Open Account Versus Letters of Credit for Latin American Purchasing
Trade letters of credit once presented the most efficient way to conduct import trade transactions and provide reasonable assurances to both buyer and seller. Today, however, the use of letters of credit is in decline, largely being overshadowed by significant growth in open account transactions.
Having worked for several banks in various trade finance positions over my 25-year career, I have personally noted the decline in the use of letters of credit by US buyers. Historically, the larger, well established US-based companies have always been loathe to issue letters of credit to purchase product. This trend has also spread to middle market companies. Asia seems to be an exception, where the sophistication of the markets allows for ‘packing credits’, or the use of the US buyer’s letter to be utilized as a form of post-export working capital, a long-standing technique employed by Asian banks. However, I would not be surprised to see a drop even in this region as an increasing number of US companies set up shop in Asia with their own sourcing venues.
Opinions vary as to how much letters of credit are being used today. Atradius, a large export insurer, maintains that the use of letters of credit as a payment method has fallen to as little as 15% while open account trading now comprises over 80%. On the other hand, the Economist Intelligence Unit asserts the claims of Atradius are exaggerated. While there may be a difference of opinion as to the exact statistics, all can agree there has been an extreme shift.
In part, the reason for this shift is the high bank charges associated with documentary credits and divergent interpretations adopted by banks that create inflexible supply chain hurdles. However, pricing is not the only contributing factor to this shift. Technology has also played a role.
In today’s technologically savvy world, information is available at the click of a mouse. Buyers and sellers are forever linked in an electronic flow of information never before experienced. This seemingly endless stream of information has been one of the main reasons for a perceived reduction of international risk in trade transactions as more open account terms are occurring every day. In short, globalization has had a great impact on attitudes to foreign risk, and a greater number of risk-averse buyers and sellers have lead to less import letter of credit issuance.
Another reason why open account terms have become so readily available to US buyers is leverage. The US economy has become largely an import economy and the largest consumer economy in the world today. That kind of clout in the marketplace helps shift the credit needs away from the traditional letter of credit and toward creative open account purchasing options, such as factoring-based solutions.
A tried and true method of capturing such open account flows (commercial invoices) into the US market is to use factoring. Technically speaking, factoring is the purchase of accounts receivable (invoices) with or without recourse. Originating and funneling these invoices through foreign-based export factoring entities (banks or financial companies) provides needed pre and post-export working capital financing to the manufacturer/exporter. The latter is achieved when the export-factoring entity bundles these invoices and sells them to a US factor, which in turn guarantees the US buyer’s ability to pay. In the end, the local export factor secures a safe way to provide pre and post-export lines of credit to its clients, supported by a payment guaranty provided by a US factor.
Historically, a great level of dependency has always existed between Latin America and the US market. Most Latin American countries’ export economies are geared to the US market. This dependency is likely to increase with the approval of the Dominican Republic CAFTA trade pact, the FTA with Chile, the existing TPAs with Peru, Panama and Colombia and, of course, the long standing NAFTA agreement between Mexico and the US. Permanent approval (FTA) appears to be coming for Peru, Panama and, lastly, Colombia waiting in the political wings.
The Latin American market has been gaining in sophistication over the years, and the emerging market factoring model has been established with success. Under this model, the US factoring company provides the factoring service (collection and guaranty), while the lines of credit to the export-factoring entities are supplied by a wholesale bank. There is tremendous potential in the Dominican Republic CAFTA region, which can be accessed by making key strategic alliances with the largest banks and factors in the region, Banco Atlantida in Honduras, Banco Industrial in Guatemala, Factoring Banorte in Mexico and Scotia Bank in the Dominican Republic. Other countries such as Peru, Colombia and Panama also offer potential since these trade pacts further the need for open account terms.
This open account trend may well prove to be the trigger of a landslide of trade flowing from Latin American countries into the lucrative US market. Companies relying on factoring solutions for open account purchasing would do well to consider the credit ratings backing their factoring companies since, in the end, the factoring guaranty is only as solid as the rating.