Export Trade Fiance - Negotiation under Documentary credit

Negotiation under Documentary credit is, under the export L/C, the beneficiary (Exporter) use some export documents as a mortgage to the local bank to do the financing before they receive the money from their buyers(importers).

Things to be noted:

1. The exporter must get the L/C first then apply for this financing before they receive the money from buyers
2. The mortgage must be the export documents.  Normally those export documents ≈ the L/C issued from issuing bank, so it has the value.  Thus, the local bank in exporter side can still sell or do some secondary mortgage in the secondary market to distribute the risk.

Why exporters use this service?

The exporter can do some short-term financing to accelerate the capital turnover and increase the exportation scale as well.  It only takes the documents as mortgage, so it is comparatively easier to get the money for exporters under L/C.

In other aspects, under the circumstances of local currency appreciation, the negotiation can turn the foreign currency into local currency earlier, so it is also a way to avoid the FX risk.

For example, Chinese Firm A choose L/C as the settlement method,  exports to Turkey some fibers valued USD 1000000.00. on 20/07/2005, and submit the L/C to a local bank. Under this L/C, the payment criteria are after 180 days of the submission of L/C. On that day, the FX is USD100 = CNY826.46, and firm can enjoy the USD interest rate 5.5% pa.  When RMB appreciates, Firm A has 2 choices :

1. Finance manager may think, even though the negotiation can turn the future-received USD into CNY to use now and avoid the FX risk. However, The company must pay the interest to the local bank (Interest cost). At that time, the USD/CNY 6-month forward FX settlement is discount. (6-month later's settlement price < current settlement price) . So compared with the current settlement price, the company has some loss. The finance manager decides not to use this service and collect the money when L/C matures. On 25/01/2006, Firm A received the money from the foreign bank. Due to an appreciation of RMB of 2 % on 21/07/2005. the exchange rate on 25/01/2006 is USD100=CNY800.06. And after deduction USD 1350 service charge from the bank, The money received in the end is (USD1000000.00 -USD1350.00) * 8.0006 = 7989799.19 yuan.
2. Finance manager considered the interest cost if apply for the negotiation but can avoid the FX risk and increase the capital turnover. So on 21/07/2005, firm A does the negotiation. the total interest cost for this service is : 

USD 1000000.00 * 5.5% * 180/360 = USD27500.00

       The earning in the end is :
             (USD1000000.00 - USD1350.00 - USD27500.00) * 8.2646 = 8026166.29 yuan

So the comparison between choice 1 and choice 2 is

8026166.29 - 7989799.19 = 36367.10 yuan

So Choice 2 is better. And this hasn't added into the RMB saving interest benefit of 180 days.


Characters of Negotiation :

1. This financing method is used after L/C is issued 
2. This financing method's time is short, normally <= 360 days. However, for Big Equipment exportation, the receivables time is 3 ~ 5 years, so in practice, the negotiation service is also 3 ~ 5 years. So, multiple negotiations are involved, each of which is <= 360 days as well. 
3. For banks to conduct this service, there is a limitation for the bank. Only negotiation bank/issuing bank/confirmation bank which is related to the L/C can conduct this service, otherwise, it's hard for other banks to tell the veracity of documents which involves a big risk. On the other side, if a bank only conducts the negotiation service for this L/C but not other correspondent services related to the L/C, (eg: L/C issuing, L/C processing), it can't maximize the profit for the bank. So banks only continue to do those negotiations for L/C issued himself.
4. Bank has the right of recourse, normally, the prioritized money source is from L/C, if the company can't timely receive the money from foreign clients, the export company must pay the bank principal + interest or auto deduct from company's bank account by the bank.

Procedures of Negotiation:

1. The export firm receives the L/C from foreign clients, then do the negotiation service from a local bank to get some financing.
2. Firm and local bank sign contract/agreement for this. stipulating fee and conditions. 
3. Bank from foreign client-side/Foreign Bank (L/C issuing bank/confirming bank) give the money to bank from exporter side (local bank/L/C Negotiation bank) when L/C matures. 
4. The local bank receives the money from the foreign bank and helps the applicant (exporter) pay the principal + interest(fees) in this bank and transfer the remainings into exporter's private bank account and inform the exporter in the end. 

How to calculate the interest?

Banks conducting the negotiation service normally don't collect fees but only collect the interest.

Negotiation interest  = Neotiation amount * interet rate * days/360

Exporter's receivables = negotiation amount - negotiation interest - bank fees

How does bank calculate Negotiation amount : 

Negotiation amount, in theory, can be 100% of L/C invoice amount. However in practice banks normally collect the interest in the first place (give out the money to exporter after deducting the interest first), so it's < 100% of L/C.

Under some circumstance of export, invoices stipulate some discount/commission
the negotiation amount shouldn't include them. For example, in a commercial invoice,

Total amount : USD100000.00,

Commission: 2%

Maximum negotiation amount : USD98000.00

Under some circumstance of export, some country has stamp duty tax, the export invoice amount and L/C amount has differences. then the bank will consider the lower one of 2 amounts.

Export invoice: USD98000.00,

L/C invoice amount: 95000.00%

Maximum negotiation amount : USD95000.00

How does bank confirm the interest rate :

Financing interest rate = Libor + Margin (0.5% ~ 1.5 %)

Difference between Packing loan and Negotiation :

1. Mortage is different, Packing loan takes the L/C as mortgage and negotiation take the documents as the mortgage.
2. Loan Amount is different, packing loan's loan amount <= 90% of L/C. Negotiation's loan amount <= 100% of some export bill/invoices. 
3. Usage is different. Packing loan's money can only be used for production/transportation... not some fix asset procurement. Negotiation's money has no limitation. 
4. Pressure is different. Packing loan is a financing method before all the documents ready. So exporter's pressure is little and it's good. Negotiation is a financing method after all documents ready. Exporters must produce, transport ... first incurring some expenses documents. So exporters have certain pressure.