LETTER OF CREDIT
NEED FOR PAYMENT SYSTEM IN INTERNATIONAL TRADE
Let us understand the basic nature of movement of the goods and payments in an international trade. In this case exporter is seller and importer is the buyer. Goods moves from exporter to the importer and payment of sales moves from importer to the exporter as shown in figure below:
GOODS
Exporter SALE CONTRACT Importer
PAYMENT
First of all exporter and importer will execute a sale contract in writing or invoice containing details of price, quantity, shipment date, payment method etc. This contract will make the base for exporter to prepare goods or services and expect payment after shipment. Sale contract also guide the importer when and how to make payment on due date. Practically exchange of goods and payment between exporter and importer is associated with number of complex problems. Some of them are mentioned below:
• Exporter and importer are in different countries separated by long distances.
• Rules and regulations, trade laws, market conventions, commercial and financial conditions are different and unknown.
• Currencies are different. Working time is not the same and it is time consuming and expensive to talk and contact the other party.
Requirements of the exporters and importers are different and their understanding is essential to find out the appropriate payment method to avoid delays and credit risks. Main requirements are as under:
________________________________________________________________________
Exporter’s Requirements
- Payment should be received on shipment of goods.
- Assurance that importer will make payment on due date.
- Convenience of receiving payment locally.
- Financial assistance before or after shipment of goods.
- Assurance that importer has good credit rating and on arrival get goods released.
Importer’s Requirements
- To pay for goods only after shipment.
- Assurance that exporter will ship quality goods as per contract.
- Goods will be delivered in time.
- System to help exporter to get finance to manufacture goods on schedule.
- Safe delivery system of getting title documents from foreign country.
We observe that exporter and importer have mutual interest, in completing the trade transaction but financial interest are complementary. Before finding out the system satisfying the maximum requirements, let us see which are the methods available for settling the payments. Some of the methods are barter, advance payment, open account and documentary collection through banks etc. On analysis of these payment methods, it is found that none of these satisfied fully the requirements of the involved parties.
Normally, the exporter would like to retain control on goods by controlling the documents till payment. On the other hand importer wants quality goods shipped on time and safe receipt of documents before making payments. Under such circumstances the only ideal way, to resolve this problem is to take the commitment of third party of excellent standings. Further this party should be professional enough to facilitate and complete the exchange of goods and payment to the satisfaction of exporter and importer.
Letter of credit system found to satisfied the requirements of both the parties. To give credit to the whole system commercial Banks expert in handling international trade and payments were brought into picture. Banks provide the LETTER OF CREDIT FACILITY WHICH IS ALSO CALLED DOCUMENTARY LETTER OF CREDIT service to satisfy the business requirements of exporters and importers. This method of payment is more acceptable and commonly used for settling international trade payments. Due to this method of payments new items, new customers and new markets are being encouraged. Please note, this method of payment creates more discipline among the trading partners to ship quality goods on time and receive payment with safety on due date. For new connection it provide necessary safety to start business.
DEFINITION OF LETTER OF CREDIT
Letter of credit is a payment method and not the security for banks to provide finance to exporters. This form of payment is used for the last hundred of years. Letter of credit payment system went out of fashion in boom years of sixties and seventies. Then world debt crisis after 1982, created sudden rush back to safer terms of sales, specially for countries with inadequate foreign exchange reserves for payments.
International Chamber of Commerce Paris France has issued Uniform Customs and Practice for Documentary Credit ICC NO 500 to define, explain terms and conditions to make interpretation uniform, for concerned parties. The banks issue letter of credit subject to Uniform Customs and Practices for Documentary Credit 1993 Revision, ICC Publication No 500 every letter of credit.
Documentary Letter of Credit means any arrangement however named and described whereby a bank (called issuing bank), acting at the request and on the instruction of the customer (applicant) or on its own behalf
1. Is to make a payment to or to the order of a third party(the beneficiary) or is to accept and pay bill of exchange drawn by the beneficiary (exporter)
Or
2. Authorized another bank to effect such payments or to accept and pay such bill of exchange (draft)
Or
3. Authorized another bank to negotiate against stipulated documents provided that the terms and conditions of the credit are compiled with.
PARTIES TO LETTER OF CREDIT
Before we discuss mechanism of L/C, let us understand the various parties involved in the transaction which are as under:
• Applicant or Importer
• Issuing bank or L/C opening bank.
• Beneficiary of the L/C or Exporter.
• Advising bank.
• Negotiating bank.
• Reimbursing bank.
APPLICANT
Applicant of the L/C is the buyer or importer of the goods or services. Importer is to make payments to exporter. Letter of credit is opened by the bank on the request of the importer on the basis of credit worthiness and standing. Importer submit an application to the bank with his terms and conditions for the payment which will be incorporated in the L/C. Exporter will get payment subject to strict compliance to these terms and conditions from the concerned bank.
ISSUING BANK
Issuing bank is the one which agree to issue letter of credit and transmit this to beneficiary directly on the address given by importer or through corresponding bank in the country of the exporter. This bank is importers bank in his country. Some time multinational banks may agree to issue L/C on behalf of buyers in different country. Issuing bank charge commission base on the amount of L/C and period of commitment. Issuing bank undertake to make payment to exporter on compliance. This conditional undertaking by the bank of good standing provides the needed credit reinforcing credit worthiness of the buyer. Exporter should satisfy the credit rating of the issuing bank by Moody’s or Poor and Standards making reference to latest edition of Banker’s Almanac. It is obligatory to the issuing bank to verify that terms and conditions of L/C have been complied with and then make payment to the negotiating bank. Issuing bank is under obligation to make payment even if importer does not make payment to the issuing bank, if all the terms and conditions of L/C have been compiled with.
Letter of credit issued by issuing bank will be IMPORT LETTER OF CREDIT for the Buyer or Importer. When the same letter of credit is given to Exporter or seller will be treated as EXPORT LETTER OF CREDIT.
BENEFICIARY
Beneficiary is normally seller of goods or exporter who has to take payment after compliance. L/C is always addressed to beneficiary and issued in his favor. Beneficiary gets L/C duly authenticated by correspondent bank in the country of the exporter. Beneficiary gets authenticated L/C by mail, telex, SWIFT normally through a advising bank in the country of the exporter. Bank may provide export finance to exporter at concessional interest rates on the basis of L/C. In case of transferable L/C beneficiary may request advising bank to transfer L/C to other beneficiary.
ADVISING AND OTHER BANKS IN L/C TRANSACTION
Advising bank is to deliver the Authenticated L/C to the beneficiary. Advising bank is different than the issuing bank and normally situated in exporter’s country. The main duty of this bank is to authenticate the L/C other wise it is a useless piece of paper. If advising bank or some other bank will add confirmation to this L/C then the bank is called confirming bank. After confirmation L/C has undertaking of two banks. In case issuing banks fails then exporter will get payment from confirming bank. If exporter is not satisfied with standing of issuing bank specially if African Banks, then confirmation by local bank may be demanded.
If issuing bank may nominate a bank, in exporter’s country to pay to exporter against compliance to L/C terms then that bank will be called nominated bank. Some times letter of credit are issued which are freely negotiable by any bank. Negotiation means, bank making payment to exporter, against compliance of conditions of L/.C.
The bank which negotiated L/C and made payment to exporter will need to be paid back by the issuing bank. Issuing bank normally print reimbursement instructions in the body of L/C. Bank which will reimburse to negotiating bank is called as reimbursing bank situated in a country depending on the currency of L/C.
MECHANISM OF LETTER OF CREDIT-HOW IT WORKS
It is very essential to understand how Letter of Credit works in completing the international trade transaction. The main parties in L/C are exporter and importer. Dual nature of L/C depending on whether, it is in the hand of exporter then it is called Export L/C or if it is in the hands of Importer then it will become Import L/C.
ISSUE OF LETTER OF CREDIT
Letter of credit is always issued on the request of the importer by the issuing bank incorporating instructions given by him. These instructions are mostly taken from the order or from the sale contract between exporter and importer. Issuing bank before opening the letter of credit satisfy with the financial capacity of the importer. Until now L/C may be called import L/C.
The L/C is always addressed to the beneficiary. Issuing bank advises this letter of credit to the beneficiary that is exporter directly or take the help of a bank in the country of the exporter. L/C in the hand of exporter will become the export L/C. Advising bank will first authenticate the genuineness of L/C and hand over the same to exporter. Some times issuing bank make request to advising bank to add confirmation by charging commission or negotiate the documents and pay to exporter on compliance.
On receipt of L/C the exporter will check whether terms and conditions and documents required are as per agreed contract and easy for compliance. If any clause is objectionable and need to be changed, it must be taken directly with buyer. To understand the L/C operations let us discuss the mechanism of opening letter of credit and movement of goods along with the payments. The mechanism is depicted by arrows showing the movement of the transaction and numbers depicting chronological order of the steps in the transaction.
Opening and advising mechanism of L/C is as under:
Importer...............................Sale Contract..................... Exporter
Application for L/C L/C Advising
Issuing Bank Credit Transmition Advising Bank
1. First of all exporter and importer will execute sale order containing all the conditions of sale of goods including the payment by L/C. Any dispute between these parties relating to sale of goods will be decides on the basis of this contract.
2. Importer will approach the issuing bank on prescribed application with request to open L/C. Importer and issuing bank has banker customer relation ship. Issuing bank charge commission for opening L/C and undertake to make payment to negotiating bank. Any dispute between importer and issuing bank will be decided by L/C opening contract only.
3. Issuing bank will send L/C by post, telex or SWIFT to advising bank with instruction to deliver it to the exporter. The relationship between issuing bank and advising bank is of principal and agent.
4. Advising bank will authenticate the L/C and mail or hand over the same to exporter. There is no binding contract of issuing bank with exporter.
But if advising bank adds confirmation, it assumes the liabilities of issuing bank. Exporter will start manufacturing activities on receipt of L/C with agreed terms and conditions. Otherwise starts the process of amendments. For amendment exporter approach the importer for amendments in L/C. In case importer agrees then issuing bank will be asked for necessary amendments. Amendments will again be advised to exporter in the same manners as in case of advising L/C. exporter will keep these amendments along with original L/C and give to negotiating bank at the time of negotiation of export bill.
MOVEMENT OF GOODS AND PAYMENT UNDER L/C
Understanding of movement of goods and payment under L/C transaction will make this method of payment very clear to importer and exporter. At the outset, please note that goods move from exporter to importer with the help of the shipping or airline company. Where as payment moves from importer to exporter with the help of the various banks as explained earlier. Mechanism of letter of credit covering movement of goods and the payment is explained as under with help of arrows and numbers:
1. On receipt of the L/C exporter manufacture the goods and ship the goods to the importer through shipping company. Shipping or airline company will issue bill of lading or airway bill giving title to the goods to the exporter. Please note who so ever will surrender this title document to shipping or airline company will get the possession of the goods.
2. Exporter will prepare the required documents as per L/C and submit the same to the negotiating bank in his country. Negotiating bank will satisfy itself that documents and other conditions of the L/C have since been compiled with strictly. If yes, negotiating bank will take all the documents including bill of lading or airway bill and make payment to exporter. Exporter will get payment before importer takes possession of the goods. Importer is getting good of his specification and on time as depicted by documents and bill of lading. This is the beauty of L/C mechanism.
3. Negotiating bank quickly without any delay send the documents to issuing bank. The bank will check that submitting the proper documents by the exporter has satisfied all the terms and conditions. If fully satisfied then take the documents and make payment to the negotiating bank.
4. Issuing bank will give the documents to the importer or the buyer against the payment.
5. Buyer will check that all the documents are as per stipulation of letter of credit. If yes, he will make payment to the issuing bank by taking the documents.
6. Buyer will take the bill of lading to shipping company or airway bill to airline company and surrender them against delivery of the goods.
We have observed that through this L/C mechanism buyer gets goods as per his specification and requirements and exporter gets payment before goods are released to importer. Hence letter of credit mechanism satisfied the basic business requirements of importer and exporter in very safe manners by utilizing the services of banks.
Please note in L/C mechanism payment is made on the basis of documents only on the strength of doctrine of strict compliance. But selection of good buyer and seller is a must because bad persons can use this system for committing frauds and cheating.
TYPES OF LETTER OF CREDITS
Depending on the requirements of exporters and importers, convenience of operations, there are various types of letter of credit used in international trade. Brief details of these letter of credits are as under:
REVOCABLE LETTER OF CREDIT
In letter of credit we have seen that main parties are importer, exporter or beneficiary, issuing bank, confirming bank. Revocable L/C is a documentary credit, which can be cancelled and amended without any consent of the concerned parties. Issuing bank with instruction from importer may cancel revocable L/C without consent of the beneficiary means exporter. So this L/C is a useless financial documents. This type of L/C is not in use in these days where main requirement of international trade is safety. For exporter it is a useless piece of paper and should not accept revocable letter of credit under any circumstances. Still it is being used in limited way in timber trade in some countries. But this L/C should be avoided.
IRREVOCABLE LETTER OF CREDIT
Irrevocable letter of credit cannot be cancelled or amended without the consent or agreement of all the concerned parties to letter of credit specially the beneficiary means exporter. From exporter’s point of view, irrevocable letter of credit is more favourable and the best to protect the business interests. A letter of credit, which is not specially indicated as revocable, is deemed to be an irrevocable letter of credit as per article 6 c of UCP Brochure 500.
STANDBY LETTER OF CREDIT
As the name suggest, standby letter of credit act as a support to other trade facilities to ensure payments. Exporters are selling goods on open account basis and if the buyer fails to make payments on due date. To protect against this risk, exporter may ask for the stand by letter of credit, so that in case of default in payment exporter, exporter can settle the claims by submitting documentary evidence of non-payment. Similarly, where exporter is using collections system, standby letter of credit can be used to support the unpaid bills. Bank issuing such credit gives an undertaking if non-performance of some act by the importer will occur then exporter can claim under standby letter of credit. For example in case of open account sale contract, in case of non payment by the importer on due date, the exporter might submit an invoice accompanied by a declaration that payment has not been made. Issuing bank will make payment under standby letter of credit. Similarly, standby credit opened to cover unpaid bills of exchange under collection basis will be paid by issuing bank on presentation of the declaration that the bill is unpaid. Standby letter of credits are issued in the irrevocable form. Issuing bank usually call for very simple document for non-performance by the importer. No transport documents are called for under standby letter of credit.
These credits are rarely used in India but are popular in USA where certain restrictions are to issue guarantees. It has replaced the guarantee, where there are restriction on issuing finance and performance guarantees. Standby letters of credit are also used where banks are requested to do so because of local laws in the exporter’s country. In such case standby letter of credit is an acceptable alternative.
A standby letter of credit in case of export of open account sale or collection basis is preferable from importer and issuing bank viewpoint as compared to the irrevocable L/C. Take an example if export order is to supply goods worth EURO240000 in a year at the rate of EURO20,000 per month. Importer will prefer to arrange the purchase this on the basis of collection , with standby letter of credit for EURO40,000 covering two months requirements. It will avoid opening of L/C for EURO240000. Importer will save lot of cost and reduce the liability to Euro24,000 instead of Euro240,000.
DEFERRED PAYMENT CREDIT
Deferred payment credit is a usance credit. Where the designated bank will make payment on the due date determined in accordance with stipulation of the credit without drawing of the bill of exchange or draft. This credit saves heavy duty on bill of exchange in certain countries. No bill of exchange will be drawn in this case only date of payment will be mentioned. Normally L/C with payment period requires the production of certain documents and usance draft or bill of exchange which will be accepted by the importer. In countries like Italy, B/E or draft attract heavy stamp duty. So deferred credit is used to avoid stamp duty on draft. It works in almost the same way as normal L/C except that there is no B/E. Once the exporter submits required documents in strict compliance then payment will be made in future date.
ACCEPTANCE CREDIT
In this credit usance draft or bill exchange is a must be drawn on specified bank or drawee or buyer named in the L/C for a tenor or usance period. The accepted draft will be paid in due date. In this case the exporter will discount this accepted draft with the bank and get payment. Where as importer will make payment, on the maturity of the bill of exchange.
NEGOTIATION CREDIT
In case of negotiation credit a draft is usually drawn by the exporter on sight or usance basis as per the terms of the credit. In case of negotiation credit, the negotiation can be restricted to a specified bank. Some times credit allows free negotiation. In this case any bank will negotiate provided it is satisfied with credit rating of the issuing bank. A bank that negotiates the draft and make payment to exporter, will buy the documents and becomes holder in due course. Under negotiation credit it is the responsibility of the issuing bank to make payment to negotiating bank on due date.
CONFIRMED LETTER OF CREDIT
Letter of credit to which another bank, other than issuing bank, adds its confirmation on the request of issuing bank. Confirmed L/C provides undertaking of payment of not only issuing bank but that of a confirming bank also. Normally exporter needs confirmation of reputed bank of his country or a bank with high international reputation. There is a double undertaking of the two banks. For exporter an irrevocable letter of credit confirmed by local bank of repute is the best. But confirming bank will charge for adding confirmation to L/C.
REVOLVING LETTER OF CREDIT
Revolving letter of credit is the one where under terms and condition of the credit, the amount is revived or reinstated without requiring the specific amendment to the letter of credit. The amount of credit can revolve with respect time and amount. The basic principle of revolving credit is that after a drawing is made, credit reverts automatically to its original amount for the use of the exporter.
There are two types of revolving letter of credit. In the first type of revolving credit, the credit gets reinstated immediately after a drawing is made. For example if revolving letter of credit is for USD 100,000 and exporter draw a draft of USD40,000. Immediately after drawl of USD40,000, the credit again revert to its original amount of USD100,000. In second type, the amount reverts back to original amount only after the confirmation of the issuing bank. Revolving letter of credit may create much higher liability for issuing bank. To protect against this, issuing bank may stipulate ceiling aggregate amount and period for which credit is available.
TRANSFERABLE LETTER OF CREDIT
Letter of credit will become transferable if specifically sated to be a transferable. It can be transferred to several beneficiaries on the request of the original beneficiary. Second beneficiary cannot transfer it to third beneficiary. Further transfer is subject to original terms and conditions of the credit except amount, unit price, date of shipment and validity. First beneficiary who is a middleman can earn his commission by substituting his invoices. The advising bank always does transfer of letter of credit by charging the nominal fee on the request of the original beneficiary.
BACK TO BACK LETTER OF CREDIT
Some times persons have contracts with foreign buyers and get letter of credit for supply of the items not manufactured by them. This beneficiary will open another local credit with similar terms in favour of manufacturer supplier offering original L/C as security. This will enable him to obtain payment against original L/C by presenting documents received under back to back letter of credit. Back to back L/C practically serves the same purpose as that of transferable L/C.
RED CLAUSE LETTER OF CREDIT
Ordinary if we look at the mechanism of L/C, it provides for payment to the exporter against shipping documents and compliance of the terms and conditions. Red clause credit is an anticipatory where payment is given to exporter in anticipation of the shipment of the goods at the preshipement stage. Documents of shipment will be submitted later on. The basic purpose of this credit is to provide finance to exporter on the undertaking of issuing bank in order to enable him to arrange for the goods. Issuing bank incorporates the special clause in letter of credit in red ink authorizing the bank to make advance to exporter which will be adjusted from the proceeds of the documents presented under this L/C. But due to some reason, exporter does not present the documents then issuing bank will make the payment to which has given advance under red clause L/C. Red clause L./C are not popular and only used in wool trade in Australia. Where beneficiary needed funds to make payment to farmer in advance to book for supply of the raw wool. This arrangement of red clause is possible where exporter and importer have long standing relationship.
GREEN CLAUSE LETTER OF CREDIT
It is an extended version of red clause L/C. Under green clause exporter not only get finance by the designated bank for procuring the goods but also for warehousing and arranging insurance charges at the port where goods are stored pending availability of shipping space. Generally, finance under this clause is given after the goods are put in warehouse up to the period till shipping space is available. In such cases, bank will take warehouse receipt as security. Since, in India preshipment finance are given by banks, against L/C to meet for financial requirements of the exporter, on priority and at concessional interest rate, so these red and green caused L/C are not in use.
Created By : Export Genius
No comments:
Post a Comment