Trade carries different risks from those carried by daily buying and selling
In this age of economic globalization, many people recognize that international trade is indispensable and taken for granted. However, how trade is conducted in practice is surprisingly unknown.
In fact, there are various risks involved in international trade.
For example, when we shop at a convenience store, we pay for and receive the product almost at the same time. This is sometimes called Delivery Versus Payment.
In this case, from the buyer’s point of view, it is almost impossible for the product to be damaged or become unavailable in the time between the payment and receipt of the product.
However, in the case of trade, the counterparties are abroad. They are simply physically separated, so it takes a relatively long time to receive the goods you ordered, not to mention the fact that legal systems and currencies are different.
Thus, in the meantime, the goods may be damaged or lost. That is why, in order to prepare for such transportation risks, there are arrangements such as cargo marine insurance.
It is easy even for people who have never been involved in trade to understand why goods to be transported are insured. So, what about payments for trade?
For exporters, it is ideal to receive payment as soon as possible, and they would want to be paid when an order is placed, or at least when the goods are produced and loaded onto a cargo ship.
However, importers would want to defer the payment as much as possible and do not want to pay until the goods have arrived and they are sure the goods are what they ordered and confirm other details.
The point is that the exporting side and the importing side have respective ideas of whether the bill will actually be paid or whether the goods will actually arrive as ordered, which is also a risk in conducting trade.
In extreme cases, the exporter wants the payment to be made definitely in advance, while the importer will not accept any payment conditions other than that after delivery.
These risks may be eliminated if there is a relationship of trust between the two parties, cultivated mainly by the accumulation of transactions between them. However, if trade cannot be carried out without establishing such a relationship of trust, new trade flows cannot be generated and trade cannot be invigorated.
To avoid such risks, a mechanism called trade finance was devised.
The essence of the concept of trade finance is to provide a mechanism which makes the payment condition such that it is in advance payment for one party and after delivery payment for the other, by having a financial institution mediate the parties in involved in trade transactions.
This mechanism started as a prototype by the middle of the 19th century and became more sophisticated with the times.
Just as it is unthinkable to transport goods without cargo insurance, nowadays it is unthinkable to conduct transactions without trade finance. To such an extent, trade finance has become a commonly utilized mechanism in international trade.
Trade finance is based on letters of credit (L/C) transactions
Among various patterns of trade finance, the basic method is to use letters of credit (L/C). Many people have probably heard the term “L/C transaction” through news coverage.
For example, suppose Company A in Country A orders goods from Company B in Country B, and Company B receives the order.
Then, Company A contacts its correspondent bank (Bank A) that it is going to make a transaction with Company B in Country B, and asks Bank A to assure the trade payment to Company B on behalf of Company A.
Bank A, which has a business record with Company A, has confidence in Company A, so the bank accepts this request and sends Company B’s correspondent bank (Bank B) a document that states the bank A will guarantee the payment of the trade transaction. After validating this document, Bank B will inform Company B that the payment is guaranteed.
Then, Company B will finalize the condition that triggers payment with Bank B. Once it is finalized, for example, that the payment will be made when the shipment of goods is completed, then Company B starts producing the goods.
When the production is completed and the goods are delivered to a shipping company, the shipping company provides Company B with a document that certifies the shipment has been completed without any problem, and Company B submits this document to Bank B.
After confirming the document, Bank B makes the payment to Company B, making it an advance payment to company B based on the guarantee from Bank A.
After that, Bank B sends these necessary documents to Bank A. After confirming them, Bank A pays to Bank B the amount of transaction. As one can see, payments originally supposed to be made between the trading parties are replaced with transactions between the banks.
Finally, Bank A collects the payment from Company A. Bank A may delay the invoice, for example, until the goods have arrived and no problems have been confirmed, or until the end of a certain month. In other words, this makes it an after delivery payment for Company A.
Through the whole mechanism, letter of credit (L/C) sent by Bank A to Bank B plays a crucial role to facilitate the payment.
Through this trade finance mechanism, both importing Company A and exporting Company B can avoid risks to a considerable extent, and the banks that undertake such risks can receive their respective fees by assessing and accepting the risks.
In other words, the use of trade finance has benefits for each of the parties involved, and this mechanism will lubricate and stimulate trade transaction.
Such as comparative advantage, research conducted in the field of international trade tends to focus on goods and industries in which each country or region has an advantage in production. On the other hand, however, the sophistication of the trade finance mechanism over time has been serving as a smoothing force of international trade and it can be said to be one of the factors fostering globalization.
Trade finance research leads to trade policy recommendations
Trade finance is an indispensable mechanism for stimulating trade, but the reality is that in the fields of international economics and international trade, progress of the research on trade finance lags behind other topics in the same fields.
Therefore, the accumulation of the relevant evidence and knowledge is still insufficient, and there is still a large knowledge gap in the field of trade finance. But this does not mean that trade finance is not worth studying.
For example, during several years after the 2008-09 global financial crisis, there was a period in which trade finance research flourished worldwide. In the wake of the bankruptcy of Lehman Brothers, global GDP dropped sharply, but the magnitude of the damage to international trade was two times bigger than global GDP. A simple question of “why is that?” drew the attention of researchers.
The main plausible factor was, of course, a drop in global demand or a cooling of the market.
But that alone cannot explain all the plunge in trade. Then came another plausible factor: Financial institutions were hit hardest by the bankruptcy of Lehman Brothers, and as a result, they lost the capacity to meet the demand of trade finance such as L/C transactions.
In fact, based on the analysis of working groups structured by international organizations, it was decided at the 2009 G20 London Summit that the world as a whole would provide trade finance support worth billions of dollars. In other words, it has been concluded that trade finance is indispensable for international trade, and that it is necessary to shore up trade finance in order to stimulate trade.
However, true to the old proverb, “once on shore, we pray no more”, although there was a rising number of research conducted after the 2008-09 financial crisis, trade finance has not received as much attention as it once did. However, it goes without saying that it is very important to conduct further analyses and studies, for one thing, in order to provide policy implications, since academic knowledge is not yet sufficient.
If we can close the knowledge gap on the mechanisms and effects of trade finance within the theoretical framework of international economics, we will be able to provide more accurate insights, which will lead to better policies.
In fact, a military coup has taken place in Myanmar, causing social disorder and forcing the suspension of commercial banks in the country. At this point in time, we do not know how long this chaos in Myanmar will continue, but since the economic activities of a country without trade are no longer conceivable, we must consider as a part of economic policies, what must be done to maintain smooth trade transactions.
Of course, there are many practical points that are important for maintaining smooth trade when an event occurs that causes social disruption, but the importance of trade finance should be recognized when banking operations are affected by exogenous factors as in the case of Myanmar.
Under such circumstances, plausible measures will include the resumption of operations limited to trade finance even if the entire banking operations cannot be resumed, and the temporary injection of trade finance into markets by the government. If the importance of trade finance is fully recognized and academic knowledge with policy implications is sufficiently accumulated, measures to facilitate trade will be discussed and implemented more comprehensively in countries in turmoil and trade partners of those countries.
For one thing, in order to be able to make these recommendations, it is very important to close the knowledge gap in trade finance through academic research, as is the case with the Evidence-Based Policy Making (EBPM) that is currently being actively promoted.
Recently, trade finance has been gaining momentum outside of academic research as the demonstration experiments of trade finance supply using blockchain technology have begun in various countries.
If the blockchain technology can be used effectively, overall business process of international trade is expected to be operating smoother: For example, the process of creating and verifying hundreds of documents, which are processed over two to four weeks with among up to around 20 organizations involved in one trade, will be greatly shortened; and the authenticity of each document on the blockchain, the implementation of updates, and the confirmation of status can be done in real time.
In other words, we can say that this is also one of the trends toward the refinement of trade finance. Since risk is closely related to time (or physical distance in essence), we may say that faster processing means reducing risks. If this trend further expands in the future, trade finance research will need to be developed in a new manner, based on the characteristics of such trends. The real world is developing at an accelerated pace that seems already faster than we can imagine. There is no end to the work of properly elucidating the mechanism in such a society and providing academic knowledge.
With the exception of those who work in the field, most people are not directly involved in these trade operations on a daily basis. However, you can understand that trade contributes to increasing the satisfaction of our lives by expanding the variety and choices of the products around us, and by enabling us to purchase the same goods at lower prices.
In other words, trade finance research is one of the research themes to further facilitate trade that leads to the enrichment of our lives.
* The information contained herein is current as of July 2021.
* The contents of articles on Meiji.net are based on the personal ideas and opinions of the author and do not indicate the official opinion of Meiji University.
* I work to achieve SDGs related to the educational and research themes that I am currently engaged in.
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