Introduction to Political and Economic Risk/Country-Related Risks
|Unit 1.1-Introduction to Political and Economic Risk||
Both the seller’s country and the buyer’s country have laws governing cross-border trade. These laws may address:
- the need for export and import licenses
- customs and import duties
- limitations on sending money out of the country (currency control laws and regulations)
There are transnational rules and agreements that may also affect trade:
- protocols and common practices for banking transactions that may be found in International Chamber of Commerce publications for collections, letters of credit and SWIFT (Society for Worldwide Inter-bank Telecommunications systems) procedures to execute payments and to communicate on collections and letters of credit
- terms of sale as defined in Incoterms, another International Chamber of Commerce publication that details when the costs, risks and responsibilities for transporting goods transfer from seller to buyer.
Some examples of country-related risks illustrate payment risk issues in cross-border transactions. Sovereign or country-related risks stem from the actions of one or more governments and government agencies or by civil war, civil unrest and strikes. A seller has a contract to deliver perishable goods to a buyer in another country. There are actions by the government that could prevent the delivery and the completion of the transaction. War by a third country with either the buyer’s or seller’s country could cause the goods not to be transported and/or delivered by one of the warring countries. An embargo or blockade could bar the delivery of the goods. A strike in the logistic pipeline could also stop the goods from being delivered.
Purely political actions like transfer and convertibility risks must also be considered as a part of sovereign risk. Transfer and convertibility risks arise as the result of issues with currency used by the buyer, seller, or other parties involved in the transaction. It should be kept in mind that transfer and convertibility risks are not the same as foreign exchange risk which will be discussed later.
Sovereign or country-related risks fall into several major subcategories: political, transfer, and convertibility. Political risks are those risks that arise from the legal and foreign relations actions of the national governments of a seller, a buyer and sometimes third countries, especially third countries through which cargo may travel. Transfer and convertibility risks also relate to the buyer and seller’s countries, but more specifically in terms of the management of the currency and the availability of foreign currencies, also known as foreign reserves.
Sometimes when a country, usually through its central bank, needs to ration the foreign currency it has available to it, it will place controls on transfer currency, sometimes even its own currency out of the country. This situation is called transfer risk. The buyer or debtor is willing and able to pay, but restrictions have been instituted that prevent the payment from taking place.
Convertibility risk is somewhat similar. The buyer or debtor is willing and able to pay with local currency and the currency may be transferred out of the country; however, there is no ready market to convert it to a currency the seller or creditor can use. The buyer or debtor may be prevented from legally exchanging the currency in his own country because of currency controls imposed by his own country, usually through the central bank. If the buyer sends his local currency to the seller, the seller could be faced with having to exchange it for a usable currency at deep discount or not being able to exchange the currency at any rate of exchange. Foreign currency exchange under a free-floating environment can be very volatile over time and should be hedged by the inexperienced.
Documentary risks are the primary cause of slow or non-payment in international trade. In its simplest form, documentary risk arises from a missing or incorrectly prepared document that is required to complete the buy/sell transaction and/or make payment. Cross-border transactions very often involve many documents, but just one missing document or a discrepancy in a document can stop a payment temporarily or permanently.
Some of the more common document problems are caused by
- letters of credit
- import and export licenses
- certifications such as certificates of origin
- customs documents
- transportation documents
- other bank and legal documents.
Here are examples of letter of credit document problems. A seller has received a letter of credit that is denominated in his/her own currency. The seller has eliminated the risk that the buyer will be unable or unwilling to make payment when it is due because the bank that issued the letter of credit now has the payment obligation. The letter of credit states that the seller will be paid upon presentation of certain documents that need to be in conformity with the bank’s (and buyer’s) requirements under the letter of credit. Documents required by commercial letters of credit for payment may include but are not limited to:
- ocean bills of lading
- air waybills
- certificate of the country of origin
- packing list
- insurance certificate
- certifications of weight, quantity or technical specification.
The documents required enable the buyer to clear the goods through customs and comply with any other contractual agreements. All of the requirements for acceptable documentation examination are set for in the ICC Uniform Customs and Practice for Documentary Credits (UCP) published by the International Chamber of Commerce in its latest version. Any modification or amplification to acceptability of required documents will be found on the face of the letter of credit. If any one of the required documents is missing, is not exactly in compliance as required in the UCP and on the face of the letter of credit, is inconsistent with other documents, or is not properly endorsed, the issuing bank will not pay the seller. Some common problems with documents being used for payment with a letter of credit include the following:
- Weights may be in pounds on one document and in kilograms on another.
- Description of goods in the letter of credit is in Spanish, but the invoices and/or packing lists describe the goods in English.
- Goods are not shipped in the quantity or time frame required under the letter of credit.
- There are misspellings in the letter of credit, but other documents have those words spelled properly.
- Negotiable transportation documents are not properly endorsed or consigned.
- Too much or too little has been shipped.
- The name and address of the buyer or seller is not in strict compliance with the letter of credit.
- Documents are not properly labeled to match the documents required under the letter of credit.
- There are inconsistencies between documents for carton, weight or number counts.
- There are incorrect consignment or notification parties on the bill of lading.
- These are only a few of the potential discrepancies that occur with a commercial letter of credit.
Standby letters of credit are issued to a seller by the buyer’s bank to cover for noncompliance with agreed upon payment terms. The standby letter of credit virtually “stands by” to pay if the buyer does not meet his/her payment obligations. The documentary requirement to claim under a standby letter of credit is a simple statement declaration made by the seller to the issuing bank of the standby letter of credit. Standby letters of credit are used when shipments are done consistently on a revolving basis to the same buyer. The cost of doing a standby over a commercial letter of credit needs to be evaluated before deciding which payment instrument should be used.
Other documentary risks arise as the result of export and import licenses as well as currency control requirements.
A seller has a contract to deliver goods to a customer in another country. The buyer has the financial strength and character to be willing and able to make payment when the goods are delivered. The buyer has, however, failed to obtain an import license. The goods are held by customs in the buyer’s country, and thus the delivery cannot be completed.
A seller has a contract to deliver goods to a customer in another country. The buyer has the financial strength and character to be willing and able to make payment when the goods are delivered. The buyer has a valid import license permitting the importation of a particular quantity of goods during a particular time window. The seller ships the wrong quantity and/or the goods are not shipped into the buyer’s country during the specified time window. The goods are held by customs in the buyer’s country, so the delivery cannot be completed.
A seller has a contract to deliver goods to a customer in another country. The buyer has the financial strength and character to be willing and able to make payment when the goods are delivered. The seller has failed to obtain a required export license. The goods may be held by authorities in the seller’s country, and/or there may be severe civil and/or criminal penalties imposed on the seller.
A seller has a contract to deliver goods to a customer in another country. The buyer has the financial strength and character to be willing and able to make payment when the goods are delivered. The buyer has, however, failed to obtain appropriate authority to convert his local currency to that of the purchase contract. The goods may or not be held by customs in the buyer’s country, but the seller will generally not be paid when payment is due, and/or payment may not be made at all.
Transfer risks can occur when a buyer has received the goods promised and is ready to make payment. The government of the buyer’s country sees its foreign reserves rapidly leaving the country. The law or central bank institutes regulations to stop all movement of funds out of the country without specific approval. This program halts the transfer out of the country of the buyer’s currency as well as the currency of any other country. The buyer is willing and able to make the payment to the seller; however, by government intervention, the payment is blocked from taking place.