Finance

SHENYANG AEROSPACE UNIVERSITY INTERNATIONAL BUSINESS

Dr. JUN-QI LIU Professor

Shenyang Aerospace University

Roni Bhowmik

Master’s Program

International Business

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# How to manage the risk for the principal under the documentary collection in International Business?

How risky is it?

A variety of payment methods is used in international business, with payment taking place at a different stage of the export deal in each. In general, this means that each method has a different level of non-payment risk for the exporter, and non-delivery risk for buyer. The diagram below illustrates the risk of documentary collection compared with other payment methods.

As my study, Documentary Collections may be settled in two different ways. A document against Payment (D/P) refers to a Collection where the Importer receives the documents only in exchange for payment. With Documents against Acceptance (D/A), the Importer may obtain the documents in exchange for the acceptance of the obligation to pay at a specified future date. These two methods of settlement carry different risks for both Importers and Exporters. Generally risk can be categorized in lack of credit information, lack of personal contract, difficult expensive collections, no easy legal recourse, higher litigation costs and mistrust. As my study I found some risk-

Payments after arrival of goods, High risk of exporter for getting payments, Currency risk,

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Non-performance/non delivery risk, Commercial Credit risk, Transfer risk, Country risk etc.

I just try to share my study and experience opinion –

1. Payments after arrival of goods

Exporter is exposed to more risk as documentary collection terms are more convenient and cheaper than documentary collection to the importer. So in this situation, generally importer most of the time choose to documentary collection process. Documentary collection may be favour the importer or buyer since payment is deferred by him until the goods arrive or even later if delayed payment arrangements are agreed to. May increase buyer market competitiveness, as this payment method is relatively low risk for overseas buyers and may also help their cash flow. But by defaulting on a bill of exchange he/she may become legally liable. Not only legally liable also his/her trade reputation may be damaged if the collection remains unpaid.

2. High risk of exporter for getting payments

Most importantly, the seller must realize that the banks will pay only if and when the buyer pays them, Banks do not assume the obligation to pay. Documentary collections do not guarantee that the buyer will be willing and able to pay as agreed. Sometimes buyer delay to pay and sometimes will not agree to pay. However, if payment is not made, the buyer won’t be able to obtain title to the goods if the buyer is unwilling or unable to pay or accept the order to receive the documents, then the seller will retain title to the goods and control of the documents. Seller risk of non-payment after delivery of Seller goods may be greater than in some other payment methods. If seller bill of exchange specifies payment at a date after delivery, seller hand over control of the goods but run the risk of non-payment on the due date. If buyer doesn’t accept the bill of exchange, or delays or defaults on payment, seller may incur unplanned expenses such as storing, disposing of or redirecting the goods. The seller will also face the effort and expense of dealing with goods already shipped to a foreign port.

If the buyer defaults on an accepted draft, then the seller will have a strong legal position but will also be confronted with the cost and effort associated with legal action. If more protection is needed, then the seller should consider requiring the buyer to use a letter of credit.

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3. Currency risk

Currency risk can arise due to variations in exchange rates, currencies fluctuate regularly and there may be a delay between the time of entering into a contract and the making of the foreign payment to the supplier. In Sometimes buyer delay to pay in the documentary collection method, that times seller face the currency risk. The local currency amount payable on settlement may be higher than the amount calculated when entering the contract, due to an adverse movement in the market price of the currency. Movements in exchange rates may significantly affect the profit margin seller expect to retain on seller’s international trade transaction.

The currency fluctuation may be solved with using the option for a third currency (US$), there is the possibility of sharing the currency fluctuation risk. This risk accrues in the period between prices being agreed and payment being received.

4. Non-performance/non delivery risk

When dealing with a seller there is always a risk of non-performance, this may be heightened when dealing with an overseas seller. Seller may not perform according to the sales contract, either by delivering the wrong or inferior goods or not delivering at all or not at the agreed time. Because in documentary collection methods will not obligated or guarantee seller/buyer must do this. Seller may not be willing or able to perform as contracted; these events may be the result of things outside the control of the seller, like industrial action, shipping availability or in extreme cases, acts of war or other violence. Non-performance, whatever the cause, may adversely affect buyer business; that time may lose customers or sales as a result. Whilst there are no guaranteed ways to eliminate these risks, may be they can managed by-

Seeking trade references before entering into a contract with a new trading partner, investigate their reputation and the product

Request appropriate shipping documentation to be presented before making payment

Arrange inspection of the goods by an acceptable independent inspection agency (this can be costly)

Have an alternate or secondary supplier available to source the goods from, this may limit damage caused by loss of supply

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5. Commercial Credit risk

Credit risk is the risk of seller insolvency or other related parties in the payment chain. Consider importing goods using unconditional methods of payment such as import documentary collection. In this method payment is not assured by the bank which issues a documentary collection. If full or partial payment is made to the seller prior to shipment, the importer may find that any payments made are not returned.

Consider importing goods using conditional methods of payment such as import documentary letter of credit. Import Documentary Letter of Credit is an ideal way to facilitate payment to the supplier with some in-built safeguards.

6. Transfer risk

When a contract of sale specifies payment is to be made in a particular currency, a 'Transfer risk' may also exist. A change in government regulations may prevent or restrict ability to make payments or exchange foreign currency; many countries regulate the transfer of money and conversion of foreign currency receipts. Unexpected regulatory changes may occur without warning, meaning that transactions already agreed to may not be able to be completed, resulting in financial loss to either or both parties.

7. Country risk

Country risk may occur if government regulations prevents or restricts the movement of particular goods, this could occur during a significant event such as war, terrorism, government bankruptcy or economic embargoes. Many countries regulate the import and export of goods. Unexpected regulatory changes can occur without warning, such as cancellation of permits or licences, transactions already agreed to, may not be able to be completed, resulting in financial loss to either party. In documentary collection methods seller and buyer both are face this problem.

In any business transaction, there are risks. However, these risks are emphasized when dealing internationally. Added to the commercial risks present in a domestic transaction are foreign exchanges as well as country risks. Exporter is exposed to more risk as documentary collection terms are more convenient and cheaper than documentary credit to the importer. All included the documentary collection offers straightforwardness between trade partners as well as the payment is quicker than other methods. Usually the political and transfer risks are not covered, I try to share my idea how to manage the risk-

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1. Need strong government politically, economically and legally stable

“You can’t have strong, healthy, prospering businesses without a big, strong government. The kinds of businesses that don’t want a big, strong government are exactly the kinds of businesses that we, the People don’t want.” Government creates the “public structures” that support smaller, innovative business. Government defines the playing field for business, right down to defining and regulating the money itself. Government creates the laws that define what business even is, and the police and courts to enforce that law. Government provides the infrastructure that is the soil in which businesses thrive or wither and die. Government educates the employees and innovators. Government negotiates the trade agreements that let businesses sell outside the country, and is supposed to protect country businesses from being undercut by those in other countries.

It is a universal economic fact that without a proper Governance the trade and businesses would not thrive along the right direction. After the Second World War the totally destroyed nations such as Japan and Germany were helped to revive their economy. These two national economies went forward whereas that of other countries involved in the war gradually went down and down. If we look at the fate of recession in Russian economy, the unemployment rate in America and the totality of degradation in the other European countries including that of Great Britain. Whereas the economies of emerging Nations such as China, India and Singapore as well as Malaysia, not to mention those affected by the Arab Spring movements, is much safer to follow as models. The Good Governance for International Business index provides a timely and useful resource for business leaders and governments alike. International payment transactions with the importing country must not be hampered or threatened by currency controls or any other such restrictions. Seller has no doubts about the buyer's ability to meet its payment obligations, if the political and economic situation in the buyer's country is stable, if there are no foreign exchange restrictions in the seller's country. So need strong and stable political government for managing the all type business risk.

2. Need strong Banking support

The bank’s legal liability is set out in the uniform rules for collections. Banks, therefore, act as intermediaries to collect payment from the buyer in exchange for the transfer of documents that enable the holder to take possession of the goods. Bank must check that they appear to have received the documents specified in the collection order, but they have no liability to examine the documents in more detail. However, in practice the remitting bank will make the some additional check before it sends the documents abroad. Bank makes sure that the instructions on the collection order are logical, and also the bill of exchange is correctly drawn, signed and endorsed. If any are missing, an explanation should be obtained and the collecting bank must be advised accordingly. If bank make sure all

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documents check clearly maybe document collection method day by day continuing their popular face in the buyer and also seller for using export import business.

3. Need to be a relationship of trust between the exporter and the importer

To understand your fear is the beginning of really seeing- Bruce Lee. Make any relationship

at first need believe. As like also, business at first condition need to be a relationship of trust

between the seller and the buyer. There must be no doubt as to the importer's willingness

and ability to pay.

At last I say that, make international trade operations more flexible, use documentary collection in cases when the seller does not want to deliver goods to the buyer on “open account” basis, but due to a long-term stable business relationship between the parties there is no need for security provided by a Letter of Credit or payment guarantee. Documentary collection is suitable to the seller: if the seller has no doubts about the buyer's ability to meet its payment obligations, if the political and economic situation in the buyer's country is stable, if there are no foreign exchange restrictions in the seller's country. Documentary collection is convenient for the buyer also because: there is no need for an advance payment; payment for goods can be made when shipping documents have been received, in cases of documents released against acceptance the buyer has the possibility to sell the goods first and afterwards make payment to the seller. Documentary Collection assures the seller that the shipping documents will be released to the buyer only upon payment or acceptance of a bill of exchange.

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# Please do some compare between documentary collection and documentary credit?

Exporting overseas is one way for a business to grow, but it won't succeed if the buyers fail to pay promptly. The business world has developed several methods for guaranteeing payment even when the buyer and seller are half the world apart. At first necessary to know what is documentary collections and documentary credit or letter of credit, follow-

Documentary Collection:

In the documentary collection process, the U.S. Department of Agriculture says, the seller sends the shipping documents and a draft for payment to the buyer's bank. The bank, acting as middleman, sends the documents to the buyer, who's the one responsible for paying the draft.

Documentary Credit or Letter of Credit:

A letter of credit is a commitment by the buyer's bank to pay for the goods, according to the U.S. Department of Agriculture. Before paying, the bank will require the seller fulfil the terms of the letter exactly. Typically, that includes delivering the goods and providing documentation for example an invoice, a packing list, and a certificate of origin drawn up exactly as the letter dictates.

Documentary credit and documentary collections both guarantee payment when the terms are met but there are important differences between them. I try to show my study learning and my little experience-

1. Will They Pay

Documentary credit or letters of credit is measured a dependable guarantee of payment, which makes it an outstanding choice when the consumer and supplier haven't done business together. If a Bangladeshi bank working with the buyer's bank confirms the letter, it's even safer. Documentary collection is less sure because the cash comes from the buyer, not the buyer's bank, so if the buyer refuses or declines to pay for any reason, the supplier is out of luck.

2. Commercial Credit Risk

In documentary credit or letters of credit eliminates the commercial credit risk, because payment is assured by the bank which issues an irrevocable documentary credit. The seller no longer needs to rely on the willingness and capability of the buyer to make payment. Consider importing goods using unconditional methods of payment such as import

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documentary collection. In documentary collection method payment is not assured by the bank which issues a documentary collection.

3. Cost or Expense

Documentary credit or letter of credit is more costly than documentary collection because of the fees charged by the buyer's bank. If one supplier insists on a letter while another bids to accept a cheaper method, such as documentary collection, the lower fees may give the second trader an edge in doing trade. While a letter of credit often costs between 1%-2% of the total payment obligation, documentary collection can be much straightforward and less expensive settlement process.

4. Exact Requirements

One disadvantage to documentary credit or letter of credit compared to documentary collection is that any departure from the terms of the letter, including improperly prepared documents, gives the bank grounds to reject payment. The supplier must then pay to have the goods returned, find a new buyer or negotiate a lower sales price in return for the bank's receiving.

5. Prepares and Presents Documents

In a documentary collection, the seller prepares and presents documents to the bank in much the same way as for a documentary letter of credit. However, there are two major differences between a documentary collection and a documentary credit: (1) the draft involved is not drawn by the seller (the "drawer") upon a bank for payment, but rather on the buyer itself (the "drawee"), and (2) the seller's bank has no obligation to pay upon presentation but, more simply, acts as a collecting or remitting bank on behalf of the seller, thus earning a commission for its services.

6. Boat Freight

Documentary collection is supreme suitable when goods are shipped overseas by boat or ship. The ocean bill of lading is a negotiable document that gives title to the goods; the shipper won't release the goods unless the buyer has the bill of lading, and the buyer can't get the bill without paying the draft.

Picture Documentary Collection and Documentary Letter of Credit working process:

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7. Banking Guaranty

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In documentary collection bank have no liability to examine the documents in more detail and also don’t guarantee that the buyer will be willing and able to pay as agreed. But in vase versa letter of credit are highly secure because if the buyer doesn’t agree to pay, buyer bank will be willing and able to pay as agreed.

8. When Use

Letters of credit are used primarily in international trade for large transactions between a supplier in one country and a customer in another. Letters of credit are perhaps most useful for doing business with a person or company that you do not know well. In such cases, the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits applies (UCP 600 being the latest version). But if the relationship of trust between the exporter and the importer that time normally use documentary collection.

9. Political or Economic Instability

Letters of credit are highly useful when a buyer’s country has political or economic instability or restrictive foreign exchange controls. International payment transactions with the importing country must not be hampered or threatened by currency controls or any other such restrictions. In strong government politically, economically and legally stable country normally use documentary collection.

10. Time Consuming

In documentary collection no need long time for opening bank account, so Payment is usually quicker than with open account, but on the other hand letters of credit or documentary credit have need long time for opening bank account. So, documentary credit use only when the buyer has enough time available, because in this method need long time.

11. High Value Shipment/s

High value shipments need more safety or security, but in documentary collection bank have no liability to examine the documents in more detail and also no guarantee of payment or immediate payment by the buyer. Another side documentary credit or letters of credit normally use the high value shipments. Because documentary credit are more safety, in this method provides a specific transaction with an independent credit backing and a clear cut promise of payment.

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Importers need inbound collections handled expeditiously. Exporters need to reduce the risk of non-payment associated with selling goods overseas on an open-account basis. Both need to control the exchange of documents and reduce associated payment risk. Documentary credit are highly useful when a buyer’s country has political or economic instability or restrictive foreign exchange controls. Documentary collection, on the other hand, can be a better option in some circumstances. Documentary collection can be much less expensive. This method is best used for parties that know each other well and do not anticipate any financial problems between them, nor much risk of the buyer rejecting the goods. After this two circumstances study my opinion documentary collection is best if the bank check that they appear to have receive the documents specified in the collection order. But if bank don’t follow their specified work that situation documentary credit better.

References:

International Settlement Book – School of Economic- 2012 Trade Finance Guide www.en.wikipedia.org/wiki/Credit_risk Trade Payment Methods www.pnc.com/international www.exportbureaux.com Credit and Collection Handbook by Michael Dennis www.ubs.com www.theblakefirm.com/finance-export-documents-letters-of-credit-international-

trade www.worldtraderef.com

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