ch 16 book notes u4 int business

reviewed exporting from a strategic perspective as a part of the chapter’s focus on entering foreign markets. We considered exporting as just one of a range of strategic options for profiting from international expansion. This chapter is more concerned with the nuts and bolts of exporting, along with tackling importing and countertrade. In some way, we can say that importing is exporting in reverse because the importing country and its companies buy from companies in other countries that are exporting. Unfortunately, the rules and regulations for importing and exporting are not always the same and, in fact, are often different in even the same country. Exporting is a tremendously important mode of foreign market entry, preferred by more than 90 percent of all companies engaging in the global marketplace. The reason exporting is preferred by such a large portion of companies engaging in the global marketplace is that most small- and medium-sized enterprises (SMEs) prefer exporting as a relatively low commitment to getting their products or services out globally. Importantly, these SMEs also make up more than 80 percent of companies going international from almost every country in the world. The volume of export activity in the world economy has increased as exporting has become easier from a large number of countries. Even countries now export themselves, such as France with its award-winning “Calling France” number. In a positive move for international trade, the gradual decline in trade barriers under the umbrella of the World Page 473 Trade Organization (see Chapter 7), along with regional economic agreements such as the European Union (EU) and the North American Free Trade Agreement (NAFTA) (see Chapter 9), has significantly increased export opportunities. Presumably, the new NAFTA—the United States–Mexico–Canada Agreement, or USMCA—if and when implemented fully will continue the increase in export opportunities in the region as well. At the same time, modern communication and transportation technologies have alleviated the logistical problems associated with exporting. Over the last two decades, firms have increasingly used e-commerce and international air services to reduce the costs, distance, and cycle time associated with exporting. Still, more than 90 percent of products and component parts still logistically get shipped via large ships around the world. Consequently, it is not unusual to find thriving exporters among small companies. In fact, of U.S. companies that trade internationally, some 85 percent of them are SMEs, and they generally do so via exporting. Nevertheless, exporting remains a challenge for many firms. Take the United States as an example. Fewer than 1 percent of all U.S. firms trade across their country borders to other countries, and those companies that do engage in trade do so with typically only one other country (about 60 percent of all U.S. companies that export trade only with one other country). This means that knowledge, data, and experience often are lacking, and smaller enterprises, in particular, can find the exporting process intimidating. Companies wishing to export must identify foreign market opportunities, avoid a host of unanticipated problems that are often associated with doing business in a foreign market, familiarize themselves with the mechanics of export and import financing, learn where they can get financing and export credit insurance, and learn how they should deal with foreign exchange risk. The process can be made more problematic by currencies that are not freely convertible. Arranging payment for exports to countries with weak currencies can be a problem. This is where countertrade comes in as a potential solution, and why we have made countertrade a focus in this chapter. Countertrade allows payment for exports to be made through goods and services rather than money. This chapter discusses all these issues, with the exception of foreign exchange risk, which was covered in Chapter 10. In Chapter 13, we dealt with the scale of market entry and strategic commitments in going international. Essentially, our focus was on involvement and commitment when engaging in the international marketplace. What we find is that the first international level for both involvement and commitment was the exporting (outbound international activity) and importing (inbound international activity) options. The remaining options for involvement and commitment, although they overlapped in some areas, were a bit different (Chapter 13 discusses turnkey projects, licensing, franchising, joint ventures, and wholly owned subsidiaries—the latter also a production facility focus in Chapter 15). That places a lot of emphasis on exporting and importing as modes of operations for many companies, and we think that this area deserves more coverage; thus, this chapter is devoted to digging deeper into the knowledge of operations (“nuts and bolts”) of exporting and importing as well as the unique case of countertrade. This is, after all, the lowest level of involvement and the lowest level of commitment a company can make when going international: selling to foreign markets (exporting) or purchasing raw materials, component parts, or finished goods for operations (importing). The bottom line is that as the global marketplace becomes more viable for many companies over time, companies must also adapt to this opportunity by strategically engaging in exporting (see Chapter 13) and operationally go about seeking opportunities globally. This could mean using suppliers from developing nations, importing products from new sources, or exporting products to new markets. Companies that have traditionally operated within national or regional trading groups may feel ill equipped to extend their market horizon. This may be as simple as feeling unable to select and manage a foreign supplier or not knowing how to sell products in a new country. But keep in mind that, by some accounts, 90 percent of the products and services that are needed locally are not produced locally; they are shipped in from somewhere else. And so, market opportunities are globally available everywhere and exporting and importing fill these voids. 1 The chapter opens in the next section by considering the promise and pitfalls of exporting. The logic for both exporting and importing is very similar. Readiness to export and/or import is a large part of the story, as illustrated in Figure 16.1.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. This was true for American universities in the opening case and for both Spotify and SoundCloud in the closing case later in this chapter. 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. For the U.S. higher-education system—where in-state tuition is usually much lower for college students attending publicly funded universities—the out-of-state and out-of-country tuition that foreign students pay significantly increase the revenues of these universities. For example, in-state, resident tuition and fees at Michigan State University are currently $14,522 for two semesters, but $41,328 for foreign students (for undergraduate education), a difference of $26,806. To make the math easy for this illustrative example only, let’s assume all students are undergraduates. Because Michigan State University has 6,243 foreign students enrolled (12.4 percent of the total students enrolled according to MSU’s official numbers), the university makes an additional $167.5 million. This is compared with if they enrolled the same number of students who are so-called in-state students, residing in the state of Michigan. Keep in mind that there are differences between undergraduate and graduate student costs and deductions for scholarships and stipends, so the exact numbers are slightly different in reality. However, the education-exporting case is powerful no matter how the calculations are done. The bottom line is that by expanding the size of the market, exporting can enable a firm to achieve economies of scale, thereby lowering its unit costs. For U.S higher education, it may mean slightly larger class sizes for teachers and students, which does not affect the costs but can bring in significant revenue. Page 475 Firms that do not export often lose out on significant opportunities for growth and cost efficiencies per unit sold. 3 Consider the case of Marlin Steel Wire Products, a Baltimore manufacturer of wire baskets and fabricated metal items with revenues of about $8 million. Among its products are baskets to hold dedicated parts for aircraft engines and automobiles. Its engineers design custom wire baskets for the assembly lines of companies such as Boeing and Toyota. It has a reputation for producing high-quality products for these niche markets. Like many small businesses, Marlin did not have a history of exporting. However, Marlin decided to engage globally in the export market, shipping small numbers of products to Mexico and Canada.Marlin’s president and CEO, Drew Greenblatt, soon realized that export sales could be the key to growth. In 2008, when the global financial crisis hit and America slid into a serious recession, Marlin was exporting only 5 percent of its orders to foreign markets. Greenblatt’s strategy for dealing with weak demand in the United States was to aggressively expand international sales. Marlin Steel has been exporting since they made the critical decision to do so in 2008, with sales made to more than 20 countries. About one-third of the company’s 45 employees are employed as a direct result of its export success. Now, exports account for some 40 percent of sales, and the company set a goal of exporting half its output. Despite examples such as Marlin Steel Wire Products, studies have shown that while many large firms tend to be proactive about seeking opportunities for profitable exporting—systematically scanning foreign markets to see where the opportunities lie for leveraging their technology, products, and marketing skills in foreign countries—many mediumsized and small firms are very reactive. 4 Typically, such reactive firms do not even consider exporting until their domestic market is saturated and the emergence of excess productive capacity at home forces them to look for growth opportunities in foreign markets. Many small- and medium-sized firms tend to wait for the world to come to them, rather than going out into the world to seek opportunities. Even when the world does come to them, they may not respond. An example is MMO Music Group, which makes sing-along tapes for karaoke machines. Foreign sales accounted for about 15 percent of MMO’s revenues of $8 million, but the firm’s CEO admits this figure would probably have been much higher had he paid attention to building international sales. Unanswered e-mails and phone messages from Asia and Europe often piled up while he was trying to manage the burgeoning domestic side of the business. By the time MMO did turn its attention to foreign markets, competitors had stepped into the breach, and MMO found it tough going to build export volume. 5 MMO’s experience is common, and it suggests a need for firms to become more proactive about seeking export opportunities. One reason more firms are not proactive is that they are unfamiliar with foreign market opportunities; they simply do not know how big the opportunities actually are or where they might lie. Simple ignorance of the potential opportunities is a huge barrier to exporting. 6 Also, many would-be exporters, particularly smaller firms, are often intimidated by the complexities and mechanics of exporting to countries where business practices, language, culture, legal systems, and currency are very different from those in the home market. 7 This combination of unfamiliarity and intimidation probably explains why exporters still account for only a tiny percentage of U.S. firms, less than 5 percent of firms with fewer than 500 employees, according to the Small Business Administration. 8 To make matters worse, many neophyte exporters run into significant problems when first trying to do business abroad, and this sours them on future exporting ventures. Common pitfalls include poor market analysis, a poor understanding of competitive conditions in the foreign market, a failure to customize the product offering to the needs of foreign customers, a lack of an effective distribution program, a poorly executed promotional campaign, and problems securing financing. 9 Novice exporters tend to underestimate the time and expertise needed to cultivate business in foreign countries. 10 Few realize the amount of management resources that have to be dedicated to this activity. Many foreign customers require face-to-face negotiations on their home turf. An exporter may have to spend months learning Page 476 about a country’s trade regulations, business practices, and more before a deal can be closed. The accompanying Management Focus, which documents the experience of Embraer, illustrates cultural barriers that sometimes can hinder both exporting and importing.Exporters often face voluminous paperwork, complex formalities, and many potential delays and errors. Exporting to Brazil is a unique experience in and of itself that still to this day often requires more than just following the rules and regulations stipulated by the country. According to a United Nations report on trade and development, a typical international trade transaction may involve 30 parties, 60 original documents, and 360 document copies—all of which have to be checked, transmitted, reentered into various information systems, processed, and filed. The UN has calculated that the time involved in preparing documentation, along with the costs of common errors in paperwork, often amounts to 10 percent of the final value of goods exported Identify the steps managers can take to improve their firm’s export performance. Inexperienced exporters have a number of ways to gain information about foreign market opportunities and avoid common pitfalls that tend to discourage and frustrate novice exporters. 12 In this section, we look at information sources for exporters to increase their knowledge of foreign market opportunities, we consider a number of service providers, we review various exporting strategies that can increase the probability of successful exporting, and we illustrate the globalEDGE™ Diagnostic Tool called Company Readiness to Export (CORE) that can help exporters. We begin, however, with a look at how several nations try to help domestic firms export. INTERNATIONAL COMPARISONS One big impediment to exporting is the simple lack of knowledge of the opportunities available. Often, there are many markets for a firm’s product, but because they are in countries separated from the firm’s home base by culture, language, distance, and time, the firm does not know of them. Identifying export opportunities is made even more complex because almost 195 countries with widely differing cultures compose the world of potential opportunities. Faced with such complexity and diversity, firms sometimes hesitate to seek export opportunities. The way to overcome ignorance is to collect information. In Germany—one of the world’s most successful exporting nations—trade associations, government agencies, and commercial banks gather information, helping small firms identify export opportunities. A similar function is provided by the Japanese Ministry of International Trade and Industry (MITI), which is always on the lookout for export opportunities. In addition, many Japanese firms are affiliated in some way with the sogo shosha, Japan’s great trading houses. The sogo shosha have offices all over the world, and they proactively, continuously seek export opportunities for their affiliated companies large and small. 13 German and Japanese firms can draw on the large reservoirs of experience, skills, information, and other resources of their respective export-oriented institutions. Unlike their German and Japanese competitors, many U.S. firms are relatively blind when they seek export opportunities; they are information-disadvantaged. In part, this reflects historical differences. Both Germany and Japan have long made their living as trading nations, whereas until recently, the United States has been a relatively self-contained continental economy in which international trade played a minor role. This is changing; both imports and exports now play a greater role in the U.S. economy than they did 20 years ago. However, the United States has not yet created an institutional structure for promoting exports similar to that of Germany or Japan. INFORMATION SOURCES Despite institutional disadvantages, U.S. firms can increase their awareness of export opportunities. The most comprehensive source of information is the U.S. Department of Commerce and its district offices all over the country (U.S. Export Assistance Centers, USEAC). Within that department are two organizations dedicated to providing businesses with intelligence and assistance for attacking foreign markets: U.S. and Foreign Commercial Service and International Trade Administration (ITA). ITA regularly publishes A Guide to Exporting. This is the United States’ “Official Government Resource for Small and Medium-Sized Businesses” in their exporting quest. The U.S. and Foreign Commercial Service and International Trade Administration are governmental agencies that provide the potential exporter with a “best prospects” list, which gives the names and addresses of potential distributors in foreign markets along with businesses they are in, the products they handle, and their contact person. In addition, the Department of Commerce has assembled a “comparison shopping service” for countries that are major markets for U.S. exports. For a small fee, a firm can receive a customized market research survey on a product of its choice. This survey provides information on marketability, the competition, comparative prices, distribution channels, and names of potential sales representatives. Each study is conducted on site by an officer of the Department of Commerce. The Department of Commerce also organizes trade events that help potential exporters make foreign contacts and explore export opportunities. The department organizes exhibitions at international trade fairs, which are held regularly in major cities worldwide. The department also has a matchmaker program, in which department representatives Affiliated with the U.S. Department of Commerce and its USEAC offices is a set of District Export Councils (DECs; connected also via the National District Export Council). DECs are composed of some 1,500 volunteers appointed by the U.S. Secretary of Commerce to help U.S. business be more competitive internationally. Another governmental organization, the Small Business Administration (SBA), can help potential exporters (see the accompanying Management Focus on exporting desserts for an example of the SBA’s work). The SBA employs 76 district international trade officers and 10 regional international trade officers throughout the United States, as well as a 10-person international trade staff in Washington, DC. Among the SBA’s no-fee services are Small Business Development Centers (SBDCs), the Service Corps of Retired Executives (SCORE), and the Export Legal Assistance Network (ELAN). The SBDCs around the country provide a full range of export assistance to business, particularly small companies new to exporting. Through SCORE, the SBA oversees some 11,500 volunteers with international trade experience to provide one-on-one counseling to active and new-to-export businesses. The SBA also coordinates ELAN, a nationwide group of international trade attorneys who provide free initial consultations to small businesses on exportrelated matters. The United States has also established a set of 15 Centers for International Business Education and Research (CIBERs), which assist with exporting needs. The CIBERs were created by the U.S. Congress under the Omnibus Trade and Competitiveness Act of 1988 to increase and promote the nation’s capacity for international understanding and competitiveness. Administered by the U.S. Department of Education, the CIBER network links the human resource and technological needs of the U.S. business community with the international education, language training, and research capacities of universities across the country. The 15 CIBERs, including the University of Washington where the author of this text is a professor (www2.ed.gov/programs/iegpscibe), serve as regional and national resources to businesspeople, students, and teachers at all levels. Many countries around the world are trying to replicate the U.S. CIBER initiative (e.g., the European Union). Additionally, the vast majority of U.S. states, regions, and many large cities maintain active trade commissions whose purpose is to promote exports. Most of these provide business counseling, information gathering, technical assistance, and financing. Unfortunately, many have fallen victim to budget cuts or to turf battles for political and financial support with other export agencies. Page 480 A number of private organizations are also beginning to provide more assistance to would-be exporters. Commercial banks and major accounting firms are more willing to assist small firms in starting export operations than they were a decade ago. In addition, large multinationals that have been successful in the global arena are typically willing to discuss opportunities overseas with the owners or managers of small firms. 14 SERVICE PROVIDERS Most companies that engage in international trade enlist the help of export–import service providers, but there are many choices. Let’s look at the main ones: freight forwarders, export management companies, export trading companies, export packaging companies, customs brokers, confirming houses, export agents and merchants, piggyback marketing, and economic processing zones. Freight forwarders are mainly in business to orchestrate transportation for companies that are shipping internationally. Their primary task is to combine smaller shipments into a single large shipment to minimize the shipping cost. Freight forwarders also provide other services that are beneficial to the exporting firm, such as documentation, payment, and carrier selection. An export management company (EMC) offers services to companies that have not previously exported products. EMCs offer a full menu of services to handle all aspects of exporting, similar to having an internal exporting department within your own firm. For example, EMCs deal with export documents and operate as the firm’s agent and distributor; this may include selling the products directly or operating a sales unit to process sales orders. Export trading companies export products for companies that contract with them. They identify and work with companies in foreign countries that will market and sell the products. They provide comprehensive exporting services, including export documentation, logistics, and transportation. Export packaging companies, or export packers for short, provide services to companies that are unfamiliar with exporting. For example, some countries require packages to meet certain specifications, and the export packaging firm’s knowledge of these requirements is invaluable to new exporters in particular. The export packer can also advise companies on appropriate design and materials for the packaging of their items. Export packers can assist companies in minimizing packaging to maximize the number of items to be shipped. Customs brokers can help companies avoid the pitfalls involved in customs regulations. The customs requirements of many countries can be difficult for new or infrequent exporters to understand, and the knowledge and experience of the customs broker can be very important. For example, many countries have certain laws and documentation regulations concerning imported items that are not always obvious to the exporter. Customs brokers can offer a firm a complete package of services that are essential when a firm is exporting to a large number of countries. Confirming houses, sometimes called buying agents, represent foreign companies that want to buy your products. Typically, they try to get the products they want at the lowest prices and are paid a commission by their foreign clients. A good place to find these potential exporting linkages is via government embassies. Export agents, merchants, and remarketers buy products directly from the manufacturer and package and label the products in accordance with their own wishes and specifications. They then sell the products internationally through their own contacts under their own names and assume all risks. The effort it takes for you to market the product internationally is very small, but you also lose any control over the marketing, promotion, and positioning of your product. Piggyback marketing is an arrangement whereby one firm distributes another firm’s products. For example, a firm may have a contract to provide an assortment of products to an overseas client, but it does not have all the products requested. In such cases, another firm can piggyback its products to fill the contract’s requirements. Successful piggybacking usually requires complementary products and the same target market of customers. There are now more than 600 export processing zones (EPZs) in the world, and they exist in more than 100 countries. The EPZs include foreign trade zones (FTZs), special economic zones, bonded warehouses, free ports, and customs zones. Many companies use EPZs to receive shipments of products that are then reshipped in smaller lots to customers throughout the surrounding areas. Founded in 1978 by the United Nations, the World Economic Processing Zones Association (wepza.org) is a private nonprofit organization dedicated to the improvement of the efficiency of all EPZs. EXPORT STRATEGY In addition to using export service providers, a firm can reduce the risks associated with exporting if it is careful about its choice of export strategy. 15 A few guidelines can help firms improve their odds of success. For example, one of the most successful exporting firms in the world, 3M (originally, Minnesota Mining & Manufacturing Company), has built its export success on three main principles: enter on a small scale to reduce risks, add additional product lines once the exporting operations start to become successful, and hire locals to promote the firm’s products. Another company—Two Men and a Truck (profiled in the accompanying Management Focus)—has had global success with a franchising approach. The probability of exporting successfully can be increased dramatically by taking a handful of simple strategic steps. First, particularly for the novice exporter, it helps to hire an EMC or at least an experienced export consultant to identify opportunities and navigate the paperwork and regulations so often involved in exporting. Second, it often makes sense to initially focus on one market or a handful of markets. Learn what is required to succeed in those markets before moving to other markets. The firm that enters many markets at once runs the risk of spreading its limited management resources too thin. The result of such a shotgun approach to exporting may be a failure to become established in any one market. Third, as with Two Men and a Truck, it often makes sense to enter a foreign market on a small scale to reduce the costs of any subsequent failure. Most important, entering on a small scale provides the time and opportunity to learn about the foreign country before making significant capital commitments to that market. Fourth, the exporter needs to recognize the time and managerial commitment involved in building export sales and should hire additional personnel to oversee this activity. Fifth, in many countries, it is important to devote a lot of attention to building strong and enduring relationships with local distributors and/or customers. Sixth, as 3M often does, it is important to hire local personnel to help the firm establish itself in a foreign market. Local people are likely to have a much greater sense of how to do business in a given country than a manager from an exporting firm who has previously never set foot in that country. Seventh, several studies have suggested the firm needs to be proactive about seeking export opportunities. 16 Armchair exporting does not work! The world will not normally beat a pathway to your door. Finally, it is important for the exporter to retain the option of local production. Once exports reach a sufficient volume to justify cost-efficient local production, the exporting firm should consider establishing production facilities in the foreign market. Such localization helps foster good relations with the foreign country and can lead to greater market acceptance. Exporting is often not an end in itself but merely a step on the road toward establishment of foreign production (again, 3M provides an example of this philosophy). THE GLOBALEDGE™ EXPORTING TOOL In Chapter 1, we introduced the globalEDGE™ website (globaledge.msu.edu), a product of the International Business Center in the Broad College of Business at Michigan State University. globalEDGE™ has been the top-ranked website in the world for “international business resources” on Google since 2004. Some 10 million people now use globalEDGE™, with about 2 million active users. The site is free, including the “Diagnostic Tools” section. In that section of the site, the Company Readiness to Export (CORE) tool has become a frequently used option by a variety of small, medium, and large firms to assess (1) a company’s readiness to export a product and (2) the product’s readiness to be exported. CORE (Company Readiness to Export) assists firms in self-assessment of their exporting proficiency, evaluates both the firm’s and the intended product’s readiness to be taken internationally, and systematically identifies the firm’s strengths and weaknesses within the context of exporting (see Figure 16.2). The CORE tool also serves as a tutorial in exporting and has been used by the U.S. Department of Commerce, U.S. District Export Councils, and other exporting facilitators to help companies succeed with their exporting. Recognize the basic steps involved in export financing. Mechanisms for financing exports and imports have evolved over the centuries in response to a problem that can be particularly acute in international trade: the lack of trust that exists when one must put faith in a stranger. In this section, we examine the financial devices that have evolved to cope with this problem in the context of international trade: the letter of credit, the draft (or bill of exchange), and the bill of lading. Then we trace the 14 steps of a typical export– import transaction. 17 LACK OF TRUST Firms engaged in international trade have to trust someone they may have never seen, who lives in a different country, who speaks a different language, who abides by (or does not abide by) a different legal system, and who could be very difficult to track down if he or she defaults on an obligation. Consider a U.S. firm exporting to a distributor in France. The U.S. businessperson might be concerned that if he ships the products to France before he receives payment from the French businessperson, she might take delivery of the products and not pay him. Conversely, the French importer might worry that if she pays for the products before they are shipped, the U.S. firm might keep the money and never ship the products or might ship defective products. Neither party to the exchange completely trusts the other. This lack of trust is exacerbated by the distance between the two parties—in space, language, and culture—and by the problems of using an underdeveloped international legal system to enforce contractual obligations. Page 484 Due to the (quite reasonable) lack of trust between the two parties, each has his or her own preferences as to how the transaction should be configured. To make sure he is paid, the manager of the U.S. firm would prefer the French distributor to pay for the products before he ships them (see Figure 16.4). Alternatively, to ensure she receives the products, the French distributor would prefer not to pay for them until they arrive (see Figure 16.5). Thus, each party has a different set of preferences. Unless there is some way of establishing trust between the parties, the transaction might never occur. The problem is solved by using a third party trusted by both—normally a reputable bank—to act as an intermediary. What happens can be summarized as follows (see Figure 16.6). First, the French importer obtains the bank’s promise to pay on her behalf, knowing the U.S. exporter will trust the bank. This promise is known as a letter of credit. Having seen the letter of credit, the U.S. exporter now ships the products to France. Title to the products is given to the bank in the form of a document called a bill of lading. In return, the U.S. exporter tells the bank to pay for the products, which the bank does. The document for requesting this payment is referred to as a draft. The bank, having paid for the products, now passes the title on to the French importer, whom the bank trusts. At that time or later, depending on their agreement, the importer reimburses the bank. In the remainder of this section, we examine how this system works in more detail. 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. Consider again the example of the U.S. exporter and the French importer. The French importer applies to her local bank, say, the Bank of Paris, for the issuance of a letter of credit. The Bank of Paris then undertakes a credit check of the importer. If the Bank of Paris is satisfied with her creditworthiness, it will issue a letter of credit. However, the Bank of Paris might require a cash deposit or some other form of collateral from her first. In addition, the Bank of Paris will charge the importer a fee for this service. Typically, this amounts to between 0.5 and 2 percent of the value of the letter of credit, depending on the importer’s creditworthiness and the size of the transaction. (As a rule, the larger the transaction, the lower the percentage.) Assume the Bank of Paris is satisfied with the French importer’s creditworthiness and agrees to issue a letter of credit. The letter states that the Bank of Paris will pay the U.S. exporter for the merchandise as long as it is shipped in accordance with specified instructions and conditions. At this point, the letter of credit becomes a financial contract between the Bank of Paris and the U.S. exporter. The Bank of Paris then sends the letter of credit to the U.S. exporter’s bank, say, the Bank of New York. The Bank of New York tells the exporter that it has received a letter of credit and that he can ship the merchandise. After the exporter has shipped the merchandise, he draws a draft against the Bank of Paris in accordance with the terms of the letter of credit, attaches the required documents, and presents the draft to his own bank, the Bank of New York, for payment. The Bank of New York then forwards the letter of credit and associated documents to the Bank of Paris. If all the terms and conditions contained in the letter of credit have been complied with, the Bank of Paris will honor the draft and will send payment to the Bank of New York. When the Bank of New York receives the funds, it will pay the U.S. exporter. As for the Bank of Paris, once it has transferred the funds to the Bank of New York, it will collect payment from the French importer. Alternatively, the Bank of Paris may allow the importer some time to resell the merchandise before requiring payment. This is not unusual, particularly when the importer is a distributor and not the final consumer of the merchandise because it helps the importer’s cash flow. The Bank of Paris will treat such an extension of the payment period as a loan to the importer and will charge an appropriate rate of interest. The great advantage of this system is that both the French importer and the U.S. exporter are likely to trust reputable banks, even if they do not trust each other. Once the U.S. exporter has seen a letter of credit, he knows that he is guaranteed payment and will ship the merchandise. Also, an exporter may find that having a letter of credit will facilitate obtaining pre-export financing. For example, having seen the letter of credit, the Bank of New York might be willing to lend the exporter funds to process and prepare the merchandise for shipping to France. This loan may not have to be repaid until the exporter has received his payment for the merchandise. As for the French importer, she does not have to pay for the merchandise until the documents have arrived and unless all conditions stated in the letter of credit have been satisfied. The drawback for the importer is the fee she must pay the Bank of Paris for the letter of credit. In addition, because the letter of credit is a financial liability against her, it may reduce her ability to borrow funds for other purposes. 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. In the example of the U.S. exporter and the French importer, the exporter writes a draft that instructs the Bank of Paris, the French importer’s agent, to pay for the merchandise shipped to France. The person or business initiating the draft is known as the maker (in this case, the U.S. exporter). The party to whom the draft is presented is known as the drawee (in this case, the Bank of Paris). International practice is to use drafts to settle trade transactions. This differs from domestic practice in which a seller usually ships merchandise on an open account, followed by a commercial invoice that specifies the amount due and the terms of payment. In domestic transactions, the buyer can often obtain possession of the merchandise without signing a formal document acknowledging his or her obligation to pay. In contrast, due to the lack of trust in international transactions, payment or a formal promise to pay is required before the buyer can obtain the merchandise. Drafts fall into two categories: sight drafts and time drafts. A sight draft is payable on presentation to the drawee. A time draft allows for a delay in payment—normally 30, 60, 90, or 120 days. It is presented to the drawee, who signifies acceptance of it by writing or stamping a notice of acceptance on its face. Once accepted, the time draft becomes a promise to pay by the accepting party. When a time draft is drawn on and accepted by a bank, it is called a banker’s acceptance. When it is drawn on and accepted by a business firm, it is called a trade acceptance. Time drafts are negotiable instruments—that is, once the draft is stamped with acceptance, the maker can sell the draft to an investor at a discount from its face value. Imagine that the agreement between the U.S. exporter and the French importer calls for the exporter to present the Bank of Paris (through the Bank of New York) with a time draft requiring payment 120 days after presentation. The Bank of Paris stamps the time draft with an acceptance. Imagine further that the draft is for $100,000. The exporter can either hold onto the accepted time draft and receive $100,000 in 120 days or sell it to an investor, say, the Bank of New York, for a discount from the face value. If the prevailing discount rate is 7 percent, the exporter could receive $97,700 by selling it immediately (7 percent per year discount rate for 120 days for $100,000 equals $2,300, and $100,000 − $2,300 = $97,700). The Bank of New York would then collect the full $100,000 from the Bank of Paris in 120 days. The exporter might sell the accepted time draft immediately if he needed the funds to finance merchandise in transit and/or to cover cash flow shortfalls. BILL OF LADING The third key document for financing international trade is the bill of lading. The bill of lading is issued to the exporter by the common carrier transporting the merchandise. It serves three purposes: It is a receipt, a contract, and a document of title. As a receipt, the bill of lading indicates that the carrier has received the merchandise described on the face of the document. As a contract, it specifies that the carrier is obligated to provide transportation service in return for a certain charge. As a document of title, it can be used to obtain payment or a written promise of payment before the merchandise is released to the importer. 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 final payment by the importer. A TYPICAL INTERNATIONAL TRADE TRANSACTION Now that we have reviewed the elements of an international trade transaction, let us see how the process works in a typical case, sticking with the example of the U.S. exporter and the French importer. The typical transaction involves 14 steps (see Figure 16.7).The French importer places an order with the U.S. exporter and asks the American if he would be willing to ship under a letter of credit. The U.S. exporter agrees to ship under a letter of credit and specifies relevant information such as prices and delivery terms. The French importer applies to the Bank of Paris for a letter of credit to be issued in favor of the U.S. exporter for the merchandise the importer wishes to buy. The Bank of Paris issues a letter of credit in the French importer’s favor and sends it to the U.S. exporter’s bank, the Bank of New York. The Bank of New York advises the exporter of the opening of a letter of credit in his favor. The U.S. exporter ships the goods to the French importer on a common carrier. An official of the carrier gives the exporter a bill of lading. The U.S. exporter presents a 90-day time draft drawn on the Bank of Paris in accordance with its letter of credit and the bill of lading to the Bank of New York. The exporter endorses the bill of lading so title to the goods is transferred to the Bank of New York. The Bank of New York sends the draft and bill of lading to the Bank of Paris. The Bank of Paris accepts the draft, taking possession of the documents and promising to pay the now-accepted draft in 90 days. The Bank of Paris returns the accepted draft to the Bank of New York. The Bank of New York tells the U.S. exporter that it has received the accepted bank draft, which is payable in 90 days. The exporter sells the draft to the Bank of New York at a discount from its face value and receives the discounted cash value of the draft in return. The Bank of Paris notifies the French importer of the arrival of the documents. She agrees to pay the Bank of Paris in 90 days. The Bank of Paris releases the documents so the importer can take possession of the shipment. In 90 days, the Bank of Paris receives the importer’s payment, so it has funds to pay the maturing draft. Prospective U.S. exporters can draw on two forms of government-backed assistance to help finance their export programs. They can get financing aid from the Export-Import Bank and export credit insurance from the Foreign Credit Insurance Association (similar programs are available in most countries). THE EXPORT-IMPORT BANK The Export-Import Bank (EXIM Bank) is a wholly owned U.S. government corporation that was established in 1934. Its mission is to assist in the financing of U.S. exports of products and services to support U.S. employment and market competitiveness. Based on its charter and mandate from the U.S. Congress, the EXIM Bank’s financing must have a “reasonable assurance of repayment” and should supplement, and not compete with, private capital lending. The EXIM Bank also follows the international rules for government-backed export credit activity under the Organisation for Economic Co-operation and Development (OECD). The EXIM Bank reported authorizing about $20.5 billion for 3,746 transactions of finance and insurance to support some $27.5 billion in U.S. exports and 164,000 U.S. jobs the last year it was fully operational. The EXIM Bank’s overall exposure was $112 billion, below the $140 billion statutory cap for its fiscal year. Interestingly, 2014 was the last year the EXIM Bank was fully operational due to a lack of quorum on the board of directors. But the EXIM Bank’s financing of exports of U.S. goods and services still supported more than 50,000 jobs in the last year completed (2018), even with a smaller operation. As an example, when the author revised this textbook, the EXIM Bank had in its pipeline almost $40 billion of pending transactions that are estimated to support nearly 240,000 American jobs. Overall, the EXIM Bank pursues its mission with various loan and loan-guarantee programs. The agency guarantees repayment of medium- and long-term loans that U.S. commercial banks make to foreign borrowers for purchasing U.S. exports. The EXIM Bank guarantee makes the commercial banks more willing to lend cash to foreign enterprises. This facilitates cross-border trade by U.S. companies. About 85 percent of the banks’ transactions support small businesses (under 500 employees).The EXIM Bank also has a direct lending operation under which it lends dollars to foreign borrowers for use in purchasing U.S. exports. In some cases, it grants loans that commercial banks would not if it sees a potential benefit to the United States in doing so. The foreign borrowers use the loans to pay U.S. suppliers and repay the loan to the EXIM Bank with interest. Using the structure of the U.S. EXIM Bank, many countries now have their own export-import banks to facilitate cross-border trade (e.g., China, India). EXPORT CREDIT INSURANCE For reasons outlined earlier, 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. 18 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 the United States, export credit insurance is provided by the Foreign Credit Insurance Association (FCIA), an association of private commercial institutions operating under the guidance of the Export-Import Bank. The FCIA provides coverage against commercial risks and political risks. Losses due to commercial risk result from the buyer’s insolvency or payment default. Political losses arise from actions of governments that are beyond the control of either buyer or seller. Marlin, the small Baltimore manufacturer of wire baskets discussed earlier, credits export credit insurance with giving the company the confidence to push ahead with export sales. For a premium of roughly half a percent ageof thepr i ceof a sal e, Marl i n has beenabl e to i nsur e i tsel f agai nst the possibi li t yof nonpayment bya for eign buyer. Countertrade is an alternative means of structuring an international sale when conventional means of payment are difficult, costly, or nonexistent. We first encountered countertrade in Chapter 10’s discussion of currency convertibility. A government may restrict the convertibility of its currency to preserve its foreign exchange reserves so they can be used to service international debt commitments and purchase crucial imports. 20 This is problematic for exporters. Nonconvertibility implies that the exporter may not be paid in his or her home currency, and few exporters would desire payment in a currency that is not convertible. Countertrade is a common solution. 21 Countertrade denotes a range of barterlike agreements; its principle is to trade goods and services for other goods and services when they cannot be traded for money. Some examples of countertrade are An Italian company that manufactures power-generating equipment, ABB SAE Sadelmi SpA, was awarded a 720 million baht ($17.7 million) contract by the Electricity Generating Authority of Thailand. The contract specified that the company had to accept 218 million baht ($5.4 million) of Thai farm products as part of the payment. Saudi Arabia agreed to buy ten 747 jets from Boeing with payment in crude oil, discounted at 10 percent below posted world oil prices. General Electric won a contract for a $150 million electric generator project in Romania by agreeing to market $150 million of Romanian products in markets to which Romania did not have access. • • • Page 491 Page 490 The Venezuelan government negotiated a contract with Caterpillar under which Venezuela would trade 350,000 tons of iron ore for Caterpillar earthmoving equipment. Albania offered such items as spring water, tomato juice, and chrome ore in exchange for a $60 million fertilizer and methanol complex. Philip Morris shipped cigarettes to Russia, for which it received chemicals that can be used to make fertilizer. Philip Morris shipped the chemicals to China, and in return, China shipped glassware to North America for retail sale by Philip Morris. 22 THE POPULARITY OF COUNTERTRADE C o u nt e r t r a d e e me r ge d i n t h e 1 9 60s as a wayfor t heoldSovi et Uni onand t hethen-comuni st sta t es of easternEuropwhose currencies were generally nonconvertible, to purchase imports. The technique has grown in popularity among many developing nations that lack the foreign exchange reserves required to purchase necessary imports. Also, reflecting their own shortages of foreign exchange reserves, some successor states to the former Soviet Union and the eastern European communist nations periodically engage in countertrade to purchase their imports. Estimates of the percentage of world trade covered by some sort of countertrade agreement grew from 2 to 10 percent about a decade ago to, by most estimates, some 20 to 25 percent today. 23 The precise figure is unknown, but it is probably at the very low end of these estimates, given the increasing liquidity of international financial markets and wider currency convertibility. However, a short-term spike in the volume of countertrade can follow periodic financial crises (e.g., 1997, 2008). For example, countertrade activity increased notably after the Asian financial crisis of 1997. That crisis left many Asian nations with little hard currency to finance international trade. In the tight monetary regime that followed the crisis in 1997, many Asian firms found it very difficult to get access to export credit to finance their own international trade. Thus, they turned to the only option available to them—countertrade. Given that countertrade is a means of financing international trade, albeit a minor one, prospective exporters may have to engage in this technique from time to time to gain access to certain international markets. The governments of developing nations sometimes insist on a certain amount of countertrade. 24 TYPES OF COUNTERTRADE With its roots in the simple trading of goods and services for other goods and services, countertrade has evolved into a diverse set of activities that can be categorized as five distinct types of trading arrangements: barter, counterpurchase, offset, switch trading, and compensation or buyback. 25 Many countertrade deals involve not just one arrangement but elements of two or more. Barter Barter is the direct exchange of goods and/or services between two parties without a cash transaction. Although barter is the simplest arrangement, it is not common. Its problems are twofold. First, if goods are not exchanged simultaneously, one party ends up financing the other for a period. Second, firms engaged in barter run the risk of having to accept goods they do not want, cannot use, or have difficulty reselling at a reasonable price. For these reasons, barter is viewed as the most restrictive countertrade arrangement. It is primarily used for one-time-only deals in transactions with trading partners who are not creditworthy or trustworthy. Counterpurchase Counterpurchase is a reciprocal buying agreement. It occurs when a firm agrees to purchase a certain amount of materials back from a country to which a sale is made. Suppose a U.S. firm sells some products to China. China pays the U.S. firm in dollars, but in exchange, the U.S. firm agrees to spend some of its proceeds from the sale on textiles produced by China. Thus, although China must draw on its foreign exchange reserves to pay the U.S. firm, it knows it will receive some of those dollars back because of the counterpurchase agreement. In one counterpurchase agreement, Rolls-Royce sold jet parts to Finland. As part of the deal, Rolls-Royce agreed to use some of the proceeds from the sale to purchase Finnish-manufactured TV sets that it would then sell in Great Britain. Offset An offset is similar to a counterpurchase insofar as one party agrees to purchase goods and services with a specified percentage of the proceeds from the original sale. The difference is that this party can fulfill the obligation with any firm in the country to which the sale is being made. From an exporter’s perspective, this is more attractive than a straight counterpurchase agreement because it gives the exporter greater flexibility to choose the goods that it wishes to purchase. Switch Trading The term switch trading refers to the use of a specialized third-party trading house in a countertrade arrangement. When Page 492 a firm enters a counterpurchase or offset agreement with a country, it often ends up with what are called counterpurchase credits, which can be used to purchase goods from that country. Switch trading occurs when a third-party trading house buys the firm’s counterpurchase credits and sells them to another firm that can better use them. For example, a U.S. firm concludes a counterpurchase agreement with Poland for which it receives some number of counterpurchase credits for purchasing Polish goods. The U.S. firm cannot use and does not want any Polish goods, however, so it sells the credits to a third-party trading house at a discount. The trading house finds a firm that can use the credits and sells them at a profit. In one example of switch trading, Poland and Greece had a counterpurchase agreement that called for Poland to buy the same U.S.-dollar value of goods from Greece that it sold to Greece. However, Poland could not find enough Greek goods that it required, so it ended up with a dollar-denominated counterpurchase balance in Greece that it was unwilling to use. A switch trader bought the right to 250,000 counterpurchase dollars from Poland for $225,000 and sold them to a European sultana (grape) merchant for $235,000, who used them to purchase sultanas from Greece. Compensation or Buybacks A buyback occurs when a firm builds a plant in a country—or supplies technology, equipment, training, or other services to the country—and agrees to take a certain percentage of the plant’s output as partial payment for the contract. For example, Occidental Petroleum negotiated a deal with Russia under which Occidental would build several ammonia plants in Russia and as partial payment receive ammonia over a 20-year period. PROS AND CONS OF COUNTERTRADE Countertrade’s main attraction is that it can give a firm a way to finance an export deal when other means are not available. Given the problems that many developing nations have in raising the foreign exchange necessary to pay for imports, countertrade may be the only option available when doing business in these countries. Even when countertrade is not the only option for structuring an export transaction, many countries prefer countertrade to cash deals. Thus, if a firm is unwilling to enter a countertrade agreement, it may lose an export opportunity to a competitor that is willing to make a countertrade agreement.In addition, a countertrade agreement may be required by the government of a country to which a firm is exporting goods or services. Boeing often has to accept counterpurchase agreements to capture orders for its commercial jet aircraft. For example, in exchange for gaining an order from Air India, Boeing may be required to purchase certain component parts, such as aircraft doors, from an Indian company. Taking this one step further, Boeing can use its willingness to enter into a counterpurchase agreement as a way of winning orders in the face of intense competition from its global rival, Airbus. Thus, countertrade can become a strategic marketing weapon. However, the drawbacks of countertrade agreements are substantial. Other things being equal, firms would normally prefer to be paid in hard currency. Countertrade contracts may involve the exchange of unusable or poorquality goods that the firm cannot dispose of profitably. For example, a few years ago, one U.S. firm got burned when 50 percent of the television sets it received in a countertrade agreement with Hungary were defective and could not be sold. In addition, even if the goods it receives are of high quality, the firm still needs to dispose of them profitably. To do this, countertrade requires the firm to invest in an in-house trading department dedicated to arranging and managing countertrade deals. This can be expensive and time-consuming. Given these drawbacks, countertrade is most attractive to large, diverse multinational enterprises that can use their Page 493 worldwide network of contacts to dispose of goods acquired in countertrading. The masters of countertrade are Japan’s giant trading firms, the sogo shosha, which use their vast networks of affiliated companies to profitably dispose of goods acquired through countertrade agreements. The trading firm of Mitsui & Company, for example, has about 120 affiliated companies in almost every sector of the manufacturing and service industries. If one of Mitsui’s affiliates receives goods in a countertrade agreement that it cannot consume, Mitsui & Company will normally be able to find another affiliate that can profitably use them. Firms affiliated with one of Japan’s sogo shosha often have a competitive advantage in countries where countertrade agreements are preferred. Western firms that are large, diverse, and have a global reach (e.g., General Electric, Philip Morris, and 3M) have similar profit advantages from countertrade agreements. Indeed, 3M has established its own trading company—3M Global Trading Inc.—to develop and manage the company’s international countertrade programs. Unless there is no alternative, small and medium-sized exporters should probably try to avoid countertrade deals because they lack the worldwide network of operations that may be required to profitably utilize or dispose of goods acquired through them.