Credit risk management instruments driving trade around the world (Part 1/6)
Globalisation has brought growing competition to world trade and with it a need to take down barriers to win new customers. As a result, companies are increasingly choosing to trade on an open account basis.
While open account terms help companies generate new business in a crowded marketplace, they come with significant risks, especially for the exporter. However, these risks can be managed with the right trade finance tools, which, in a testament to their effectiveness, are estimated to facilitate hundreds of billions of dollars’ worth of global trade.
With an economic recovery expected to coincide with the ongoing transformation of trade finance – where emerging economies are increasingly beginning to compete with developed nations who have long dominated global business – now is the time to get familiar with the most common credit risk management tools as well as those with the potential to dominate trade finance in coming years.
Letters of credit, or LCs, which offer a means of securing payment by transferring the risk from the buyer to a bank, have been the preferred credit management solution for decades. This is especially so in certain emerging markets, which have the highest rate of LC usage in the world. However, the use of LCs has been gradually but steadily declining despite a resurgence during the Global Financial Crisis and, more recently during the Covid-19 pandemic. Apart from the cost and the additional documentation burden, perhaps this is due to the realisation that the LC is not as secure as some believe.
Simply put, invoice discounting and factoring allow sellers to obtain finance against the security of the invoices drawn on their buyers. They are an attractive means of raising funds to enhance cashflow and meet working capital needs, particularly for SMEs for whom other options are not available. Their usage is growing in Asia along with the growth of exports from the region, especially as companies there become more knowledgeable and sophisticated in open account trade.
A bank guarantee is a financial assurance issued by a bank to provide security against default by or insolvency of the buyer. It is independent of the sales contract and transfers the ultimate risk from the debtor company to the bank. Like in the case of LCs, bank guarantees are a sensible choice for suppliers who wish to secure a single large transaction where there is some concern over the buyer’s creditworthiness. However, for bank guarantees to be truly effective, they have to be accurately drafted by lawyers to suit the legal requirements of each jurisdiction because mistakes can render them worthless.
Credit insurance offers comprehensive protection in a cost-effective manner. The main advantage of credit insurance is that for sellers who trade regularly with both domestic and international buyers, once a credit limit is approved, the seller can trade securely on a continuous basis with no further administration costs. A seller also benefits from the insurer’s reach and expertise, which allows them to assess not only the buyer’s creditworthiness and payment record but also a range of wider issues, such as the availability of sufficient foreign currency to honour payments, as well as the general political stability and economic strength of a particular country.
Making the right choice
World trade stood at nearly USD19 trillion in 2019 by merchandise volume and is expected to increase by as much as 8% in 2021 as the global economy begins its post-pandemic recovery. Meanwhile, Asia’s stature as a trading powerhouse continues to grow, which will ensure that the use of bank guarantees, LCs, invoice finance and credit insurance will continue to grow, as the region’s companies seek to protect their businesses from the vagaries of an uncertain business and geopolitical environment.
But successfully optimising the credit risk management function will be closely tied to the ability to gain a good understanding of the available options and make the right choice.
Read our blog series that will provide an in-depth look at each of these credit risk management tools and their strengths and weaknesses.
1 of 6: Credit risk management instruments driving trade around the world
2 of 6: Letters of Credit: The traditional solution to secure payment
3 of 6: Invoice financing: A cashflow management alternative
4 of 6: Bank guarantees: Facilitating and securing high-value transactions
5 of 6: Credit insurance: A holistic and cost-effective risk management solution
6 of 6: Credit risk management: Choosing the right solution can make all the difference
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