Export practice:
Letters of credit

Letters of credit are bank guarantees to pay a seller (usuallyan exporter) for goods or services that the seller has shipped
to a buyer (usually an importer). The letters are obtained
from the bank by the importer as a way to assure theexporter that it will be paid. They substitute the credit of theissuing bank for the credit of the buyer. That is, the banktakes on the obligation to pay for the goods.
The exporter receives payment aslong as he can show proof that hehas sent the goods as agreed. The
importer thereby has assurancesthat the exporter will ship thegoods before receiving payment.
Letters of credit are most often used
in international trade when theimporter is unknown to the exporter,or where political risks.How letters of credit work
A letter of credit typically involves
five parties: an importer and its
bank, an exporter and its bank, anda carrier. In simplified form, this is
how it works:
The importer – typically at therequest of the exporter – buys aletter of credit from its bank, called
the issuing bank. The fee that theimporter pays for this letter depends
on its creditworthiness, but canrange from 1 %-8 % of the value ofthe goods.
The issuing bank sends this letter tothe exporter. The exporter now has
assurance that he will be paid by theissuing bank.
At the same time, the issuing bankarranges for an advisory bank in theexporter’s country – typically theexporter’s own bank – to transfer
the agreed payment to the exporter
when the exporter has shown proof
that the goods have been shipped.
The exporter then consigns the goods
to a carrier, in exchange for a bill oflading. The exporter then gives thebill of lading to the advisory bank, inexchange for payment for the goods
he has shipped.
The advisory bank then forwards thebill of lading to the issuing bank, andreceives payment for the goods.
The issuing bank then presents thebill of lading to its customer, theimporter, as proof that the goods
have been sent. The issuing bank isthen paid by the importer.
The key to this system is theprecision of the documents involved,
including the original contract ofpurchase and sale, the letter ofcredit itself, and the bill of lading.
The details of all these documents –including credit amounts, payment
deadlines, serial numbers of theproducts sold, etc – must matchup perfectly, to ensure that all thepayment flows take place
as planned.

The key to this system is the precisionof the documents involved
Types of letters of credit
In practice, letters of credit come inseveral varieties, and it is importantfor exporters to be aware of exactly
what kind of letter the importerhas obtained.
■ Irrevocable/revocable lettersof credit
An irrevocable letter of credit
cannot be cancelled before a
specific date without agreement by
all the parties involved. A revocableletter of credit can be amended
at any time by the issuing bank.
Letters of credit are automaticallyconsidered irrevocable unless theyexpressly state otherwise.
■ Confirmed/unconfirmed lettersof credit
A confirmed letter of credit gives
the exporter a double guaranteeof payment, one from the issuingbank and one from the advisorybank. Under a confirmed letter ofcredit, the advisory bank agrees
to pay the exporter for the goods,
even if the issuing bank ultimately
fails to honour its obligations. An
unconfirmed letter, in contrast,
offers no express guarantee by theadvisory bank. Letters of credit areusually unconfirmed. Confirmed
letters are used when an exporterhas doubts about the issuingbank’s ability to pay – perhaps
because of potential
currency restrictions in theimporters’ country.

■ Transferable letters of credit

A transferable letter of credit
is used when the exporter isessentially a middleman between
a product manufacturer andan importer. The exporter (ie,the middleman) may not wantthe manufacturer to know theidentity of the importer, to avoid
enabling the two parties to“eliminate the middleman”. In thiscase, the exporter will request atransferable letter of credit, anduses it to guarantee payment to themanufacturer. Once he has paid
the manufacturer, the exporter canuse the letter to receive payment
for the export. Transferable lettersrequire the agreement of theimporter and the issuing bank.
Only one transfer per letteris allowed.
■ Back-to-back letters of credit

If a transferable letter is notpossible, then back-to-backletters of credit can be used. This
involves two parallel letter of credit
transactions, one involving themiddleman and manufacturer,
and the other involving themiddleman and his end-buyer(usually an importer in anothercountry). These two transactions
are independent of each other.
However, the letter issued by theimporter’s bank can offer security
to the middleman’s bank that its
letter (guaranteeing payment to
the manufacturer) will ultimately
be covered by the export sale.

Exporters must ensure they canmeet their own delivery obligations
before relying on letters of credit
to ensure payment, since their own
non-performance could cancel theimporter’s obligations. Such nonperformance could occur through nofault of the exporter – for example, if
it discovers belatedly that it cannot
export the goods due to import
restrictions in the importer’s country.
It is up to the exporter to determine
in advance whether such external
factors could threaten the viability ofan export deal.

■ Standby letters of credit

A standby letter of credit isa second line of defence forexporters, in cases where an
importer has an open (revolving)line of credit, has received
advance payment in some form, orotherwise has ongoing contractual
obligations to the exporter. Astandby letter is usually issued
in addition to the regular letterof credit. Under a standby letter,the issuing bank agrees to pay
the exporter in case the importer
fails to perform as called for by thecontract. It thereby strengthens theimporter’s creditworthiness in theeyes of the exporter.
■ Sight/deferred payment lettersof credit
Sight letters of credit are payableas soon as the required documents
have been presented. Usually,
however, seven days are allowed
under such letters, to permit thebanks to examine the documents
in detail. A deferred payment letterof credit allows the importer to takepossession of goods by agreeing to
pay the issuing bank or the advisorybank at a future date, for example
60 days after the date of shipment.
The issuing and advisory banks
state that they will pay the exporteron the agreed future date. Deferredpayment letters serve as financing
instruments for the importer. He
can, during the waiting period,
sell the goods onward and use theproceeds to pay for the import.

■ Revolving letters of credit

Under a revolving letter of credit,
the issuing bank establishes aline of credit to the importer, andrestores the credit to its originalamount once the importer has
drawn it down. Usually thesearrangements limit the numberof times the importer may
draw down its line over apredetermined period.
■ Red clause letters of credit

These letters provide the exporter
with cash prior to shipment, tofinance production of the goods.
The issuing bank may advancesome or all of the funds. The
importer is essentially financing
the exporter, and takes on the risk
for all advance payments
Points to consider when using lettersof credit
The key to successful use of lettersof credit is proper documentation.
This requires paying close attention
to the fine print on such matters as
description of the goods, deadlines
for delivery of goods and payment,
price of goods, etc. All the details of
the sales contract, letter of credit
and bill of lading must be consistent.
Common sources of errors are details
such as the number of items shipped,
the weight of goods, the shipment
dates, product serial numbers, anddocument reference numbers.

The terms of a letter of credit should
allow sufficient time for the payment
flows to take place – otherwise
the letter could be nullified due
to missed deadlines. If necessary,
exporters should ask for a clause in
the letter that allows an extension oftime in case of delays in electronicbank-to-bank transfers.
A letter of credit is used as aguarantee in case of doubts
surrounding the importer’s ability
or willingness to pay. With that inmind, exporters should consider thedegree of risk involved before asking
for a letter of credit. For example:
What is the value of the order,
and would the bank fees be out of
proportion to the value? What is thecredit rating of the importer, and is
this importer entirely unknown tothe exporter? What is the country
risk of the importing country?
How credit-worthy is the issuingbank? What is the usual practice intrading with this country or in thisline of products? Should additional
protective measures be taken, suchas credit insurance?

Pros and cons of letters of credit
For exporters, letters of credit offer
guaranteed payment; the exporter
receives the issuing bank’s promise
to pay, to back-up the importer’s
promise to pay. This can be asignificant factor when dealing
with unknown customers and/or
risky countries.
In many cases exporters have nochoice but to require an importer toobtain a letter of credit. It might be alegal requirement in the importing
country, or it may be a requirementof the exporter’s credit insurer. In thelatter case, the insurer would pay theexporter if the advisory bank fails topay for goods shipped.
While letters of credit offer exporters
security of payment, they present
several drawbacks. They arepotentially costly to the importer,
which in turn could make theexporter uncompetitive vis-à-vis
other exporters who do not demand
letters of credit. Moreover, in manycases the importer asks to transfer
part or all of the bank fees to theexporter. If a confirmed letter isused, the confirmation costs could
add another 2%-8% to the final tallyof bank fees.
There is also a cost to exporters interms of the time required to checkdocuments and ensure they are

Letters of credit involve a large
amount of fine detail, and payment
will only be made if the terms of theletter are met precisely
error free and internally consistent.
Letters of credit involve a large
amount of fine detail, and payment
will only be made if the terms of theletter are met precisely. Exporters
should consider whether the size andrisks of a particular deal justify thiscost, or whether they might do betterwith an alternative method.
There is a broad range ofalternatives, each posing different
degrees of risk. Under advancepayment, the exporter bears no risk
because the importer pays for goodsin advance. With an open account, incontrast, the exporter bears all therisk, because the importer agrees to

pay only when goods are received.
In between are such arrangements
as documentary collection, in whichdocuments, including a bill ofexchange (a written order from theexporter to the importer to pay) aresent through the banking system.
The bank presents the documents
to the importer and – if all goes
well - receives payment, which
it then passes on to the exporter.
Many exporters also choose credit
insurance. This typically covers up
to 90 % of the invoice value, but theprocess of receiving payment ismuch less time consuming than witha letter of credit.

Connect with Atradius

atradius

Contact us
Atradius.com@atradius

atradius group

Atradius
David Ricardostraat 1 – 1066 JS Amsterdam
Postbus 8982 – 1006 JD Amsterdam
The Netherlands