Why Export Credit Insurance is typically offered by Government Agencies?-Discuss
Export means to ship the goods and services out of the port of any country. In international trade exports only refers to selling goods and services produced in the home country to the market of another country. There are many ways of exporting goods and services like mailing, hand-delivering, shipping by air, shipping by boat etc.
Whereas we take it for granted that many large businesses export or produce overseas, numerous small business do too, often with major benefits. The volume of export activity in the world economy is increasing as exporting becomes easier. The gradual decline in trade barriers under the umbrella of GATT and now the WTO, along with regional economic agreements such as the European Union and North American Free Trade Agreement, has significantly increased export opportunities. At the same time, modern communication and transportation technologies have alleviated the logistical problems associated with exporting. Firms are increasingly using the Internet, toll free 800 phone numbers, and international air express services to reduce the costs of exporting. Consequently, it is no longer unusual to find small companies that are thriving as exporters.
2. Importance of Export for a Country’s Economy:
The great promise of exporting is that large revenue and profit opportunities are to be found in foreign markets for most firms in most industries. The international market is normally so much larger than the firm’s domestic market that exporting is nearly always a way to increase the revenue and profit base of a company By expanding the size of the market, exporting can enable a firm to achieve economies of scale, thereby lowering its unit costs. There is a huge effect of export on international trade and economic stability. Economic growth rate and distribution of wealth of a country also affect the export growth. If the rate of export is low, it earns low foreign exchange which gives a small purchasing capacity of a nation in international market. If export earnings fluctuate, it gives uncertainties in the economy. It affects the economic behavior. It adversely affects the efficiency of investment. So, it results negative effect on growth. Export of goods and services brings much more foreign currency in home country. So, the home country’s economic condition improves if the export rate increases. The fluctuation of export hampers the stability and growth of the less developed countries. Export fluctuation causes borrowing costs which results in balance of payment complexities. So there is a low confidence of people in the process of maintenance of the exchange rate. Inflation is also caused by export fluctuation. The simple rule of thumb is that when inflation rate rises, products and services become costly. The all of these problems happens when the export system is hampered of a country. So the importance of export for a country is very high.
3. Document used for International trade commonly:
Documents which are used in international trade vary from transaction to transaction, destination to destination and type to type. The following documents are used mostly in case of international trade.
a. Letter of Credit:
A letter of credit, abbreviated as L/C, stands at the center of international commercial transactions. Issued by a bank at the request of an importer, the letter of credit states that the bank will pay a specified sum of money to a beneficiary, normally the exporter, on presentation of particular specified documents.
A draft sometimes referred to as a bill of exchange, is the instrument normally used in international commerce to effect payment. A draft is simply an order written by an exporter instructing an importer, or an importer’s agent, to pay a specified amount of money at a specified time.
c. Bill of Lading:
The third key document for financing international trade is the bill of lading. The common carrier transporting the merchandise issues the bill of lading to the exporter. It serves three purposes: it is a receipt, a contract and a document of title. The bill of lading can also function as collateral against which funds may be advanced to the exporter by its local bank before or during shipment and before payment by the importer.
d. Commercial Invoice:
Commercial invoice is the accounting document which claims payment from the buyer. It includes, Seller’s name and address, buyer’s name and address, issue date, invoice number, Country of origin, L/C number etc.
e. Export Credit Insurance:
Exporters clearly prefer to get letters of credit from importers. However, sometimes an exporter who insists on a letter of credit will lose an order to one who does not require a letter of credit. Thus, when the importer is in a strong bargaining position and able to play competing suppliers against each other, an exporter may have to forgo a letter of credit. The lack of a letter of credit exposes the exporter to the risk that the foreign importer will default on payment. The exporter can insure against this possibility by buying export credit insurance. If the customer defaults, the insurance firm will cover a major portion of the loss.
In this case my main concern is on only the Export Credit Insurance which is also called as trade Credit Insurance or Business Credit Insurance.
4. Export Credit Insurance in Details:
Export credit insurance is an insurance policy which works as a risk management product offered by export credit agencies. This insurance policy protects the business entity’s accounts receivable from loss which results from credit risks such as default, insolvency or bankruptcy. It also protects the business entities from the risk of non-payment of foreign buyers due to currency issues, political unrest etc.
Export credit insurance plays a very important role in case of international trade. Export credit is an alternative to prepayment or cash on delivery system. It is offered to provide buyers time to generate income from sales for paying to the seller or exporter. Sometimes this causes the seller to incur non-payment risk. In local, domestic and export transaction, risk increases when laws, rules and regulations are not fully understood. Moreover, there may be some problem of time between product shipment and its availability for sale. Accounts receivable can be compared as a loan which shows the capital invested and borrowed by the exporter. So this is not a secure asset until it is paid. If the buyer’s debt is insured by credit, the large and risky asset becomes secure.
Exporters buy export credit insurance to ensure their accounts receivable from loss which is caused by the insolvency of the debtors. It’s not available to individuals. The premium is charged monthly. Premium is calculated as a percentage of sales for that month or as a percentage of all outstanding receivables.
A portfolio of buyers is covered by export credit insurance. It pays a agreed percentage of an invoice which remains as unpaid due to default, insolvency or bankruptcy. The premium rate of insurance reflects the average credit risk of the insured portfolio of buyers.
5. Export Credit Insurance Working Process:
Export credit insurance protects the exporter from the importer’s failure of payment. In case of insuring the credit, the exporter’s trade sector, risk philosophy, business strategy, financial health, funding requirements and internal credit management process should be understood. The main purpose is not only to protect the losses resulting from default, but also helping the insurance holder to avoid catastrophic losses and maintain the growth of the business. If an exporter buys export credit insurance, the insurance does not get filed away until next year’s renewal. The policy can be changed over the period. Exporter’s credit manager has an important role in this case. The export credit insurer will consider the exporter’s buyers and divide the credit limit to each of them. During the time of the insurance policy exporter may want to extend the credit limit of a particular buyer. In that case, the export credit insurer will analyze the risk of extending the credit limit and then will either extend the credit limit or lower the limit with a written notice. In a same way, exporters may apply to issue credit limit on a new buyer. Export credit insurer monitor the buyer’s to ensure their credit worthiness. They gathered information about their purchase, different records, and financial statements. When the insurer has any doubt about buyer’s increased financial difficulty, the insurer informs the exporter so that the exporter can be alerted before doing business. This is how export credit insurance can help the exporter by alerting about the foreseeable losses.
6. Importance of Export Credit Insurance:
So far cash in hand and letters of credit have been used in international market, but in case of credit risk there were limited way, so, export credit insurance is a very important for covering losses in case of export. Its needs aroused from selling on credit which is an important risk management tool. It transfers the payment risk to the credit insurer; Insurer gives the insured exporter the related advice about trading. Sometimes insured exporter may face liquidity shortages or insolvency due to late payment or non-payment. Export credit insurance reduces earning inefficiency of exporter by protecting major portion of their assets against risk of loss. Export credit insurance improves the relationship between the exporter and importer. Again, if the exporter ask for cash in hand and cash on delivery payment system, it can reduce some of buyer. So to handle the buyers and increase the buyers export credit insurance is helpful. Export credit insurance gives exporters the chance to compete in a global market. Before using export credit insurance exporter might not be able to business with some buyers. But after using export credit insurance there is an opportunity of extending lines of credit.
7. Export Credit Insurance as a Financial Tool:
Export Credit Insurance covers many political risk as well as commercial risk. Political risks include currency in convertibility, foreign exchange controls, transfer risks, war, strikes, riots, revolution, trade sanctions and changes in import and export regulation. Commercial risk include bankruptcy, receivership, default caused by cash flow problems, balance sheet issues, market demand, currency fluctuation etc. The cost of export credit insurance depends on the terms of extend, buyer and country risk and previous exporting experience. Export credit insurance help the buyer to purchase in a large quantity. It increases market share and brand recognition. It also enhances the borrowing capacity of exporter. It strengthens the balance sheet and keeps the company’s financial position secured. It reduces the bad debt reserves. Export credit insurance increases the exporter’s overall cash flow. Accounts receivables are covered by export credit insurance. So it looks normal in the eyes of banks and lenders. Short term Export credit insurance covers 90-95 percent default loss and Long term export credit insurance covers 85 percent default loss. So there is a low possibility of experiencing losses.
8. Issuance of Export Credit Insurance:
Export credit insurance is issued both by private agencies and government agencies. In case of private agencies premiums are determined on the basis of risk factor and if the exporter is experienced then the premium rate can be reduced. Private agencies export credit cost is less than letter of credit. In case of foreign content there are no restrictions for private agencies. If private agencies face loss government does not help them. In case of government agencies exporter can get premium discount. Foreign market risks are increasing day by day. So government agencies can cover those risks which the private agency can’t do. If government agencies face any losses government help them.
9. Growing use of Export Credit Insurance:
Export Credit Insurance is one of the hidden key of today’s growing export. Previously, there were many barriers in case of international trade. But With the falling barriers, international trade is becoming very easy and the world is becoming very smaller fro business. So export credit insurance plays a very important role in this case. This growth potential and competitive situation leads the exporters to do more and more export. So the use of export credit insurance is increasing day by day, because the tool for export, Letter of Credit has some lickings. Letter of Credit has a significant cost disadvantage. It is not headache free for traders. It creates tremendous paper work for traders. Letter of credit uses specific dates and schedule for exporting. If the date somehow fails, this document has to be amended again. But Export credit insurance is burden free. Exporters’ purchases export credit insurance as a protection of default risk. Although this creates cost for the seller, the benefits more than compensate for the cost. If exporters are exporting and insisting on letters of credit as payment, they are probably losing business to competitors who are offering open terms. If this is the case, they should look into export credit insurance as an alternative to letters of credit. Credit insurers incorporate a number of factors in deriving the premiums they charge, including the financial stability of product buyers and the country in which the buyer resides. The latter is important for political considerations, which can affect the debtor’s commercial obligations. By financing its receivables, a company enhances its cash flow, that is, it gets cash from the bank immediately rather than waiting for shipments to be delivered and customers to pay their invoices. The customer also benefits. By integrating export credit insurance into a foreign sales strategy, exporters are provided with enormous flexibility and creativity in how they can structure a deal. Because the bank’s loan is backed by the credit insurance, it is possible to provide higher advance rates at less risk and perhaps include more receivables in the borrowing base. The insurance provides comfort, making it a larger, safer loan for the lender. From that perspective, all parties benefit.
10. Export Credit Insurance Typically Offered By Government Agencies:
Export credit insurance can be issued by government agencies as well as private agencies. But it is typically offered by government agencies. We know if a country’s export increases, government of that country also will earn more foreign currency. If an exporter gets order to export some goods, then the exporter also have to bring those goods from another place or bring the raw material to produce that goods. The exporter has to pay the price of raw material or goods after exporting and getting the price from the importer from which the exporter got the order to export goods. In that case the government agency will pay the price of those goods on behalf of the exporter to those from which the exporter brought the goods or raw materials. This is called export credit facility. Then, government gives the full coverage on that purchase by insurance. That means if the exporter face any difficulty or losses due to insolvency of importer from which the exporter got the order, government will insure the exporter. This is done typically by government agencies because export import is always a big concern of government. That’s why government wants to insure the exporter. But private agencies don’t want to insure the exporter typically, because, in that case there is a possibility of losses for private agencies. Private agencies don’t want to bear that much loss. If the government agencies face losses government will take care of it. But government does not back the private agencies, so private agencies don’t want to insure the export credit insurance. There are some purposes of government of issuing export credit insurance. Government wants to improve the export of its country. If exporters don’t get any insurance facility they will not be able to export that much which will hamper the earning of foreign currency. They will not get any help from bank because bank will not give the exporter money without insurance. So, there will be a problem of exporting. Again, if export increases, there will be a problem of dollar reser. As a result balance of payment will decrease in state bank. If dollar reserve increases the value of domestic currency will increases. All of these activities involve high level of risk. But private agencies don’t want to insure that much huge insurance policy due to high level of risk of losses. So the export credit insurance is typically offered by government agencies.
Export credit insurance arises when there is a risk associated with the payment of importer to exporter. It helps the exporter to get rid of losses due to non-payment or late payment from the insolvency, default or bankruptcy of importer. To help the exporters government issues export credit insurance for exporters. Export credit insurance system is a big opportunity for the exporters, because if exporters get some hope from government to export, they will increase the export. So government encourages the exporters by providing insurance policy. It helps a country’s exporter to compete in the global business. It helps to improve the country’s economic condition. With reduced non-payment risk exporter also can establish market share internationally. They will be able to get more help from bank with this insurance policy. It improves the exporter and importer. So importer will import more from exporter. So the exporter’s network will be increase. Government’s policy of export credit insurance helps the exporters to face a fair competition in global market. It also helps to reduce the political and commercial risks. Although the private and government agencies both issue export credit insurance, but the government agencies support is more secured and less risky for government. So export credit insurance is typically offered by government agencies.
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World Trade Organization. Deals with global rules of trade between nations. It is an organization that intends to supervise and liberalize international trade. The organization officially commenced on January 1, 1995 under the Marrakech Agreement, replacing the General Agreement on Tariffs and Trade (GATT), which commenced in 1948. The organization deals with regulation of trade between participating countries; it provides a framework for negotiating and formalizing trade agreements, and a dispute resolution process aimed at enforcing participants’ adherence to WTO agreements which are signed by representatives of member governments.
Economic and political union of 27 member states which are located primarily in Europe. The EU operates through a system of supranational independent institutions and intergovernmental negotiated decisions by the member states.
Absence of excessive fluctuation in the economy. An economy with fairly constant output growth and low and stable inflation would be considered economically stable. An economy with frequent large recessions, a pronounced business cycle, very high or variable inflation, or frequent financial crises would be considered economically unstable.
A legal status of an insolvent person or an organization, who cannot pay the debts.
High severity loss that does not lend itself to accurate prediction and should be transferred by the individual or business to an insurance company.
See, How Does the trade credit policy works? (Jones, P.M. (2010) Trade Credit Insurance, Washington DC, The World Bank, Page 11)
See, Kumar, M. (2000). Export Credit Insurance; An analysis. The Journal of Export Credit Insurance. Asia Insurance Post.(paragraph 18)