By Nimna Haputhanthri
Trade finance involves a range of financial instruments and services to facilitate international trade so as to ease business transactions and protect sellers and buyers by mitigating counterparty risks. According to the World Trade Organisation, 80-90% of global trade relies on trade finance. Transactions in trade finance involve three parties: importer/ buyer, exporter/ seller, and financial institutions. While the seller requires an assurance of payment before delivery, the buyer requires an assurance from the seller for the delivery of goods (or in the provision of services), preferring cash on delivery in the chain of business transactions. For such needs, both the buyer and the seller can acquire the support of financial institutions that can provide various forms of financial aid. This includes letters of credit, guarantees, factoring, trade insurance, supply chain financing, purchase order finance, e-commerce finance, risk mitigation etc. This blog will consider the central role of trade finance in Sri Lanka and assess its challenges.
According to the World Bank, Sri Lanka is a developing nation with approximately USD 88.93 billion (2021) GDP. With a small domestic market, international trade is essential to Sri Lanka’s economy. The average economic growth throughout the closed economic period (pre-1977) in Sri Lanka was 3.48%, although this significantly increased to an average economic growth of 5.89% due to trade liberalisation by 2012. Since then, Sri Lanka has been at the centre of trade and investment in South Asia. In Sri Lanka, trade finance involves various aspects, including payment methods, currency exchange, risk management, regulatory compliance, trade documentation, and trade finance products.
Among other things, Sri Lankan businesses have been confronted with a variety of difficulties in the past, such as credit risk and limited access to funding in various engagements in international trade. Trade finance reduces such risks, giving companies access to the working capital they need to grow and expand. For instance, trade finance solutions have made it possible for Sri Lankan tea exporters to access the working capital they need to meet the global demand while managing risks like exchange rate fluctuations and payment delays.
In Sri Lanka, controlling trade finance is the responsibility of the Central Bank. In addition to regulating both domestic and foreign banks in Sri Lanka, it also regulates payment methods and information on banking systems, foreign exchange controls, US and correspondent banking and more. Commercial banks, export credit agencies, development finance institutions, multilateral organisations, and non-banking institutions such as factoring companies and insurance companies are other key players in Sri Lanka’s trade finance.
When considering payment methods as a mode of trade finance, Letters of Credit (LC) are significant. An LC is a bank-issued guarantee payment made to the seller following the satisfaction of certain requirements, like the presentation of specified documents, and is valid for up to 365 days. In Sri Lanka, LCs are governed by the Uniform Customs and Practice for Documentary Credits (UCP) issued by the International Chamber of Commerce (ICC). Documentary Collections are also important in this regard as the exchange of shipping and payment documentation between the buyer and seller is facilitated by banks through such means. This reduces the risk of non-payment and guarantees that the buyer will receive the items only when the full payment has been received.
In Sri Lanka, trade finance also involves managing risks. Financial institutions are helpful here in providing a range of risk management products such as credit insurance, guarantees, and hedging. Businesses that engage in international trade are also required to abide by the regulations of both Sri Lanka and the destination countries. Financial institutions provide services in this regard by assisting businesses to adhere to laws relating to imports/exports and exchange control. These institutions also offer currency exchange services and a variety of trade financing products, including export, import, and working capital finance. In addition, trade documentation, bills of lending and commercial invoices help mitigate the transaction risks.
Despite the growing demand for trade finance in Sri Lanka and the increasing digitalisation of trade finance, limited access to finance poses a significant challenge. For instance, Small and Medium Enterprises (SMEs) in Sri Lanka struggle to access financing due to high costs, inadequate trade infrastructure and regulatory barriers. Considering the above factors, it is clear that trade financing is essential to Sri Lanka’s economy, which largely depends on global trade. In this regard, financial institutions offer a range of goods and services to help reduce the risks associated with cross-border trading, including credit risk, currency risk, and regulatory compliance. Commercial banks, export credit organisations, institutions that fund development, multilateral organisations, and non-banking institutions are some of the major actors in Sri Lankan trade financing. Documentary collections, together with LCs, play a large role in Sri Lankan trade finance as well. Thus, the rise of trade finance in Sri Lanka, its crucial role in the nation’s economy and its ability to enhance Sri Lanka’s competitiveness in the international arena heighten the need for the country to address the challenges posed in accessing trade finance.
The views and opinions expressed in articles submitted to the Comparative Advantage Blog are those of the author and do not necessarily reflect the views of The Moot Court Bench