A letter of credit (abbreviated as L/C) is a written conditional undertaking by a bank (issuing bank or issuer) with the instructions (through prior agreement) of the account party (i.e., the buyer) in favour of the beneficiary (i.e., the seller) to pay, accept or negotiate the beneficiary’s draft up to a certain sum of money in the prescribed currency, within the prescribed time limit upon the presentation of stipulated documents.
Documentary Payment Modes:
There are three ways to make or receive payments.
First is ‘Document against Payment’ or D/P. Under this method the bank checks that all the documents are there as listed in the agreement. The bank shall handover the documents to the importer only after having received the payment. The importer can claim the goods only thereafter.
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The second documentary mode is known as ‘Document against Acceptance’ or D/A. The documents will be sent to the importer’s bank, which will inform the importer of the arrival of documents. The documents shall be handed over only after the bill has been signed. The exporter than can discount the bill, if he so wishes. The basic difference between D/P and D/A is that under D/A immediate cash is not paid, rather paid at a later date.
The third method is payment through letter of credit or a sort of guarantee from the importer’s bank, or documentary credit.
Why L/C?
L/C is the second best method to receive payments in international trade only next to advance payment. It reduces the risk of breach of contract due to inability of the buyer to pay or obtain financing or unwillingness to pay in a depressed market, as the promise is from the bank and not from the firm. It also eliminates the risk emerging due to the buyer’s country from making payment on the documents.
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It also provides immediate financing after shipment, once the bank finds that documents are in order. To the importer, it assures that the exporter will be paid only if he provides certain documents, which are in order.
In case of non-shipment, it is easier to recover the amount from the bank than the exporter. The importer is enabled to remove commercial risk to the exporter in exchange for other considerations. In brief L/C offers the following merits:
1. Security while reducing risk. An L/C, in which a bank accepts an obligation to pay, is better than a normal bill of exchange being accepted.
2. Transparency. Since all the terms and conditions are specified in an L/C, both the parties feel protected.
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3. Liquidity. If the need be, the exporter can get money before maturity by getting it discounted from his bankers, and that too at a rate lower than the bill of exchange.
4. Advantageous to the buyer. As compared to advance payment, it is easier for buyer as he is buying now and paying letter. Second, he is also assured of timely delivery.
Limitations of L/C:
The limitations of L/C are as under:
Inflexible, cumbersome and complex: First, to open an L/C is a tedious task as lot of paperwork is required. Then, if any amendment is to be made it is very difficult, as the buyer himself may not agree. Even if he agrees, every amendment cost financially. Using L/C is unsuitable when the transaction is unusual and needs flexibility.
Expensive: To open an L/C by an India buyer, he is to deposit 25% of the amount in cash and balance by way of mortgage. If the buyer has nothing to mortgage, then he has to deposit 100% amount with the issuing bank. The interest to be received by the buyer from the bank until payment is made is much less than what the bank charges to the buyer.
Not a fool-proof method: There are many instances when forged documents are presented to the issuing bank and payment is collected without actual loading of cargo. The payment may be denied by the issuing bank even if there is a minor discrepancy.