Forfaiting is on the up and China is proving to be one of the most popular destinations for this established method of trade finance. Lower interest rates and a decline in cover provided by export credit agencies, is turning exporters towards forfaiting in capital construction projects and commodity deals. More countries are coming into play in a market which has had no major tremors since the collapse in payments from Iran and the ex-Soviet Union.
Forfaiting is a relatively straightforward method of financing where the exporter agrees to surrender the rights to claim for payment on goods or services delivered to an importer under a contract of sale in return for a cash payment from a forfaiting bank. The exporter is only liable for the quality and reliability of the project. Importantly in a developing market such as China, the supplier or exporter grants credit terms to the buyer or importer and repayment is guaranteed by a bank in the importing country.. Transaction amounts range from US$250,000 up to tens of tens of millions of dollars, depending on the nature of the project and country.
Forfaiters make their money on the margins of discount. As in other financial markets, the higher the risk the more expensive the finance. Deals in China are currently for a maximum of five years at rates in London around two per cent above the London Interbank Offered Rate (Libor), which is better than for the likes of Vietnam, Argentina or Mexico.
Forfaiting accounts for between 0.5 per cent and 1 per cent of world trade, representing a total volume of outstanding deals of US$20bn-30bn. Whilst this is a tiny proportion, it is an increasingly popular form of trade finance. Leading companies such as Eximbank and London Forfaiting Company have seen their business grow by around 50 per cent over the first half of 1993.
One factor is the decline in export credit agency cover (ECA). "In the past, exporters have been spoilt by ECA," says Ian Guild, Chief Executive of Indosuez Aval. "But recently ECAs have been having a tough time, losing money in Latin America and East Europe." This has resulted in less funds being available to exporters through ECA.
But there are other advantages that forfaiting has over export credit schemes, despite being more expensive. First, forfaiting accounts for the entire invoice value, enabling the exporter to recover the entire invoice amount without recourse. With an export credit scheme such as ECGD in the UK there is always 15-20 per cent residual risk and if the buyer fails to pay, the exporter may have to wait up to 18 months to receive payment. And unlike factoring and other market instruments, forfaiting covers political risk as well as commercial risk.
A typical scenario would involve a company from the US, Japan or Europe exporting equipment to a country where the financing capacity of banks is low or where the financial risks are high. For the importer the problem is being unable or unwilling to pay substantial amounts of foreign currency for the machinery within the normal credit period of 180 days. Forfaiting is one way of financing such a deal, providing the necessary financial guarantees and phasing payment over a number of years.
In assessing such a risk the forfaiting bank must scrutinise the credentials of the exporter and importer ? invariably they favour companies with established trading ties with the country. Then, once a deal has been struck, the forfaiter often sells all or part of the debt to the secondary market in order to dilute risk.
By providing guarantees (or avals) in the form of bills of exchange or promissory notes, banks in the importing country play a crucial role in forfaiting. But it is here that problems with the Chinese market begin. Whilst many people in China are familiar with trade finance instruments, interpretation often differs. "There are instances where the English version of the contract doesn't tie up with the Chinese version," says Guild. 'You have to make sure that the Chinese bank puts the same interpretation on documents you are issuing. interpretation
In forfaiting, the bank guarantee is deemed 'irrevocable and unconditional' and any problems such as with the machinery or a dispute over the contract should not affect However ? and this is a problem perhaps unique to China ? the Chinese side often regard such matters as an integral part of the transaction. This can lead to uncertainty and costly delays.
For forfaiting to work properly there must also be a legal framework in the importing country. With China in the process of developing such a structure, there is no established recognition of the existence of bills and avals.
"You also have to be careful about which branch or department within the Bank of China or Agricultural Bank you are dealing with," says Stephen vu of London Forfaiting Company. Policy reform within the banks, changing names of branches and the growing number of state banks necessitates careful review. Concluding a successful deal with one branch of a state bank today doesn't mean you can do a similar deal with another branch of the same bank tomorrow.
However, the situation is getting better. The creation of the State Administration of Exchange Control has given comfort to many foreign bankers. When the market opened up there was a good deal of uncertainty and lack of knowledge over trading practices. "Previously it was a matter of guesswork", says Guild. But now that the Bank of China has issued a list of authorised branches, things have improved.
Forfaiting is also being used in projects where the foreign element is minimal. Indosuez Aval is currently assessing a US$30m bridge construction project in China, in which the Chinese company is effectively using the forfaiting market to raise money for the project.
China is well placed to take advantage of forfaiting to finance their exports but here the SAEC is a barrier to development. "Credit terms can be offered to a Chinese steel exporter, for example, but the SAEC doesn't see forfaiting as clear cut," says Guild. A number of major Chinese banks are currently addressing how they are going to handle this issue, but it is an area where they clearly need the help of Western banks. If progress can be made, then forfaiting could be an important mechanism in China's bid to boost exports amongst its domestic producers. *