Estimated reading time: 5 minutes
Cross-border trade is an inherently risky activity with numerous types of risk that can appear at all stages of trade. But today, we will discuss two types of risk: commercial risk and, transfer risk, a type of political risk.
Though EXIM is revered to be a source of trade finance that fills in the gap created by the private lending market, this article will also briefly discuss how that role may be waning due to the evolution of financial markets.
One of the significant risks faced by exporters when partaking in international trade is commercial risk.
Commercial risk most commonly refers to default risk that is not related to political risk, that is, the risk that the buyer may default on their payment obligation after receiving the product from the seller.
This default may appear due to a multitude of reasons such as liquidity issues, insolvency, force majeure, or fraudulent behaviour.
Although it may be argued that the seller could demand payment in advance of shipping the goods or just trade with a buyer that is trustworthy, in the interests of advancing trade, that is not always a solution.
Therefore, exporters often turn to providing importers terms of credit to facilitate their trading interests, thereby exposing themselves to considerable default risk.
Higher risk in international trade is generally linked to higher returns and therefore, traders pursue international trade finance products such as insurance, to mitigate and transfer the risks to a third party.
Although commercial banks support credit for foreign buyers to import products of local exporters, as they are private lenders, there is a limit to the credit risk they are willing to assume. This gap is then filled in by financial institutions like export-import credit agencies (‘ECA’), such as EXIM.
EXIM offers an Export Credit Insurance product, through which an exporter may extend credit to the foreign buyer and then be insured by EXIM after reporting the shipment and paying a premium.
In this instance, should the buyer default, EXIM will pay the exporter instead. Although purchasing this insurance adds an additional expense for the exporter, it can be a wise investment. When weighed against the likelihood of facing default risk—which could result in significant losses—the insurance can be seen as an effective way to increase potential returns and reduce risk.
Political risk in international trade
Political risk is considered a default risk that occurs due to political issues such as war, civil unrest, government intervention in the buyer’s business etc.
Political risk could also appear as the inability of a buyer to lawfully acquire the exporter’s foreign currency in their local financial market and appropriately transfer the same to pay for the imported product – known specifically as transfer risk.
EXIM helps mitigate transfer risk by offering a product called Foreign Currency Guarantee policy (FCG). The FCG is a cover offered for Loans or Export Credit Insurance, through which a buyer may pay for the imported goods in their local currency.
As a result, even if the buyer were to fall victim to transfer risk, they would be able to uphold their obligation to pay the exporter. In this instance, EXIM itself does not directly offer the foreign buyer of US goods trade credit, but instead, the buyer may receive credit from a commercial bank.
Should the buyer then default in their obligation to repay the bank, the bank may reclaim its principal and regular interest through a 100% guarantee provided by EXIM. In this scenario, EXIM plays a crucial role in reducing risk, helping banks lend to foreign buyers with more confidence.
This, in turn, boosts local trade.
With the backing of EXIM, the likelihood of experiencing a default from an ECA in a country like the US is extremely low.
Peso foreign exchange crisis
Though it may seem abstract, this insurance product has been proven useful as evidenced by its role during Mexico’s foreign exchange crisis in 1982.
When the Mexican government banned foreign currency sales and converted dollar accounts to peso accounts, EXIM agreed to cover ‘political risk claims’ for defaults post-crisis, as long as they weren’t due to the buyer’s own financial problems.
In situations like this, the FCG not only helps mitigate risk for the exporter but also helps commercial banks and other private lenders maintain their liquidity by providing a 100% guarantee, as a result of which, foreign political crises may have minimal impact on the stability of local US financial markets.
The role of EXIM: A multifaceted institution
EXIM’s main function is to manage and mitigate risks through products as well as monitor transactions by filling the gap left by the private lending market.
When evaluating EXIM’s role in reducing cross-border trade risks, it’s worth noting that it initially served as a backup lender. It offered its services selectively, within specific governmental frameworks, while letting private lenders take the lead in trade finance.
Although EXIM remains an important source of trade finance to fill the gap left by private lenders, the financial market has evolved since its conception.
It is argued that EXIM should move away from its role as a lender of last resort and take on a more efficient role by displaying qualities of a public and private agency, acting as a ‘semi-market player’.
The role of EXIM has been called into question as the financial markets have evolved to fill the gap previously left by private lending, suggesting that it should widen its scope of duties in order to fulfil the needs of local traders more efficiently in the coming future.
Although commercial and political risks are inevitable in cross-border trade, employing financial products such as insurance and guarantees offered by agencies like EXIM will lessen these risks to an extent, by bearing small additional costs.