In a world that continues to advance and become more integrated than ever before, it is important to recognize the risk associated with this globalization. Globalization is the process of increasing cross-border interaction and assimilation of various aspects of human activity, particularly through trade and financial flows. Companies increasingly do business abroad to diversify and expand their sources of revenue and profitability. As such, a credit professional should understand the aspects of international credit risk. Aside from commercial risk, the two main types of risk in international sales are political and sovereign.
Political risk can be defined as the risk an investment’s return could suffer as a result of political changes or instability in a country. For example, a change in government could lead to discriminatory regulations, contract breaches, currency alterations, or even civil war. If you are wondering if there is an increase in political risk on a global scale, the answer is yes. Between 2007 and 2015, the number of conflicts increased twofold. These events can place downward pressure on your customer’s profits and / or business goals, which in turn could hurt your company’s bottom line.
Any risk arising on chances of a government failing to make a debt repayment or defaulting on a loan is called sovereign risk. The strength or weakness of a country’s banking system, in addition to the depth of its capital markets, are important factors to monitor. Debt obligations have the potential to become a fiscal burden or impair fiscal flexibility. Should a government fail to repay its obligations, it could send its country into a tailspin, having a negative impact on global markets as a whole.
After assessing the above risks, what might a credit professional consider to mitigate such risks? Letters of credit (“LC”) are typically used in international sales, as they provide an increased level of security for both parties. Essentially, letters of credit are “a method of shifting the credit risk from the customer to a financial institution issuing the LC” (Journal of Business Credit). This means that the issuing bank has agreed to cover the transaction and that the seller will be paid subject to meeting the conditions noted in the letters of credit. However, we note letters of credit are costly.
EXIM Bank (Export-Import Bank of the United States), is also another option in this situation. EXIM works with private banks so exporters can secure financing for overseas sales through a working capital loan guarantee. We see many companies choosing credit insurance as a means to eliminate the need for letters of credit, to level the competitive playing field, and offer attractive open credit terms with foreign customers. Export credit insurance will protect your business from non-payment of commercial debt.
Financial and political woes can have significant implications on a company’s business. Although this is often overlooked, a credit professional needs to understand how it could influence their international customer’s credit profile.
Sources: ProfitGuard, Coface, and Standard & Poor’s