The role of factoring in international trade

http://www.thefinancialexpress-bd.com/2015/06/25/97917 VOL 22 NO 221 REGD NO DA 1589 | Dhaka, Thursday, June 25 2015

The role of factoring in international trade M. S. Siddiqui International trade is cross-border deal and both buyer and seller usually conclude the deal with communication without face to face contact. The buyer wants to be sure that he receives the goods of the quantity and quality agreed. On the other hand, the seller is eager to receive payments on time and in the currency required. In order to meet these demands, various methods of payment have been developed.

There is another more important issue which is frictional money cost, which is often hard to appreciate. The cost of finance is not simply the rate that is charged - it is also the restricted availability.

Finance is also limited for buyers, and it is also limited for Western banks. Importers very often request for deferred payments of their import LC or contracts. The trade finance remains stubbornly an issue for everyone - creating an unwelcome frictional cost in the bargains that rational companies want to make.

Two other factors are at play. First, after many years of discussion, new regulations (Basel 3) are now finally coming into force across international markets. One requirement is that banks maintain a leverage ratio. This is the ratio between their core equity and their total balance sheet.

LC (or trade finance) occupies a lot of balance sheet, but delivers only a low return for the provider. Consequently, LC is falling out of favour - as banks would rather use their balance sheet capacity (restricted by the leverage ratio) for higher margin activities.

Second, banks are retreating to their home territories under pressure from regulators and shareholders. This pressure stems from the need to make sure that banks are only playing with the risks that they (and the market) understand.

There are basically four methods of making payment for international transactions. These are i) cash in advance, ii) open account, iii) documentary collection and iv) documentary credit.

There is a solution to the payment terms, crisis of fund and reduction of cost of transactions through different types of trade financing for both exporter in developing country and importer in developed country. The buyers not taking advantage on price of exported products on the basis of

payment terms. The additional cost of transaction with LC that the exporters and the importers are shared between them. But alternately buyers prefer open account basis without LC and also factoring of transactions to reduce cost and time of transactions.

For Bangladesh, this is important to understand. Historically, exporters could rely upon buyers offering them a LC as financial support, which could be used for back-to-back finance in the local market. Buyers were happy to do this - LC's were not that expensive to organize - banks were willing to provide. Exporters can obtain working capital loan against exporter LC and further collateral security.

But Bangladesh exporters offering lower prices were attractive. In the new world, this is changing. As credit (and LC) becomes scarcer, buyers become reluctant to provide LC. This is driving them into the hands of Indian and Chinese factories who are better capitalised than typical Bangladeshi manufacturers - and who can work without LC and offer open account and delay of payment.

Using this new financing product allows the Bangladeshi seller to work with good quality buyers around the world on equal terms with the Chinese and the Indians. Equal terms means that the buyer is simply not troubled by the financing required in order to bridge the time from "order to cash". The buyer gets what he wants - which is to pay for the goods only when he has sold them himself (90 days after receiving them)! This is good news for the buyer - because his scarce credit resources are used for his own purposes. This is good news for the buyer's bank, who can refocus his credit supply onto higher margin lending and services, and away from low margin trade finance.

A new breed of finance companies is emerging that can level the playing field for Bangladeshi factories allowing them to trade with buyers on open account with delay of payment and without LC. In South Asia factoring services has begun in 1990 after its successful launching in India and Sri Lanka. There are already two such overseas players in the Bangladesh market - PrimaDollar and DS-Concept.

The new product is a hybrid between factoring (which is quite new in Bangladesh) and trade finance (which is as old as the hills, and which everyone understands). It is an agreement between an exporter and factor whereby the factor purchases the trade debt from the exporter and provides the services such as finance, maintenance of sales ledger, collection of debts, and protection against credit risks. There are various forms of international factoring. It may be simply defined as a purchase of receivables by factor from its client and collect it during the maturity from the debtor. Usually the factor pays the client about 80 per cent of the value of the receivable and remaining is paid by collecting from the debtor after the deduction of charges.

There are few categories such as (1) Bulk Factoring, (b) Maturity factoring, (c) Agency Factoring, (d) Invoice discounting etc. Factoring is flexible form of finance and with the help of factoring it is very easy to predict the cash flows. The factors immediately finance up to a certain percentage of the eligible export receivables.

Bangladesh exporter can bargain better payment terms like deferred payment, export against contact or factoring etc. Western buyers are ready to pay more for better and less expensive

payment terms. Exporter can now offer the same deal to the buyer that his stronger international competitors can. Bangladesh can compete with other competitors with better finance and better business terms with the acceptance of factoring and innovative financing of trade for value added products.

The writer is a Legal Economist. shah@banglachemcial.com