FINANACE OF INTERNATIONAL TRADE.EXAM TYPE QUESTIONS AND ANSWERS

 

Question 1:

(a) Explain four advantages of using a Letter of Credit (L/C) as a method of payment in international trade for both the exporter and the importer. (8 marks)

(b) Differentiate between a confirmed Letter of Credit and an irrevocable Letter of Credit. (4 marks)

(c) Briefly describe four documents commonly required under a Letter of Credit. (8 marks)

Model Answer:

(a) Advantages of using a Letter of Credit (L/C):

• For the Exporter (Seller):
• Payment Guarantee: The exporter receives a guarantee of payment from the issuing bank, provided they comply with the terms and conditions of the L/C. This reduces the risk of non-payment due to the importer's financial difficulties.
• Reduced Risk of Non-Acceptance: The exporter can be confident that the importer will accept the goods if the documents presented are in compliance with the L/C terms.
• Facilitates Access to Financing: The L/C can be used as collateral to obtain pre-shipment financing from a bank, allowing the exporter to fund production or purchase goods for export.
• Improved Cash Flow: The exporter can receive payment quickly after presenting the required documents to the bank, improving their cash flow.
• For the Importer (Buyer):
• Assurance of Compliance: The importer is assured that the exporter will ship the goods according to the agreed terms and conditions, as the bank will only make payment if the documents presented are in compliance with the L/C.
• Control over Payment: The importer retains control over the payment until the documents are presented to the bank, ensuring that the exporter has fulfilled their obligations.
• Negotiated Terms: The importer can negotiate the terms and conditions of the L/C to ensure that they are favorable to their interests.
• Reduced Risk of Defective Goods: By specifying detailed requirements for the goods in the L/C, the importer can reduce the risk of receiving defective or non-conforming goods.

(b) Difference between Confirmed and Irrevocable Letter of Credit:

• Irrevocable Letter of Credit: This type of L/C cannot be amended or cancelled without the consent of all parties involved (the issuing bank, the confirming bank (if any), and the beneficiary (exporter)). It provides a guarantee of payment from the issuing bank.
• Confirmed Letter of Credit: This is an irrevocable L/C that has been confirmed by another bank (usually in the exporter's country). The confirming bank adds its own guarantee of payment to the exporter, providing an additional layer of security. In case the issuing bank defaults, the confirming bank is obligated to make the payment.

(c) Documents Commonly Required under a Letter of Credit:

• Commercial Invoice: A document that lists the details of the transaction, including the description of goods, quantity, price, and payment terms.
• Bill of Lading (B/L): A document issued by the shipping company that serves as evidence of shipment and a document of title. It confirms that the goods have been received for shipment.
• Insurance Policy/Certificate: Proof that the goods are insured against loss or damage during transit.
• Packing List: A detailed list of the contents of each package or container, including the quantity, weight, and dimensions.

Question 2:

(a) Explain four methods of payment available to parties involved in international trade, highlighting one advantage and one disadvantage of each to the exporter. (12 marks)

(b) ABC Ltd. is considering exporting goods to a new customer in a politically unstable country. Advise the company on two trade finance instruments or services they could use to mitigate the risks associated with this transaction. (8 marks)

Model Answer:

(a) Methods of Payment in International Trade:

• 1. Cash in Advance:
• Description: The importer pays for the goods before they are shipped.
• Advantage to Exporter: Eliminates the risk of non-payment.
• Disadvantage to Exporter: May be unattractive to the importer, especially for large orders, making it difficult to secure the sale.
• 2. Letter of Credit (L/C):
• Description: A bank guarantees payment to the exporter on behalf of the importer, provided that the exporter meets specific conditions outlined in the L/C.
• Advantage to Exporter: Provides a high level of security, as payment is guaranteed by the bank.
• Disadvantage to Exporter: Can be costly due to bank charges, and requires strict adherence to the terms and conditions of the L/C.
• 3. Documentary Collection (D/C):
• Description: Uses banks as intermediaries to handle the exchange of documents and payments.
• Advantage to Exporter: Reduces the risk of non-payment compared to open account.
• Disadvantage to Exporter: The exporter ships the goods before receiving payment, and the importer may refuse to pay or accept the documents.
• 4. Open Account:
• Description: The exporter ships the goods to the importer with the understanding that payment will be made at a later date.
• Advantage to Exporter: Can be attractive to the importer, facilitating sales and building relationships.
• Disadvantage to Exporter: High risk of non-payment, especially if the importer is in a financially unstable or politically risky country.

(b) Trade Finance Instruments/Services for ABC Ltd.:

• 1. Export Credit Insurance:
• Explanation: Export credit insurance protects exporters against the risk of non-payment by foreign buyers due to commercial risks (e.g., bankruptcy) or political risks (e.g., war, expropriation, currency inconvertibility).
• Application to ABC Ltd.: By obtaining export credit insurance, ABC Ltd. can protect itself against the risk of non-payment due to political instability in the importing country. If the importer is unable to pay due to political events, the insurance company will compensate ABC Ltd. for the loss.
• 2. Confirmed Letter of Credit:
• Explanation: ABC Ltd. can request a confirmed Letter of Credit. In this case, a bank in ABC Ltd.'s country (the confirming bank) adds its guarantee of payment to the L/C issued by the importer's bank.
• Application to ABC Ltd.: Even if the importer's bank is located in a politically unstable country, ABC Ltd. has the assurance that the confirming bank will make the payment if the issuing bank is unable to do so due to political events. This provides a higher level of security.

Question 3:

(a) Explain what is meant by the term "exchange rate risk" in international trade. (4 marks)

(b) Describe three techniques that an exporter can use to hedge against exchange rate risk. (9 marks)

(c) What are Incoterms, and explain their significance in international trade. Give any four examples of Incoterms. (7 Marks)

Model Answer:

(a) Exchange Rate Risk:

Exchange rate risk refers to the potential for losses in international trade transactions due to fluctuations in exchange rates. This risk arises when a company has receivables or payables denominated in a foreign currency, and the exchange rate changes between the time the transaction is agreed upon and the time the payment is received or made. These fluctuations can reduce the value of the transaction when converted back to the company's domestic currency.

(b) Techniques to Hedge Against Exchange Rate Risk:

• 1. Forward Contract:
• Description: An agreement to buy or sell a specified amount of foreign currency at a specified exchange rate on a specified future date.
• Application: An exporter expecting to receive payment in a foreign currency can enter into a forward contract to sell that currency at a fixed exchange rate, eliminating the risk of exchange rate fluctuations.
• 2. Currency Option:
• Description: The right, but not the obligation, to buy or sell a currency at a specified exchange rate on or before a specified date.
• Application: An exporter can purchase a currency option to protect against adverse exchange rate movements while still benefiting from favorable movements.
• 3. Money Market Hedge:
• Description: Involves borrowing in one currency and lending in another to create a synthetic forward contract.
• Application: If an exporter is expecting to receive foreign currency in the future, they can borrow the foreign currency today, convert it to their domestic currency, and invest it. This effectively locks in the exchange rate and eliminates the risk of fluctuations.

(c) Incoterms (International Commercial Terms):

Incoterms are a set of standardized trade terms published by the International Chamber of Commerce (ICC) that define the responsibilities of buyers and sellers in international trade transactions. They clarify who is responsible for costs, risks, and tasks associated with the delivery of goods from the seller to the buyer.

Significance of Incoterms:

• Clarity: Provide clarity on the obligations of buyers and sellers, reducing misunderstandings and disputes.
• Standardization: Offer a standardized framework for international trade, facilitating trade transactions.
• Risk Allocation: Clearly allocate the risk of loss or damage to goods during transit.
• Cost Allocation: Specify which party is responsible for different costs, such as transportation, insurance, and customs duties.

Examples of Incoterms:

• EXW (Ex Works): The seller makes the goods available at their premises, and the buyer is responsible for all transportation costs and risks.
• FOB (Free on Board): The seller delivers the goods on board the ship at the named port of shipment, and the buyer is responsible for all costs and risks from that point onward.
• CIF (Cost, Insurance, and Freight): The seller pays for the cost of goods, insurance, and freight to the named port of destination, and the buyer is responsible for costs and risks from that point onward.
• DDP (Delivered Duty Paid): The seller is responsible for delivering the goods to the named place of destination, cleared for import, and pays all duties and taxes.

I. Balance of Payments (BOP)

Question 1:

(a) Define the term "Balance of Payments (BOP)" and explain its importance in international economics. (5 marks)

(b) Describe the main components of the Balance of Payments account and provide examples of transactions recorded in each component. (10 marks)

(c) Distinguish between a "current account deficit" and a "current account surplus" and explain the potential economic implications of each. (5 marks)

Model Answer:

(a) Definition and Importance of the Balance of Payments (BOP):

The Balance of Payments (BOP) is a systematic record of all economic transactions between the residents of a country and the rest of the world over a specific period (usually a year). It includes transactions involving goods, services, income, financial assets, and financial liabilities.

Importance of the BOP:

• Provides a comprehensive view of a country's international economic position: It shows the flow of goods, services, and capital between a country and the rest of the world.
• Indicates a country's competitiveness in international markets: Surpluses or deficits in the current account can reveal whether a country is competitive in producing goods and services.
• Helps policymakers make informed decisions: The BOP provides information that policymakers can use to assess the country's economic performance, identify potential problems, and design appropriate policies.
• Signals potential exchange rate pressures: Large and persistent BOP imbalances can put pressure on a country's exchange rate.
• Assists in assessing a country's creditworthiness: The BOP is a key indicator used by international lenders to assess a country's ability to repay its debts.

(b) Main Components of the Balance of Payments Account:

• 1. Current Account: Records transactions involving goods, services, income, and current transfers.
• Merchandise Trade: Exports and imports of tangible goods (e.g., cars, computers, agricultural products).
• Services: Exports and imports of intangible services (e.g., tourism, transportation, financial services).
• Income: Income earned by residents from investments abroad and income paid to non-residents from investments in the country (e.g., dividends, interest, wages).
• Current Transfers: Unilateral transfers without quid pro quo (e.g., foreign aid, remittances).
• 2. Capital Account: Records transactions involving the transfer of ownership of fixed assets and non-produced, non-financial assets.
• Examples: Transfer of patent rights, copyrights, and trademarks.
• 3. Financial Account: Records transactions involving financial assets and liabilities.
• Direct Investment: Investment made to acquire a lasting interest in a foreign enterprise (e.g., a company buying a factory in another country).
• Portfolio Investment: Investment in foreign stocks and bonds (e.g., buying shares of a foreign company).
• Other Investment: Loans, deposits, and other financial transactions.
• Reserve Assets: A country's holdings of foreign currencies, gold, and special drawing rights (SDRs) used to settle international payments.
• 4. Errors and Omissions: A balancing item to account for statistical discrepancies in the reported data.

(c) Current Account Deficit vs. Current Account Surplus:

• Current Account Deficit: Occurs when a country's imports of goods, services, income payments, and current transfers exceed its exports of goods, services, income receipts, and current transfers.
• Potential Economic Implications:
• Increased foreign debt: The country needs to borrow from abroad to finance the deficit.
• Currency depreciation: The demand for the country's currency may decrease, leading to a depreciation of its exchange rate.
• Job losses in export-oriented industries: If imports are replacing domestically produced goods, it can lead to job losses in export sectors.
• Current Account Surplus: Occurs when a country's exports of goods, services, income receipts, and current transfers exceed its imports of goods, services, income payments, and current transfers.
• Potential Economic Implications:
• Accumulation of foreign assets: The country is lending to the rest of the world and accumulating foreign assets.
• Currency appreciation: The demand for the country's currency may increase, leading to an appreciation of its exchange rate.
• Potential for inflationary pressures: If the surplus is too large, it can lead to increased demand and inflationary pressures.

Question 2:

(a) Describe five factors that can influence a country's current account balance. (10 marks)

(b) Discuss the strategies that a country with a persistent current account deficit can take to improve its balance of payments position. (10 marks)

Model Answer:

(a) Factors Influencing a Country's Current Account Balance:

• 1. Exchange Rates: A depreciation of a country's currency makes its exports cheaper and imports more expensive, improving the current account balance (assuming the Marshall-Lerner condition holds). Conversely, an appreciation of the currency has the opposite effect.
• 2. Relative Inflation Rates: If a country has a higher inflation rate than its trading partners, its exports become relatively more expensive, and its imports become relatively cheaper, worsening the current account balance.
• 3. Relative Economic Growth Rates: If a country's economy is growing faster than its trading partners, its demand for imports will increase, potentially worsening the current account balance. Conversely, if its trading partners are growing faster, its exports will increase, improving the current account balance.
• 4. Productivity and Competitiveness: Higher productivity and competitiveness in export-oriented industries can lead to increased exports and an improved current account balance.
• 5. Government Policies: Fiscal policies (e.g., government spending and taxation) and trade policies (e.g., tariffs and quotas) can influence the current account balance. Expansionary fiscal policies can increase demand for imports, while protectionist trade policies can reduce imports.

(b) Strategies to Improve a Persistent Current Account Deficit:

• 1. Devaluation/Depreciation of the Currency:
• Explanation: Lowering the value of the currency makes exports cheaper and imports more expensive, encouraging exports and discouraging imports.
• Considerations: Effectiveness depends on the elasticity of demand for exports and imports (the Marshall-Lerner condition).
• 2. Fiscal Policy Measures:
• Explanation: Reducing government spending or increasing taxes can decrease aggregate demand, including demand for imports.
• Considerations: Can lead to slower economic growth and may be politically unpopular.
• 3. Supply-Side Policies:
• Explanation: Improving productivity, innovation, and competitiveness can increase exports. This includes investing in education, infrastructure, and technology.
• Considerations: These policies take time to implement and may not yield immediate results.
• 4. Trade Promotion:
• Explanation: Actively promoting exports through marketing campaigns, trade fairs, and export subsidies can boost export revenue.
• Considerations: May face opposition from trading partners and could violate international trade agreements.
• 5. Import Substitution:
• Explanation: Encouraging domestic production of goods that are currently imported can reduce import spending.
• Considerations: May lead to inefficiencies and higher prices for consumers if domestic industries are not competitive.

II. Trade Restrictions

Question 3:

(a) Define the term "trade restriction" and explain four common types of trade restrictions used by governments. (8 marks)

(b) Discuss the arguments for and against trade restrictions, considering both economic and non-economic factors. (12 marks)

Model Answer:

(a) Definition and Types of Trade Restrictions:

A trade restriction is a government-imposed limitation on the free international exchange of goods or services. These restrictions can take various forms:

• 1. Tariffs: Taxes imposed on imported goods.
• Purpose: To increase the price of imports, protect domestic industries, or raise government revenue.
• 2. Quotas: Quantitative limits on the amount of a good that can be imported during a specific period.
• Purpose: To restrict the supply of imports and protect domestic producers.
• 3. Non-Tariff Barriers (NTBs): A wide range of measures, other than tariffs and quotas, that can restrict international trade.
• Examples:
• Sanitary and Phytosanitary Regulations: Regulations related to food safety and plant health.
• Technical Barriers to Trade: Regulations related to product standards, labeling, and testing.
• Subsidies: Government subsidies to domestic industries that give them an unfair advantage.
• Customs Procedures: Complicated or time-consuming customs procedures.
• Local Content Requirements: Requirements that a certain percentage of a product must be produced domestically.
• 4. Voluntary Export Restraints (VERs): Agreements between countries where the exporting country voluntarily limits its exports to the importing country.
• Purpose: Often used to avoid the imposition of tariffs or quotas by the importing country.

(b) Arguments For and Against Trade Restrictions:

• Arguments For Trade Restrictions:
• 1. Infant Industry Argument: Protecting new industries until they are mature enough to compete internationally.
• Rationale: Allows domestic industries to develop and gain a competitive advantage.
• 2. National Security Argument: Protecting industries that are essential for national defense.
• Rationale: Ensures a reliable supply of critical goods in times of crisis.
• 3. Job Protection Argument: Protecting domestic jobs from foreign competition.
• Rationale: Prevents job losses in industries that are threatened by imports.
• 4. Protection Against Unfair Competition (Dumping): Counteracting dumping (selling goods in a foreign market at below-cost prices).
• Rationale: Prevents foreign companies from unfairly undercutting domestic producers.
• 5. Revenue Generation: Tariffs can generate revenue for the government.
• Rationale: Provides a source of income for the government to fund public services.
• Arguments Against Trade Restrictions:
• 1. Reduced Consumer Welfare: Trade restrictions increase prices and reduce the variety of goods available to consumers.
• Rationale: Consumers pay more for goods and have fewer choices.
• 2. Reduced Efficiency and Innovation: Trade restrictions protect inefficient domestic industries and reduce the incentive for innovation.
• Rationale: Domestic industries become complacent and less competitive.
• 3. Retaliation: Trade restrictions can lead to retaliatory measures from other countries, resulting in trade wars.
• Rationale: Countries impose tariffs on each other's goods, reducing trade and harming all parties involved.
• 4. Distortion of Resource Allocation: Trade restrictions distort the allocation of resources, leading to inefficient production.
• Rationale: Resources are diverted to protected industries, rather than being used in the most productive sectors.
• 5. Reduced Economic Growth: Trade restrictions can reduce trade and investment, leading to slower economic growth.
• Rationale: Trade is an engine of economic growth, and restrictions stifle this engine.

III. International Financial Institutions (IFIs)

Question 4:

(a) Describe the main objectives and functions of the International Monetary Fund (IMF). (8 marks)

(b) Discuss four criticisms that have been leveled against the IMF, particularly in relation to its lending policies and conditionality. (12 marks)

Model Answer:

(a) Main Objectives and Functions of the IMF:

The International Monetary Fund (IMF) is an international organization that promotes international monetary cooperation, exchange rate stability, and orderly economic growth. Its main objectives and functions include:

• 1. Promoting International Monetary Cooperation:
• Encourages countries to work together on monetary and financial issues.
• Provides a forum for international consultation and cooperation.
• 2. Facilitating the Expansion and Balanced Growth of International Trade:
• Promotes free and open trade among countries.
• Provides technical assistance to help countries integrate into the global economy.
• 3. Promoting Exchange Rate Stability:
• Encourages countries to maintain stable exchange rates.
• Provides surveillance of exchange rate policies.
• 4. Providing Financial Assistance:
• Lends money to countries facing balance of payments problems.
• Helps countries to restore economic stability.
• 5. Surveillance:
• Monitors the economic and financial policies of member countries.
• Provides advice on how to improve their economic performance.
• 6. Technical Assistance:
• Provides technical assistance to member countries to help them improve their economic and financial management.

(b) Criticisms of the IMF:

• 1. Conditionality:
• Explanation: The IMF imposes conditions on its loans, requiring countries to implement specific economic reforms.
• Criticism: These conditions can be harsh and lead to reduced social spending, increased inequality, and economic instability.
• 2. Lack of Ownership:
• Explanation: The IMF's conditions are often seen as being imposed from the outside, undermining national sovereignty and limiting the ability of developing countries to design their own development policies.
• Criticism: Countries may be less likely to implement reforms if they do not feel ownership of them.
• 3. One-Size-Fits-All Approach:
• Explanation: The IMF has been criticized for applying a one-size-fits-all approach to its lending policies, without taking into account the specific circumstances of each country.
• Criticism: This can lead to inappropriate and ineffective policies.
• 4. Moral Hazard:
• Explanation: The availability of IMF loans can create moral hazard, encouraging countries to take on excessive debt and engage in risky economic policies.
• Criticism: Countries may be less disciplined in their economic management if they know that the IMF will bail them out if they get into trouble.