• The role of merchants in cotton exports

    Chapter 4 - Cotton trading - The role of merchants in cotton exports 


    It might be tempting to think that cotton merchants have an easy job. They do not grow cotton, they do not gin cotton, and they do not spin it. Are they not just a intermediaries who buy and sell? Because trading is their job, they must surely know whether prices will go up or down, and therefore it must be easy to make money out of doing very little. Exporters might be farmers, ginners, cooperatives, privately owned traders or government departments, or indeed a combination of two or more of these. Why should they not sell their cotton direct to overseas spinners? By cutting out the intermediary will they not be able to obtain a better price for their cotton?

    In order to answer these questions it is necessary to understand the role of the merchant, which is a complex one.

    The cotton market is geographically very diffuse. Although China is easily the largest importer, it still accounts for less than 40% of all global cotton imports. More than 70 countries account for the balance of over 60%. The larger international merchants have offices or agents in all the major importing countries. It is the job of these offices and agents to make regular visits to the spinning mills in their territory in order to find out when the mills are in the market and for which qualities. They will then do their best to negotiate sales to those spinners. However it is a sad fact of life that not all businesses are reliable, honest, and financially sound. The agent must judge which spinners fall into this category.

    The fact that spinners are spread so widely across the world means that they are located in many different time zones, and of course theyThey have to be ready to take calls out of normal office hours and they know that they may be woken during the night. The plans soon to extend to 22½ hours the daily trading hours on the Intercontinental Exchange (ICE) are likely to intensify this pressure on international traders. like to trade during their own office hours. Traders in a merchant's office accept that theirs is a 24/7 business.

    Time plays a part in the merchant’s role in another respect, the timing of purchases and sales. Exporter suppliers seldom want to sell at the same time as the merchant’s spinner customers want to buy. In some countries the farmers need loans well in advance of harvest time in order to pay for inputs such as pesticides and fertilizers. Often the banks will make such loans only if the farmer, or the organization that exports on behalf of the farmer, can provide evidence of sale contracts to a party which the bank knows to be reliable. Therefore farmers in these countries may need to make sales well in advance of the crop. In other countries, such as Brazil and Australia, producers may sell as much as two, or even three, years ahead if the price looks profitable to them. Few spinners would want to commit themselves so far ahead, but a reliable producer will nearly always be able to find a merchant who is willing to make a price and enter into a contract. Merchants may hedge their risk by making a sale of New York futures, or may cover themselves by selling the same cotton, or a completely different cotton, for an earlier shipment. They must use their experience and judgement to decide what the difference in price should be between the physical cotton that they have bought and the cotton or futures that they will sell. They may even decide not to make a sale at all in the belief that the price will eventually go up. There may be people who will say with disapproval that this sort of trading is speculation. However, without ‘speculating’ merchants, producers would not be able to sell their cotton so far in advance. By using their skill and judgement to take a calculated risk in this way the merchants provide a service to the producers and to the spinners. Sadly, from the merchants’ point of view, their market judgement will not always be right, and they will make losses as well as profits. However, it is safe to assume that established merchants must have been right more often than they have been wrong!

    We have seen that probably the exporter will not want to sell at the same time as the spinner will want to buy. It is also likely that the exporter will not want to sell on the same terms as the spinner will want to buy, especially as regards payment. Most exporters want to be paid by an L/C against shipping documents at sight, or in some cases against documents of overland transport when the cotton is delivered from the gin. Some exporters may want to be paid before shipment against a warehouse receipt at the shipping port, or even before the cotton has been harvested. It is the job of the merchant to do his or her best to meet these requests as far as possible. It will not always be possible to meet the exporter’s optimum requirements, but it is surprising how often creative solutions can be found by a merchant. On the other hand, spinners may want entirely different payment terms. They may be willing to open n L/C, but often with a term of 180 or even 360 days instead of at sight. In such cases the merchant must take the risk that the opening bank will remain creditworthy for the full period or must find another international bank to confirm the L/C. An international merchant will have close relations with many of the Receipt and confirmation of a valid L/C is only the start of the process of receiving payment. Many L/Cs are very demanding with regard to the documents the seller must furnish in order to obtain payment. They will usually demand bills of lading, a phytosanitary certificate, a certificate of origin, an invoice, and a packing or weight list. The seller will also have to furnish an insurance certificate (if the sale is on CIF terms) or a copy of the seller’s advice of shipment to the buyer’s insurance company if the sale is CF or FOB. The wording of all these documents must comply exactly with the requirements of the L/C, and the complete set of documents must be presented to the negotiating bank within the time stipulated in the L/C. They must also comply with the International Chamber of Commerce Uniform Customs and Practice for Documentary Letters of Credit. If even the smallest detail in the documents does not comply, the bank will advise the seller that there is a discrepancy in the documents, and payment will be refused until the opening bank has notified the negotiating bank that it accepts the discrepancy and authorizes payment. Obtaining this authorization can be a very long process and, at this point, the seller depends entirely on the goodwill of the buyer. Obtaining payment by L/C can require not only an expert shipping and documentary department, but also a good relationship with the buyer. This is an important part of the role of the merchant.

    The accepted international currency of the cotton trade is the United States dollar. However some exporters may wish to be paid in their own currency, and some spinners may wish to buy in a currency other than the United States dollar. It is part of the role of the merchant to bridge this gap.

    A more obvious gulf between the exporter and the ultimate buyer is a probable difference of language. Many international business relationships founder because communications break down. When speaking or writing in an unfamiliar language it is all too easy to convey a message that was not intended. Even when the two parties speak the same language it is quite common for misunderstandings to occur and for words to be taken as hostile when they were not intended to be so. When the two parties have no common language, such difficulties are magnified. It is part of the merchant’s job to ensure that he or she can communicate clearly and effectively with both suppliers and with customers, either directly or through his or her branch offices or agents.

    Not only is it likely that exporters and spinners will seldom want to buy and sell at the same time or on the same payment terms, it is also likely that their requirements as to transport will be different. Exporters will probably want to sell on ex gin or FOB terms, whereas spinners are likely to want CF, CIF, ex warehouse in their own country or delivered mill terms. In order to transport the cotton in the cheapest and most efficient way it is necessary to have close contacts with numerous shipping companies. Some of them may be cheap but not efficient. Others may be very efficient but have high freight rates. The merchant will be in constant touch with the major shipping companies in order to ensure that his or her cotton is transported across the world in the most effective possible way.

    The global market is dominated by China. China is important because it accounts for about 40% of the world’s cotton imports; consequently, world prices are very sensitive to the strength or weakness of demand in China. The Chinese market is not only large but very complicated and difficult to service efficiently. Nobody knows exactly how many cotton spinning mills there are in China but the number is thought to be over 10,000. Of course, many of these are too small to be able to import cotton effectively, but China consumes between 10 million and 11 million tons of cotton annually, and produces less than 7 million tons, so it is easy to understand that there are many large importing mills. They are spread over a huge area, so in order to service the Chinese market the merchant must have sub-offices or representatives all around the country. In recent months it has become more and more usual for merchants to ‘consign’ cotton to China. That is to say, they will ship unsold cotton to China, store it in port warehouses and finance it until they can find a buyer. Chinese spinners like to buy from consignment stocks because they can inspect the cotton before buying it. Furthermore they can take delivery on whatever exact date they agree with the merchant, so they do not have the uncertainty about arrival time that is inevitable when they buy cotton which is still in the country of origin. At the time of writing it is believed that international merchants have stocks of about 350,000 tons lying unsold at Chinese ports. Chinese spinners are growing used to buying in this way and they expect their major suppliers to be able to provide this service.

    It should now be clear that, even if goodwill exists between the parties, the performance of an international cotton contract is a very complicated task. Problems may arise at any time. Vessels may be delayed, harvesting of a crop may be delayed, and transport of the cotton to the port may be disrupted by strikes, bad weather, or even war. The spinner may wish to delay shipment because of an unexpected downturn in demand for its yarn or cloth. If a shipment to China is delayed, for example, the merchant may be able to deliver substitute cotton on time to the spinner from stocks already lying in China, thus avoiding disruption to the spinner. If a spinner wishes to have a shipment delayed, the merchant may be able to allocate the cotton to another of his or her sale contracts, and thus still take delivery from the supplier on time. This kind of problem solving is an important part of the merchant’s job.

    It can also happen that, despite the best efforts of the seller, the spinner may be dissatisfied with a shipment. It may be that the spinner is unhappy with the quality or with the condition of the bale packing. If it is a matter of quality the spinner will need assurance that it is going to be financially compensated and that future shipments will be of the correct quality. If there is a problem with the condition of the bales this may be a matter for an insurance claim or for a claim on the seller, depending on the type of damage and the terms of the contract. It is much easier to solve this kind of problem in an amicable way by face-to-face discussion. As we have seen, the merchant will have a branch office or an agent who can visit the spinner to assess the nature of the problem and discuss it personally on the spot. If the problem is really serious the merchant may decide that an executive from the head office should visit the spinner.

    Perhaps the most interesting part of the merchant’s role is to bridge the many diverse cultures which exist in the world. Only by regular travel and telephone contact can mutual confidence and understanding be made to grow and prosper. If the two parties know each other personally and have developed some mutual understanding it becomes much easier to do business and to solve any problems that eventually may arise.

    By far the most serious problem that can confront an exporter is a complete failure on the part of the buyer to perform the contract. Like any other business, spinning mills round the world vary in their financial strength and in their attitude to contract performance. In recent months world cotton prices have been very stable, but this has been a very unusual period. The Cotlook A Index has moved within a range of less than 5 cents per lb. However, the average range over the past 15 seasons is over 18 cents per lb, and in 1994–1995 the range was over 46 cents per lb. Figure 4.1 illustrates the unusual stability of prices since January 2005.




    The more prices fluctuate, the greater the risk of non-performance. If the price has fallen sharply between the date of the contract and the contracted date of shipment, it may be that the spinner does not have the financial strength to open an L/C at the original contracted price. Spinners might gamble that prices would increase when they buy cotton, and he/she be unwilling to face the loss when prices do the opposite to what they expect, so simply refuse to open their L/Cs. A more frequent occurrence than outright refusal to open the L/C is an assurance that it will be opened next week, then the following week, then next month, until it finally becomes clear to the seller that it will never come. In such a case the seller will be able eventually to obtain a financial award at arbitration, which in theory will compensate the seller for the loss. However, arbitration is a lengthy and laborious process which can take many months. When the award has been obtained it may take more time to persuade the spinner to comply with the award or to enforce it in the courts of the spinner’s own country. Losses due to contract non-performance can be very substantial: a loss of 18 cents per lb (the average fluctuation in the A Index over the last 15 seasons) on sales of 2,500 tons amounts to about $1 million.

    Performance guarantee is probably the most important of all the merchant’s roles. An established international merchant cannot afford to default on a contract with an exporter, even if the merchant’s own customer has let him or her down. Although the cotton trade spans the globe, news within the cotton community travels very fast and bad news travels fastest of all. Many of the major merchants have spent many decades building up their reputation, and their continued existence depends upon maintaining this reputation. To default on a contract would, and indeed should, ruin their reputation and eventually drive them out of business.

    It would be foolish to maintain that there are no circumstances in which exporters should sell directly to spinners in another country, but they should be aware that there are many potential risks and a great deal of hard work involved in doing so. Because international merchants have a large turnover they are able to work for a small margin. Therefore a merchant can often pay to the exporter a price which is very close to the price that a spinner would pay. Indeed, it is not uncommon for a merchant who takes a bullish view of the market to pay a higher price to the exporter than is currently being paid by spinners.

    Ease of travel and modern methods of electronic communication make it simpler today for exporters and spinners to be in contact with each other if they so wish. Nevertheless, merchants will certainly continue to provide their services to exporters and spinners for many decades to come. 

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