Trade is a fundamental enabler of sustainable development, inclusive growth, and poverty reduction. By facilitating the exchange of goods and services, trade sustains businesses, and creates jobs and livelihoods. To sustainably engage in trade, businesses need financing, also known as trade finance.
This refers to financial products that enable buyers and sellers of goods to overcome what is known as the trade dilemma, a situation where the seller wants payment for goods before they are delivered yet the buyer wants to pay when they receive the goods. Trade finance introduces a third party to the transaction, usually a bank, to remove payment and supply risks.
This type of financing is mostly used in import-export transactions where the parties are in different countries and/or have not transacted with each other before. The goods, receivables, and cash generated from the trade are normally used as security. It could also apply to local contracts where some form of surety for performance is required. There are essentially two types of trade finance – funded and unfunded. Unfunded trade finance is where the customer simply wants credit support as a guarantee they will perform the contract. This includes bid bonds, performance bonds, Local Purchase Order (LPO), and Local Service Orders (LSO) financing. Funded is where actual money or credit is provided by a lender to secure performance by the parties. Letters of Credit (LCs) are a good example.
So, why would a small business require such kind of financing? Small and Medium Enterprises (SMEs) involved in trade enjoy numerous benefits from this type of financial arrangement.
First, it helps them manage their cash flows more efficiently. A product like invoice financing allows a business access to cash even before it receives payments for goods delivered. Many SMEs grapple with cash flow problems mostly due to delays in payments by customers. A financial solution of this kind takes care of their cash flow needs thus bridging financing gaps in the trade cycle.
Second, trade finance helps growing businesses boost their working capital, for instance, by enhancing their capacity to service orders they would otherwise find impossible due to balance sheet constraints. For instance, a small firm supplying tiles to a large housing construction project may require a trade finance loan to enable it to import the items in bulk from suppliers abroad with whom it has had no previous business relationship. This way, it can grow and expand its clientele.
Third, this financial product helps trading enterprises manage a variety of risks that if not properly mitigated, could inflict massive losses on the business or even force it to close. These include foreign currency volatility exposing importers to financial loss. Think of the Kenya Shilling losing value against the major currencies like the US dollar. Letters of Credit (LCs) minimize the financial impact of such risks by protecting the interests of both the buyer and seller.
These and other benefits make trade finance a crucial source of financing for SMEs seeking to become competitive in the local and international markets. A growing number of SMEs in Kenya are venturing into international trade and require LCs and similar instruments. Others want enhanced facilities to service local contracts and here unfunded trade finance comes to mind.
There is therefore a need to innovatively meet the growing demand by small businesses for affordable trade financing solutions. Local lenders are rethinking their value proposition by offering competitive pricing, flexible collateral, and improved turnaround times for such products. For example, at Faulu Bank we realized that a growing number of SMEs want customized trade finance hence our decision to revamp our products to meet the unique needs of this important segment.
In addition, training customers on how to fully harness the benefits of these products while equipping them with insights from experts on navigating the domestic and international trade landscape is imperative to the growth and prosperity of this critical sector of the economy. Trade finance also contributes to the realization of the Sustainable Development Goals on ending poverty (Goal 1) and creating decent work and economic growth (Goal 8)
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Mr. Ouma is the acting CEO, of Faulu Microfinance Bank. His email is Marketing@faulukenya.com