Nancy McGirr might forgive you if your eyes glaze over when someone chats you up at a party and talks about “letters of credit.” But if you want to do business internationally, you should pay attention.
“They’re terribly unsexy, but they are part of the system that makes sure that global trade works,” says Ms. McGirr, strategic account executive for infrastructure and financial services at Export Development Canada.
Actually, letters of credit are more interesting than you might think, and they’re vital to global commerce. They’re the building blocks of trade finance, the sophisticated international variant of ordinary corporate finance. Basically, they are guarantees that payment will occur.
James Bond would have to rely on a letter of credit to carry on his spying as Agent 007 – his cover story was that he was representative of a company called Universal Exports.
“The trade facilitation that EDC does contributes about 5 per cent of Canada’s GDP, and we’re not even involved in all aspects of trading,” says Ms. McGirr.
“The impact of what goes across the border is huge. We have a fairly small domestic market and that’s only so many consumers. In order to grow, you have to sell your stuff globally, whether it’s apple pies or machinery to plow a field.”
Many people expect Canada’s global trade to grow even more with the advent of the trade agreement that was reached with the European Union in October. Once it is ratified in both Canada and Europe – which could take two years – it will eliminate 98 per cent of tariffs on both sides, making it easier for all kinds of Canadian businesses to expand global trade.
That’s going to make trade finance all the more important.
“Trade is all about the financing of imports and exports, and this takes place across borders. The most frequently used instrument to do this is the letter of credit,” says Silvia Brudar, vice-president for product management and business planning at the Bank of Nova Scotia in Toronto.
At its simplest level, a letter of credit is a way for a larger organization, such as a bank, to assume risk, for a fee, on behalf of a company doing business abroad, she explains.
For example, a Canadian firm might want to work with a company in China. The Chinese firm might be considered sub-investment grade – there’s little or no financial information available in Canada about its business – and the Canadian firm might be too new or small to be understood by the Chinese business market.
This is where the banks step in to exchange letters of credit, says Ms. Brudar.
“Our bank will receive this instrument [a letter of credit], for example, from the Bank of China. When the company there is ready to ship or provide payment, instead of the less-known company in China, it’s now us dealing with the Bank of China. We take on the risk.”
EDC, a federal Crown corporation, also works closely with companies and banks on trade finance deals in a number of ways, says Ms. McGirr.
“EDC provides guarantees to the banks – we do about 700 of those a year. It makes it easier for the companies’ financing,” she says.
“We can be a guarantor or a direct lender. Often for foreign buyers, a Canadian company may need to show the foreign company it has its financing. For example, when a company is bidding on a project somewhere in the world, they might be asked for a bond up front to prove that the company is serious.”
The bank will provide the letter of credit, saying that the company has its trade finance in place. The company will put up its funds as collateral, and then EDC will provide a bond to the bank to replace this collateral, so the company can use its funds to do the actual work it has bid for.
With the government agency’s backing, “everybody has more to work with,” Ms. McGirr says.
Global trade is predicted to gain in importance, as people in emerging markets climb into the middle class and seek Canadian goods and expertise, she says.
EDC has been operating for more than six decades, she notes, and prides itself for being business-friendly and easy to work with – which Ms. Brudar agrees with.
“It’s a symbiotic relationship. Canada is known as a great example,” she says.
Canada’s solid trade finance reputation helps burnish Canadian companies’ reputations even in sectors where the government’s image building is faltering, such as the environment.
“We’re recognized as a green country with very advanced technologies, and other countries are coming to our companies when they are trying to set up their environmental facilities,” Ms. Brudar says.
Catalysts for trade
The tools of trade finance are expanding beyond letters of credit as countries around the world recognize how important trade is to their economies.
For example, banks are moving into the financing of supply chains. “Banks don’t just exchange documents, they actually move to financing suppliers, taking on the buyers’ risks,” says Silvia Brudar of the Bank of Nova Scotia in Toronto.
It’s a risk that’s apparently worth it to Canadian banks, which have developed a reputation for stability since the 2008 global economic crash. “In the last four years we’ve doubled our trade business in terms of how many people we employ, and our asset base has grown by 20 per cent,” says Ms. Brudar, noting that Scotiabank is active in 55 countries.
Post-economic crisis, world trade “has historically been growing at more than the GDP rate, and in the last few years that has definitely been true. Trade has been helping the world recover from crisis, and companies recognize this,” she says.
Follow us on Twitter: