Abstract
This paper analyzes the financing terms that support international trade and sheds light on how and why these arrangements affect trade. Using detailed transaction level data from a U.S. based exporter of frozen and refrigerated food products, primarily poultry, it begins by describing broad patterns about the use of alternative financing terms. These patterns help discipline a model in which the trade finance mode is shaped by the risk that an importer defaults on an exporter and by the possibility that an exporter does not deliver goods as specified in the contract. The empirical results indicate that transactions are more likely to occur on cash in advance or letter of credit terms when the importer is located in a country with weak contractual enforcement and in a country that is further from the exporter. Letters of credit, however, are rarely used by the exporter. As an importer develops a relationship with the exporter, transactions are less likely to occur on terms that require prepayment. During the recent crisis, the exporter was more likely to demand cash in advance terms when transacting with new customers, and customers that traded on cash in advance terms prior to the crisis disproportionately reduced their purchases. These results can be rationalized by the model whenever (i) misbehavior on the part of the exporter is of little concern to importers, and (ii) local banks in importing countries are typically more effective than the exporter in pursuing financial claims against importers.
Highlights
Managers at ...rms that engage in international trade must decide which ...nancing terms to use in their transactions
The model identi...es a key condition under which exports to locations characterized by weak contractual enforcement are more likely to occur on cash in advance or letter of credit terms as opposed to other terms
The theory predicts that an increase in the likelihood that an importer faces a liquidity shock is associated with an increase in the use of cash in advance terms when transacting with new customers
Summary
Managers at ...rms that engage in international trade must decide which ...nancing terms to use in their transactions. The model identi...es a key condition under which exports to locations characterized by weak contractual enforcement are more likely to occur on cash in advance or letter of credit terms as opposed to other terms. This requires that local banks in the importing country be better able than exporters to pursue ...nancial claims against importers. These latter traders face a liquidity shock and do not honor a contract when it is not enforced In this set up, the exporter learns which importers are trustworthy and o¤ers post shipment terms as a trading relationship develops.
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