Trade Credit from foreign exchange perspective
Dun & Bradstreet, the leading business credit bureau describes trade credit as a transaction allowing businesses to receive goods or services in exchange for a promise to pay the supplier within a set amount of time. From our foreign exchange angle, this definition is enlarged to cover such credit extended by a bank or a financial institution in the supplier’s country or in a third country also besides by the supplier. Where credit is extended by the supplier to the buyer, it is called as suppliers’ credit because the credit is extended by the supplier. Here the supplier is out of funds unless the supplier approaches a bank and borrows against the underlying receivable. Alternatively, the supplier may help the buyer in getting finance from a local bank [i.e. a bank in the supplier’s country and hence a foreign country for the buyer], which finance is used to pay off to the supplier. While the supplier gets payment immediately though it is a credit sale, the buyer needs to pay only at the end of the agreed credit period. Such credit availed from a bank or financial institution in a foreign country is called buyers’ credit because the credit is availed by the buyer.
The term ‘trade credit’ is frequently used in import transactions. It implies the Indian importer availing credit for the import [trade] from abroad. This is a capital account transaction [borrowing from someone resident outside India or borrowing in foreign currency] and hence requires RBI permission. However, RBI has given general permission up to certain quantum with conditions. The generic term, “trade credit” includes both buyers’ credit and suppliers’ credit.
As per RBI, Trade Credits (TC) refers to the credits extended by the overseas supplier, bank, financial institution and other permitted recognized lenders for maturity, for imports of capital/non-capital goods permissible under the Foreign Trade Policy. Understanding the RBI regulations and other practical tips is important for those who handle it in importing firms, for bankers and for auditors.
Where an importer needs funds for paying the import bill and to finance the inventory arrived, the traditional source would be to avail a cash credit from a bank in India at the usual prevailing INR linked rates. Alternatively, the importer can request the supplier to extend credit. The supplier may levy interest for the credit period either separately or loaded in the price. If a bank or financial institution abroad extends finance for this [buyers’ credit], there will be clear interest cost. In all these cases, the interest rate will be linked to the interest related to the currency of the invoice. For most foreign currencies like USD or Euro, the interest rate will be substantially lower than that for INR and hence the importer is tempted to avail such credit. The importer has an exchange risk if the credit availed is in foreign currency. This can be hedged using a derivative product like a forward contract. If the cost of cover [e.g. forward premium] plus the overseas interest rate is still lower than the INR rate, the temptation will be furthermore.
However, the importer should note the following:
- If the invoice price is loaded with the interest cost, then the customs duty, if any, will be proportionately higher.
- For availing suppliers’ credit, the importer may have to get an LC established through the bank in India. For availing buyers’ credit, the importer may be asked to provide a bank guarantee from a bank in India. These have costs and the importer should include these while arriving at the overall cost.
- On the interest payable to a resident outside India [the supplier in case of suppliers’ credit, if the interest is separately mentioned or the lender abroad in case of buyers’ credit], there will be withholding tax. This adds to the cost further. It may be recalled that a branch of an Indian bank is considered as a resident entity from a forex perspective because it is owned and controlled by an entity [it’s head office] in India. Hence, if the lender abroad is a branch of a bank from India [e.g. SBI or BOB], then no withholding tax is payable since the interest is paid to a ‘resident’ entity, even though there is a foreign exchange outflow in the form of interest. This may look illogical but that is the law and importers and banks take advantage of it. It is the reason why the ‘quotes’ of branches of Indian banks abroad are favorable to the importer than those offered by foreign banks.
Thus, before opting for trade credit, purely from a cost perspective, an importer has to compare
- the interest payable on INR borrowing in the form of cash credit versus
- the interest payable on foreign currency [say USD] borrowing plus hedging cost [i.e. forward premium] plus the cost of LC, guarantee and other documentation costs plus implication on customs duty plus withholding tax, if payable.
RBI Policy – Trade Credits Framework for Importers
If the importer decides to opt for trade credit, the following important points of the ‘Trade Credits Framework’ of RBI should be noted.
- Trade credit can be availed only for the import of goods into India up to USD 50 million or equivalent per transaction without any RBI permission [i.e. automatic route]. For oil/gas refining & marketing, airline and shipping companies, this amount is USD 150 million. This ceiling amount is per transaction and not cumulative amount outstanding at any time. RBI permission is needed if the amount is more.
- The maximum duration of this credit from the date of shipment is as under:
- For capital goods: 3 years
- For import of non-capital goods by shipyards/shipbuilders: 3 years
- For non-capital goods by others: 1 year or operating cycle whichever is less
- The maximum cost of borrowing inclusive all types of costs [all in cost includes interest, other fees, expenses, charges, and guarantee fees but not withholding tax payable in INR] should not exceed the benchmark rate +2.5% pa. The benchmark rate is the 6-months LIBOR or any other 6-month interbank interest rate [e.g. EURIBOR] applicable to the currency of borrowing.
- Trade credit is generally availed in the currency of import. However, the importer can avail it in a different currency also to take advantage of any possible such cross-currency movements. It can be availed in INR also, though once availed in INR cannot be converted into a foreign currency.
- LCs are established to support the import. Banks are also permitted to issue guarantee favouring the buyers’ credit financing bank. The importer can also offer the security of movable assets (including financial assets) / immovable assets (excluding land in SEZs) for raising trade credit. Issuing corporate or personal guarantee is also proposed.
- Banks may permit the creation of charge on the security offered/accept corporate or personal guarantee, duly ensuring that:
- Loan agreement permits/authorizes this
- No objection certificate, wherever necessary, from the existing lenders in India has been obtained
- Such an arrangement is co-terminus with underlying TC
- In case of invocation, the total payments towards guarantee should not exceed the dues towards trade credit
- Other provisions of FEMA are complied with
- Suppliers’ credit can be availed from the overseas supplier. Buyers’ credit can be availed from Banks, financial institutions, foreign equity holder(s) located outside India[not necessarily in the country of the supplier], or financial institutions in IFSCs located in India.
- The importer should have a board-approved risk management policy. The importer should adhere to this policy and other regulatory guidelines on this.
- While the primary responsibility of ensuring adherence to the TC policy lies with the importer, the bank is also expected to ensure compliance with applicable parameters of the trade credit policy/provisions of FEMA by the importer.
- Trade credit can also be availed denominated in INR, in which case, the Indian importer does not have any exchange risk but the supplier bears that [though it can be hedged] and hence is not popular. The prevailing yield of the Government of India securities of corresponding maturity will be the benchmark rate.
- Each trade credit is given a unique reference number by the bank and consolidated information on the trade credits sanctioned is submitted on monthly and guarantees issued on a quarterly basis to RBI by banks.
- There are specific rules relating to SEZ units availing trade credit for purchase from other SEZ units and also DTA unit buying from the SEZ unit.
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