LCs versus Forfaiting - Indian Context- Part 1

Forfaiting in India became available in India’s financial market from 1992 when the country’s central bank, Reserve Bank
of India (RBI), which administers the country’s foreign-exchange matters and regulates banking, allowed foreign forfaiters to market their service and allowed the indigenous banks, authorised to deal in foreign exchange by the RBI (and hence called authorised dealers in India’s banking language), to broker and market the foreign or imported forfaiting services.

Of course, there is use of both foreign forfaiting skills and indigenous marketing skills in India. The Export- Import Bank of India (Exim Bank) has collaborated with a foreign forfaiter, WestLB, to form a joint venture named Global Trade Finance, to market forfaiting services in India. Exim Bank has local knowledge while the foreign forfaiter has forfaiting skills.

The foreign forfaiters and their Indian agents are touting the advantages of forfaiting to Indian exporters with such slogans as “change a credit sale into a cash sale with forfaiting”, “take cash without recourse in forfaiting”, “make a long-term credit sale to boost exports and still maintain cashflow with forfaiting”, “no risk of documentary discrepancies in forfaiting as with LCs”, “instant cash for deferred payment”, “balance sheet not burdened by accounts receivables”, “helpful in doing business with riskier countries”, “interest-rate and exchange- rate fluctuation management in forfaiting”, and so on.

But, despite its inherent advantages, forfaiting is still not terribly popular among Indian exporters, particularly smaller ones, or among India’s international traders. The main reason is that the minimum transaction amount prescribed by foreign banks offering forfaiting services is too high for an average exporter in India, often $1m. And pricing is a problem.

The LC is ubiquitous and indigenous, while use of forfaiting services is neither worldwide nor widespread and is often by big exporters only. Of course, in other parts of the world too, forfaiting is struggling, even in Western Europe where it originated.

But the International Chamber of Commerce has standardised only LC practice through its UCP 500 and ISBP 645, not LC-based forfaiting. The long- time existence and effectiveness of the regulatory UCP is one reason why the use of LCs remains a more popular option than forfaiting. LC financing is a standardised practice, while forfaiting is generally an arbitrary practice.

And while it is not yet clear how fully the forfaiting market will embrace the new market practice guidelines, documentary credit bankers around the world have, on the other hand, become addicted to the Paris-based ICC’s UCP rules, which have proven very successful in regulating documentary credit practice and indirectly very helpful in promoting international trade.

However, in India, forfaiting practice falls under the control of the RBI, which is the foreign-exchange manager for and on behalf of the government of India.
Forfaiting in India involves foreign exchange and is therefore under foreign- exchange management by the RBI.

LC or Forfaiting?

On the question of export LCs versus forfaiting, one of the main differences is that the importer arranges for the issue of a documentary credit by a bank in the importer’s country as a means of providing an assured payment to the exporter, whereas in the case of a forfaiting transaction the exporter obtains the forfaiting commitment from a bank in the exporter’s country as a way of offering credit terms to the importer coupled with payment security to the exporter.

Documentary credits provide above all a secure means of payment, with, in some cases, short-term credit facilities, whereas one of the principal objectives of forfaiting is to provide credit – traditionally medium-term credit – to the importer, as well as giving the importer assurance of payment through the forfaiting bank’s commitment to
negotiate without recourse.

None of this is absolute. Also, of course, payment under documentary credits depends essentially on presenting conforming shipping documents and related documentation, a procedure that seems to cause more and more anger and hair-splitting (ie, the current debate over clauses of bills of lading in the ICC Banking Commission). In the case of forfaiting, the exporter is saved all this, since the documentary requirements are simpler.

Read the second part of LC vs Forfaiting - Indian Context here..