Comercial

Medi-Caps Institute of Techno Management

Managing commercial risk: a China case study

Submitted ToProf. Gopal Sing

Jadhav

Submitted ByVijendra Thakre

Chandresh ChouadhreyRavi Gupta

Commercial Risk

• Commercial risk is defined as the possibility that an international transaction will not be settled due to a foreign-based customer's inability to honor its debt.

• One particularly noteworthy aspect of commercial risk is the risk of non-completion, a situation in which an importer is not able to pay an exporter for goods it has purchased.

Examining how one company, which exports to the People's Republic of China (PRC), manages commercial risk will yield critical information for firms considering trading with China,

China

• The importance of managing commercial risk in China has increased greatly as that country's economy has experienced difficulties.

• For decades, China conducted the majority of its commercial transactions with carefully planned, allocated funds and physical goods. Prior to 1978, the growth of China's money supply was low, steady and planned.

To be continued

• However, with the onset of economic development, demand for money and credit increased dramatically, resulting in inflation; prices increased approximately 26 percent from 1987 to 1988.

• As a result, the Chinese government instituted an adjustment period, and the People's Bank of China announced its intention to trim the money supply by 20 to 30 percent and cut credit growth by 10 percent, thus reducing available credit and funds allocated to state enterprises.

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• Consequently, China's credit squeeze in 1989 reportedly led to widespread delayed payments, especially among state enterprises.

AEW Inc.• In response, many companies are recognizing the need to

focus on managing commercial risk. One of those companies is AEW Inc., which is a pseudonym for an American company founded in the early 1980s to market Western products to the PRC. The company, with US$150 million in sales to China, represents scores of Western manufacturers of high technology goods.

• The company's main office in Beijing comprises the marketing, sales and technical service staff, while the U.S. corporate offices provide support for Western Hemisphere clients and customers. The firm also has liaison offices in Guangzhou and Shanghai, which serve as bases for the staff, and technical service engineers who provide sales and service support throughout China.

The company reports that there are three entities involved in the sale of goods to China:

• AEW (the exporter), • The end user (the importer) and • The appropriate foreign trade corporation. China's

foreign trade corporations, under the auspices of the Ministry of Foreign Economic Relations and Trade (MOFERT), provide services to importers and exporters and receive a fee in return.

The presence of a foreign trade corporation in the purchase process has both benefits and

disadvantages for AEW.• The primary benefit is that AEW deals

constantly with the foreign trade corporations and thus has little concern if the end user is someone with whom AEW has not done business previously.

• The primary disadvantage is that the entity buying the goods (the end user) is not the entity making payment (the foreign trade corporation), and this can create problems.

Credit Policies

A firm's credit policy determines whether credit should be extended to a customer, and if so, how much. The establishment of a textbook credit policy has three basic steps:

• establishing credit standards (the minimum criteria for the extension of credit to a customer),

• developing procedures for credit analysis (the evaluation of credit applications),

• and obtaining and evaluating credit information on the firm's creditworthiness.

Information Collection

• when engaging in international trade, such information may be hard to obtain. Despite the existence of the Foreign Credit Interchange Bureau (FCIB) and other agencies, exporters may not be able to ascertain the credit standing, integrity and reputation of their international trade partner due to the high cost of agency reports and the length of time it takes to receive them.

• Consequently, AEW Inc. does not have a formal credit policy but rather depends on the presence of a foreign trade corporation to alleviate the need for one. As stated above, the appropriate foreign trade corporation is involved in the purchase process by the time it reaches the contract stage. It is at this point that AEW begins to take the end user seriously because the company considers the involvement of the foreign trade corporation as a guarantee that payment for the goods will be received. This view of the foreign trade corporation as the implicit guarantor of payment is a function of three facts:

(1) the foreign trade corporation is an arm of the Chinese government and therefore has its backing; despite the problems the Chinese government has had, AEW considers it to be extremely creditworthy;

(2) AEW has dealt with the foreign trade corporation in the past; and

(3) by the time the foreign trade corporation enters the process, the funds have been approved for expenditure. Thus, according to the company, the presence of a foreign trade corporation in the purchase process obviates the need to establish credit standards, develop procedures for credit analysis, and obtain and evaluate information on the purchaser's creditworthiness.

• After a firm has developed a credit policy, it must focus on its credit terms, which specify the repayment terms required of all the firm's credit customers. There are four major types of credit terms used in international trade:

• cash in advance, • open account,• documentary collections and • letters of credit.

Cash in Advance• As the name indicates, the cash in advance method involves

payment for the goods by the importer before the exporter makes shipment. Typically, payment is made by certified check. Companies that export goods to foreign countries prefer this payment option because it eliminates any risks involved in the international transaction, such as commercial, political or foreign exchange risks.

• However, a drawback to the exporter using the cash in advance method is that potential importers often look for flexible payment terms when buying goods from another country, and may reject a transaction that requires payment in advance.

• It should be noted, however, that cash in advance can be used as a marketing tool because the exporter assumes no risks and therefore can offer discounts to customers if payment is made in advance, thereby increasing the probability of escalating sales.

AEW rarely sells on cash in advance terms. The reasons for this are twofold.

• First, the cash in advance method tends to be utilized when the importer and the exporter have not done business previously.

• In AEW's case, the company has a long, well-established presence in China,

• and has some knowledge of or information about the majority of its customers;

• AEW also views the foreign trade corporation under whose jurisdiction the end user falls to be an implicit guarantor of payment.

• Second, cash in advance terms are often used when an exporter has no recourse if an importer cannot or does not make payment. This is not the case for AEW, whose presence in China allows the company to maintain continuous contact with its customers and to address any payment problems that may arise.

Consequently, AEW tends to utilize the cash in advance method only at

the customer's request. • The company reports that the primary advantage to

the importer of paying cash in advance (usually in the form of a wire transfer) is that it alleviates concern about the availability of foreign exchange and fluctuations in the exchange rate. Two additional benefits to the importer of the payment of cash in advance are:

• (1) it typically requires less paperwork than other methods, resulting in lower transaction costs; and

• (2) the importer does not have to be concerned about the timing of documents, a problem that will be discussed later.

Open Account

• At the opposite end of the credit terms spectrum lie the terms that pose the most risk: open accounts. When utilizing open account credit terms the exporter agrees to ship the goods to the importer, and the importer promises to pay the exporter an agreed-upon amount within a specific time period. Open account payments are typically made by check or wire transfer; thus, payment is customer-initiated

• Accordingly, this is the least secure technique for the exporter because there is no guarantee that the importer will make payment. In countries in which the political, economic and foreign exchange risks are high, the open account method is rarely used. Nevertheless, it is considered the most widely used international payment method; some estimates have found that nearly 75 percent of all exports are sold on open account.

The reasons for this method's popularity are simple:

• Importers are interested in easy and flexible payment methods,

• Exporters are interested in decreasing their paperwork and transaction costs.

• The AEW company sells on open account credit terms for transactions up to US$10,000. This credit policy benefits the company in two ways.

• First, AEW considers sales of goods under US$10,000 to be a relationship-enhancing favor to the customer because AEW makes little profit on such small sales.

• And second, the company has decided that for transactions of US$10,000 or less it is not financially feasible to sell on stricter terms that require more paperwork.

• The only problem AEW has experienced with the open account method is delayed payments, which the company believes are a function of China's cash flow problems.

• AEW considers delayed payments a common cost of doing business in China, rather than an area for major concern

Documentary Collections

• Documentary or draft collection credit terms are similar to open account credit terms because payment is customer-initiated. However, this method offers less risk to the exporter because the importer does not take possession of the goods until he or she presents payment, usually to a third party who processes the documents that give the importer title to the goods. Payments are made in the form of sight or time drafts. A sight draft is payable upon demand, while a time draft is payable a specific number of days (typically 60 to 90) after it has been presented.

• AEW does not use the documentary collections method for several reasons.

• First, if AEW holds title to the goods when they arrive at the Chinese port, it has to pay the import taxes, which can be substantial. With the other credit terms, the importer either has tax-exempt status or pays the import taxes itself.

• Second, once the goods are shipped to the importer, the documents, including the title of the goods, are forwarded to the third party. As a result, once the goods are shipped, AEW has no control over them, so utilizing documentary collections credit terms would produce an unacceptable level of risk.

Letters of Credit

• Perhaps the most important instrument in international trade is the letter of credit. A letter of credit is a document, issued by a bank at the request of the importer, in which the bank promises to pay a beneficiary (the exporter) upon presentation of documents specified in the letter of credit. In its simplest form, a letter of credit transaction requires three participants: the importer, the bank issuing the letter of credit and the exporter. More complicated letters of credit involve more participants, but the above-mentioned will always exist.

• The most common type of letter of credit is the commercial one, which is payable against the presentation of commercial documents, including the invoice, draft, bill of lading and insurance papers, to the bank upon shipment of the goods. It is important to note that prior presentation of the documents to the exporter is not required because the commercial letter of credit is the primary payment mechanism for the transaction.

• The most common type of commercial letter of credit is the irrevocable one. It is considered the least risky method of payment because the issuing bank cannot change or cancel the letter of credit without prior consent of the importer and the exporter. The irrevocable letter of credit may also be a confirmed letter of credit, which means that a second bank has confirmed the foreign bank's letter of credit. This bank is usually located in the country of the exporter, and if the foreign bank does not pay, the confirming bank will take responsibility for payment. A confirmed letter of credit may be requested by the exporter when there is some doubt about the foreign bank's ability to pay, possibly as a consequence of uncertainty about the financial standing of the foreign bank, or the environment in the importer's country.

AEW sells most of its goods using letters of credit

• More specifically, the company uses irrevocable, non-con firmed letters of credit.

• AEW has, however, experienced some problems in using irrevocable, non-confirmed letters of credit. Most of these problems appear to be the result of a fact mentioned previously, namely that in China, the entity paying for the purchase (the foreign trade corporation) is not the entity buying the goods (the end user). Consequently, the purchase process is long and coordination sometimes difficult.

This situation has led to several problems.

• First, AEW has found that there may be a delay in opening the letter of credit because the end user may have problems accumulating enough renminbi (Chinese currency) to pay for the goods. This is often a result of the problem mentioned above, that approval of the expenditure does not necessarily result in the availability of the funds.

• Second, AEW notes that the Bank of China is sometimes concerned with what the company considers minor discrepancies. For example, AEW reports that if the Bank of China spells the company's name wrong on documents, it expects the exporter to do so. Or, if the Bank of China has "To Whom It May Concern" on its documents and AEW doesn't have it on its own, this may also create problems.

• Third, AEW has experienced a lack of flexibility and pragmatism in the Chinese bureaucracy and reports that this tends to make the entire process longer and more difficult.

• Fourth, and also a result of the Chinese bureaucracy, AEW has had difficulties with the delivery of letters of credit to the United States. The company says that letters of credit may be sent by telex or fax but that the Chinese bureaucracy prefers to send them via airmail because it is less expensive

• Fifth, AEW perceives potential problems with increased levels of political risk because the Bank of China, which is the issuer of letters of credit, is part of the government. Consequently, if China has political risk problems, the Bank of China may also have problems, and so may the exporter.

• Despite these problems, AEW considers the letter of credit to be the most effective way of exporting goods to China and managing commercial risk. Accordingly, the company makes most of its sales on these terms.

Collection Policies• After a firm has decided on which credit terms a sale will be

made, it must be concerned with collecting payment. A firm's collection policies are the procedures for collecting on the firm's accounts receivable when they are due or overdue. Common collection techniques include letters, telephone calls, personal visits, collection agencies and legal action. Whichever techniques a firm utilizes, it is useful to remain vigilant because the international collection environment is constantly changing.

• AEW tends to utilize letters, telephone calls and personal visits in its attempts to collect on overdue accounts. This is in keeping with the Chinese concept of guanxi discussed above. Consequently, the company has found that if it talks to the parties involved in the transaction, determines where the problem is and follows through, payment results. Once again, the company reports that its strong presence in China is of tremendous assistance in this process.

• COPYRIGHT 1994 Risk Management Society Publishing, Inc.

• COPYRIGHT 2008 Gale, Cengage Learning

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