new trade opportunities. Thus, entry to the markets of partnering countries becomes easy and hassle-free.

Low tariff barriers

Tariff barriers inhibit trade and make products costly. By reducing these barriers the countries that are participants in the agreement experience the free flow of trade and in result their economies flourish.

Low cost in importing raw materials

Raw materials essential for products may be available at lower prices in the markets of the partnering countries. This makes imports of raw materials cheaper, which in turn reduces the cost of a product.

Countries india has a free trade agreement with

Though India has not entered into any new FTA for the past three years, there are several countries India has a Free Trade Agreement with. The countries are-

  • Sri Lanka
  • Singapore
  • ASEAN [Association of South-east Asian Nations]
  • Malaysia
  • Japan and Korea
  • Bangladesh
  • Bhutan
  • Nepal
  • Thailand
  • Maldives
  • Afghanistan
  • Pakistan
  • South Korea
  • Chile

FTA is under negotiation with countries-

  • Canada
  • Peru
  • New Zealand
  • Israel
  • Europe

MSME exporters and India’s FTAs

MSME sector contributes majorly to the revenues and economic development of the country, as they are the biggest sector to generate employment. Thus, it is essential that the existing or new free trade agreements of India contain provisions to bring maximum growth opportunities for the MSME exporters of the country.

To extract the maximum benefits of the FTA, it is therefore essential that MSME exporters go through each provision of the FTA and assess how it can be used.

Out of 28.5 million MSMEs in India, 25 million are micro-enterprises that cannot compete against the enterprises from developed economies.

The key provisions in an FTA can significantly affect the MSME sector and the MSME exporters in India. Following are the provisions and how they may affect the functioning of the MSME sector:

Import duties

Since the MSME sector lacks a well-secured marketing facilities network, increase in import competition with partner countries infiltrating the domestic markets can pose a big threat to the Indian MSME sector. “Most MSMEs do not have money to invest in market research, advertisement, packaging and are unable to carry out design and technical improvements to keep up with market demands” (P.254, SIDBI, 2010a). However, in certain situations, FTAs may also have a detrimental effect on MSMEs.

Import duty cuts for a partner country can cause a threat to domestic MSMEs. For example, toy imports from China, flooding the Indian market, came as a major setback for the MSME toy industry in India when applied duties were removed.

Non-tariff barriers

MSMEs in India lack the facilities to produce as high standard goods as produced in the developed countries. FTAs have stringent norms regarding standardization and quality of products. It becomes easier for MSMEs to standardize their products, as there are clear rules as per FTAs regarding the quality of products. By complying with the quality standards according to the FTA, MSME exporters can indisputably enter the markets and increase their export turnover.

Rules of origin

Rules of Origin identify the originating region or the country of the exported goods. Since Rules of Origin are different under each FTA, to receive preferential benefits, MSMEs must meet the required Rule of Origin applicable to specific products and the specific FTA.

MSME exporters can only ensure benefits from India’s FTAs through strict compliance of quality standards including packaging facilities. To get the maximum benefits of FTAs, they can take help of the government schemes to facilitate their production and quality standards and answer to the following questions can help them further:

  • What is the HS code of their product?
  • Which countries have India FTAs with?
  • Is the product they manufacture being imported into or being produced in the partner countries?
  • Is their product on the sensitive lists (not included in the duty cuts) in the signed FTAs?
  • Have duties been reduced to zero in India or the partner countries?
  • Are their products competitive in terms of prices and quality as compared to FTA partners?
  • What is the current duty on their product in the partner country?
  • Will duties be less on their exports to FTA partners?

An EndNote

FTAs serve the vital purpose of reducing trade barriers such as quotas or tariffs between countries. Lowering trade barriers helps the partner countries to boost their outreach and increase their sales. They witness a wider range of products and at lower and more competitive prices under an FTA. MSME exporters can benefit from the FTAs if they skillfullymaneuver the provisions in the FTA after understanding them intricately.

How to deal with payment defaults in exports?

Challenges and restraints have always surrounded international trade yet global growth, owing to the exchange of goods and services over borders, has been dynamically significant over the years. The proactive approach, adopted towards globalization and international trade, by the emerging market economies has been the reason why outcomes have been this positive and promising.

Exports and payment defaults

There has been a consistent growth of exporters in the Indian subcontinent, over the years. The benefits exporters derive outweigh the difficult tasks that are required to be handled by them.

Even though there are systematic payment methods to safeguard the interests of the exporters, owing to a lack of trust between the international traders, default in payments may pose a serious challenge for the exporter.

An export procedure beginning with the registration of export business ends when the goods are delivered to the importer, procuring payment in return. During this process, an exporter may face careless or unforeseen and unavoidable challenges. To overcome these hurdles, an exporter has to be resilient and well prepared.

The approach exporters can take to avert payment defaults

Whereas the most worrisome feature of international trade for importers is the procurement of high-quality goods at competitive prices, for exporters it is the timely payment by the importer after they have dispatched the goods.

How much an exporter can safeguard his payments is directly correlated to the type of approach he takes as his business strategy. An exporter can adopt a reactive or a proactive business approach, or a blend of both strategies to deal with the risk in payments. Thus, either the exporter can wait for the importer to default in making payments and then take measures to deal with it or can take precautionary measures beforehand to safeguard his payments. Of course, taking proactive measures tends to minimize the chances of having to take recourse of reactive measures at a later date.

Proactive approach

A proactive strategy is always more effective to meet the challenges of payment default because they involve prior preparation and take into account all possible challenges.

Exporters have to be very careful while agreeing on several aspects. It includes a method of payment, the terms, and conditions in the contract, ensuring their bills of exchange or documents. Also, exporters must keep in mind the countries that have a high default rate in payments.

A. Payment method

It is crucial for an exporter to agree to the payment method that is either completely safe or holds minimum risk. Given below are some methods through which exporters receive payments in international trading.

Clean payments
Under this payment system, the transfer of related documents is direct between the importer and the exporter and the bank is only involved in clearing the amount. Clean payments can be as an advance payment by the importer or as an open account in which the payment is given by the importer only after he receives the goods.

Documentary collections

Under this payment system, the banks hold the concerned documents to be released to the importer only when they clear the payments. It may be against payment D/P or acceptance D/A, i.e., against acceptance of a draft.

Letter of credit

Under an L/C, the importer assures the exporter, through a legal negotiable instrument, that he shall receive payment after completing his end of the agreement, by the importer’s bank.

The exporter can also use the letter of credit as a form of export credit. To improve his cash flow or to meet any unavoidable expenditure, the exporter can present the letter of credit to a bank for it serves as collateral and takes a credit against it.

B. Drawing the contract

To overrule any potential confusion between the exporter and the importer and to help resolve any difference, it is essential to draw a written contract between the two rather than just a verbal agreement.

While framing an agreement or a contract, many facets require coverage to eliminate the risk factors associated with exporting. The contract should be clear about what and when also enclosing the responsibility for both the parties.

Included in the contract must be the goods and the quality compliance they have to meet. The details regarding the price such as the amount, the currency and the exchange rate, terms & conditions regarding the payment. It should include when and how, delivery terms, shipping costs, custom related conditions, and insurance details covering the party to bear the risks and the type of risks to be borne by each party at every stage.

Besides this, the contract should include the procedures to settle disputes in case of any defaults made by the parties and the place where legal proceedings shall be conducted in case of a legal dispute.

C. Credit insurance

In International trade, it is always easier to avoid the risk factor before it has occurred. To safeguard their payments, even if the importer defaults in making a payment, it is essential that an exporter ensure the potential risk of non-payment by the importer by export credit insurance (ECI).

ECI is a kind of conditional assurance to the exporter. In case an importer fails to make the payment arising out of any political or commercial fluctuation, the exporter shall receive his payments.

D. Norms of the importing country

Each country has a different set of laws and regulations that govern its functioning. It is essential for an exporter to understand and gain knowledge about the importing country. The exporter should formulate a written contract accordingly and well substitute any contingent law of the importing country.

Reactive approach

The foremost step of an exporter should be to communicate and negotiate with the importer. The exporter should look for good terms and convince him to make the payment. When communicating with the importer, the exporter should be willing to compromise on a few unreasonable demands of the importer. Also, if the need arises, as it would save the exporter from incurring substantial losses from non-payment.

If however negotiating with the importer fails and the sum is large, the exporter could obtain assistance from several sources. It could be of its bank, qualified trade experts, trade commissions, recovering agencies or legal counsel.

A. Recover from insurance policies

To mitigate the risk of non-payment, the exporters can opt for account receivable insurance policy to be used in case of default in payment by the importer. The insurers, under the ARI policy, pay the exporter if the importer does not pay owing to fraudulent intention.

One such central government undertaking body in India is the Export Credit Guarantee Corporation. It ensures credit guarantee to the exporter against any possible default of payments by the importer. ECGC is more or less operates as an insurance agency. It guarantees payment to the exporter if the importer defaults in making a payment.

After both the parties have signed the agreement, the exporter approaches the ECGC. It is to get an approval and amount of limit. If the importer fails to make the payment, ECGC reimburses that amount to the exporter. Also, its operational network tries to find the cause of default. If the ECGC deems fit, they blacklist the buyer who makes it difficult for him to continue business. It is because it affects his creditworthiness in the market.

B. Protection with ‘without recourse finance’
When an exporter is unfamiliar with their buyer’s bank or is involved in trading with a country where political risks are considerable, then they can opt for without recourse finance. This protects the exporter from default payments against L/C.

C. Legal channels

Certain countries have stringent laws. It may be difficult for an exporter to recover the lost amount from the importer belonging to such countries. It is essential for an exporter to sign a contract with the importer of such countries. Sometimes it is also better if the exporter builds a strong local network in that country. It helps them recover their amount from the importer.

The exporter can approach their embassy, Foreign Chamber of Commerce etc. and seek their intervention if the importer refuses payment. The exporter must present documentary proof in the form of a contract to the legal advisor. But, the exporter should seek assistance from these legal channels only when the amount is considerable or high.

There is a multitude of international agencies that extend their collection services against fees to the exporters against any possible default by the importer. Since the legal costs of processing such cases are high, collection procedures often recover very little of the outstanding amount.

If both the exporter and the importer agree, then they can take their dispute to an arbitration agency. It is better than the exporter taking legal action against the importer. The settlement of dispute via an arbitration agency will be quicker. It will be less costly than legal action, which could take too much time.
The International Chamber of Commerce does not belong to any single country and is therefore acceptable to all international traders. It handles major international arbitration.

An Endnote
Receiving timely and proper payment from the importer is the most critical aspect of the deal for an exporter. It is essential that an exporter treads and plans about this criteria delicately and meticulously. There are specific measures, which an exporter can take in advance. They can contact certain agencies or trade commissions after the importer has made a default in payment for due action and reimbursement of the amount through legal intervention.