How Will the Global Trade Finance Sector Help In the Growth Of the Country
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It is well understood in economic circles that free-flowing international trade leads, over the medium term, to growth and prosperity. Of course, there are times when governments should rightly intervene in the operation of the free market, but this should be the exception rather than the rule.
This article is being written on the eve of the US elections, with an interventionist US President still in charge and major challenges to free-flowing international trade on many fronts. Amid accusations of subsidies and countries not playing by the WTO rules, failing to honour bilateral trade agreements or stealing intellectual property, the famous Brexit process in the UK or the increasing spat between India and China; the atmosphere in global trade has become decidedly frosty. And many governments are riding on a political theme that protectionism has somehow become politically-acceptable and is a good way to build domestic prosperity.
Perhaps we can all agree to disagree on this—but the main point here is that increasing global trade should generally be is good for growth whoever you are—and that trade barriers might bring short term political wins, but these will typically be at the expense of economic growth in the medium term.
So if we accept the premise that increasing global trade can be good for the growth of the country, then we need the finance sector to play its role.
The job of trade finance is simple: when an exporter ships his goods, he should be paid in cash, and the buyer can pay later. This makes supply chains work efficiently.
Every trade has supplier-side risks and buyer-side risks. The supplier-side risks are the risks of production: can the supplier produce what is contracted by the deadline that he has accepted? The buyer-side risks are whether he will pay, and then when will he pay? As a general principle, supplier-side risks should remain supplier-side, and buyer-side risks should be buyer-side. When there is cross-over of risks, usually the supply chain becomes inefficient, costs go up and suppliers lose competitiveness because supplier-side funders cannot price or manage the buyer-side risks efficiently. Buyers do not always understand this, and can be merciless in their demands for credit from suppliers. In the end, crossing over the buyer-side risk to the supplier-side just adds costs to the supply chain which the buyer, inevitably, has to pay in the landed price of the goods.
So the task of trade finance is to keep the two sets of risks, supplier-side and buyer-side, efficiently allocated to their own locations and to minimise the cross-over between the two. And the best way to do that is to ensure that payment to the supplier happens at shipment, whilst allowing the buyer to pay later.
The government has provided a number of supports to Indian exporters to help them manage buyer risks; for example, the state-backed insurance and subsidies for export loans. These are artificial supports that are intended to help Indian exporters manage buyers who are demanding credit terms. And similarly, there are tariff and other restrictions which have been erected to support the Made In India program on the import side in order to encourage greater domestic production. Whatever the short-term merits, as a general principle, government interventions distort markets and can lead to trade barriers with medium term costs as other countries retaliate against perceived unfair subsidies and restrictions. Moreover, the benefits in the local economy are often hard to access and restrictions usually have to be worked around to keep business moving.
The market provides two working models of trade finance in India, and these are available to support both Indian imports and Indian exports.
First, we have traditional banking products like the letter of credit. The letter of credit enables the exporting supplier to get paid at shipment, or at least before handing over control over the goods being shipped. In this respect, the letter of credit is a good solution and ensures that there is no cross-over of buyer-side risks on to the supplier-side of the trade. Interestingly, our calculations suggest that, whether for imports or exports and notwithstanding the fee that get charged, using a letter of credit usually results in a lower net financing cost for the supply chain than working open account with deferred payment. So this is good for imports and exports, as it results in a lower landed cost of goods because financing is efficient.
The second working model is international factoring or supply chain trade finance. In this model, the buyer-side risks are handled by a technology platform that ensures payments come to the supplier at shipment allowing the buyer to pay later and without recourse for the buyer credit risk. This neatly ensures that the supplier and his local bank are not exposed to the buyer-side risks. And supply chain trade finance is relevant to both Indian imports and Indian exports, and our calculations indicate that this is the lowest cost way to manage the way in which suppliers are funded and paid post-shipment.
These two market-based approaches should be sufficient to maintain a healthy trade finance sector, which is an essential support for the Indian economy, and trade finance should be seen as an enabler of efficient trades rather than as a cost that has to be avoided.