Letter of Credit in the International Trade

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Introduction

Since man existed there has been trade between different people and countries: from the Greek and Persian to Romans which highlighted the economic importance. Goods that were traded were mainly timber, textiles and precious metal. During this period they made business transactions using credit facilities. The First and the Second World Wars accelerated the use of credit facilities particularly the documentary credits to help in the expansion of international trade because an importer or buyer in a war tone country could easily make payment to the seller. Though this was the darkest period in international trade, countries economies dropped leading to disparities in currencies calling for protection and GATT was formed to incorporate international trade,(Goode, R. 1995)

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Over the years international trade has increasingly grown so is the law of international trade. This law governs international transactions and it has helped in world growth through amalgamation of world markets. A transaction is eligible for international trade if more than one country is involved. It also plays a critical role in the management of racket cases. One of the laws that govern the international trade is CISG which refers to Convention on the International Sale of Goods that takes care of the buyer and the seller’s responsibility when a transaction is carried out (Davies, I. 2005).

Some of the international payment modes are:

Advance payment here the buyer sent money to the seller before he/she receives goods. This mode of payment is only safe to the seller. Documentary credit; unlike the advance payment, it was introduced in the 19th centaury by businessmen around the world. This payment method is both secure and efficient for the seller and the buyer since it involves the bank making payment to the seller on behalf of the seller and the quality of goods shipped are in accordance with the information provided by the bank.However,it is very expensive (Hugo, C.2000). Direct payment; this mode of payment involves the seller shipping the goods and then waits for the buyer to forward the bill usually on open account provisions. Documentary collection; this payment method involves shipping goods, then title documents are sent to the buyers bank by the sellers bank and then the buyer makes payment. However, using documentary collection as a mode of payment there are possibilities of goods not being delivered and if delivered it is late or poor quality shipped, (Macintosh, Kerry L. et al, 2003).

Risks in international trade

Business transaction involving different countries is very difficulty as a result of distance, varying laws and currencies, political systems communication problems caused by different dialects and technical problems.Generally, there are risks a trader is likely to encounter in worldwide trade:

Economic risks: these are risks resulting from an inadequate credit worthiness of the involved parties: exporter, importer and the banks on each side. Exporters’ risks may be the importer might fail to take the goods delivered mainly because of late shipment or unable to make payment.

Whereas the importers risks could be the exporter failing to perform that is quality and quantity of the delivered goods. In a broader perspective economic risks entail insolvency of the importer and arbitrary cancellation of the contract.

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Political risks: also called state risks. They are set procedures by the government to prevail the international transactions or alternatively wars that hinder performance of international trade.

Currency risks: caused by different countries floating exchange rates brought about by economic and political reasons. For instance, when an exporter signs a contract with the important as far as payment terms, he/she (exporter) ends up getting less than what he signed for. On the other hand the importer ends up paying a lot of money as he is paying in foreign rates.

Transport risks: mainly caused by loss or damage of goods when being shipped to the importers destination. In many instances the importer is the one who bears this risk as he/she has to pay for the goods whether received or not since they are in an agreement with the exporter. However, in cases where goods are delivered and the buyer rejects the goods it becomes difficult as who is to cover for such costs. Letter of credit can be used to reduce some of the risks involved in international trade (Goode, R. 1995).

This paper will address letter of credit: how they work, their problems and solutions to the problems.

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Letter of credit (LC)

A commercial letter of credit in financial institution is used mainly as a source of payment in trade economics to offer an irreversible payment activity in international trade. Letter of credit guarantees that the buyer makes correct payment to the seller at the right time. In cases where the buyer does not make payment on purchase the bank will be required to pay full or remaining payment (Brindle. and Cox,R.1996). Letter of credit is very crucial in the international transactions, because it seals the deal between the supplier and the client in different countries. As a result of the nature of international transactions including issues like distance, varying laws in different countries and complexity in knowing each party in person, the usefulness of the letter of credit has become a very essential characteristic of international trade. Also the bank can act on behalf of the buyer (proprietor of the letter of credit) by ensuring that the seller doesn’t receive payment until the bank obtains verification that goods have been shipped to the buyer (John A. Jr.1991).

Letter of credit can also be useful in other areas such in the development of land to guarantee that the permitted public facilities such as drainage systems, streets among others are built. Letter of credit primarily involves the beneficiary, the issuing bank and advising bank. In the issuing bank the applicant is the client and the advising bank the applicant is the beneficiary. The letter of credit is not irreversible as mentioned above because before an agreement is made between the issuing bank (client) and the advising bank (beneficiary) it cannot be modified or even cancelled, (Davies, I.2005). During transactions the letter of credit integrates the client and the beneficiary. In that the beneficiary has to present certain documents before he receives payment. These documents are the commercial invoice and the bill of lading. Conversely, these documents can be negotiated to show the description of quality of goods shipped or their place of origin (Fazio, S.2007).

Letter of credit can either be negotiable or revocable/irrevocable. They are negotiable in the essence that the issuing bank has the responsibility of paying both the seller and the advising bank. For these to happen the letter of credit must include an unconditional pledge of paying on demand or at a specific time. Letters of credit are also considered negotiable in cases where the issuing bank makes payment to the importer, (Fazio, S.2007).

There is also revocable or irrevocable; a revocable letter of credit is the one that allows for modification or enhancement without notification by the issuing bank therefore, it cannot be confirmed and the revocable letter of credit is not regularly used but only in the provision of guidelines for shipment of goods and services. Whereas in irrevocable letter of credit before any changes are made there has to be an agreement of the involved parties: issuing bank, advising bank, exporter and the importer. This ensures that the exporter will be paid since all the documents are in order.

Functions of letter of credit

Letters of credit have been used widely in the evolving economic world and still continues. They perform a number of functions including credit, payment and credit functions.

Payment function

It assists in the arrangement of payment between the importer and exporter. The letter of credit is very significant for payment especially to the exporter as they can receive payment for the goods after handing over the documents at the bank, verification done and even before goods are delivered to the importer. It also helps the exporter to claim additional payment only after getting compensation from the letter of credit, (John A. Jr. 1991).

Credit function

The importer and the exporter need to assist them in the production and buying of goods and services. The issuing bank (exporter’s bank) can pay for the goods to the seller on behalf of the buyer who later makes payment to his bank to refund the issuing bank. A letter makes it easier banks to help in the payment of goods (Cranston, Ross 1997).

Security function

Since the exporter and importer do not know one another they need financial agreement to help the seller deliver goods and services to the buyer and likewise the buyer pays for the services offered. Therefore, the letters of credit serves as the security as it ensures both the seller buyer live up to their terms and are protected against bankruptcy. That is the seller receives payment only after handing over the contractual agreement to the bank (Murray, Carole and Cleave, Barbara, 2002).

How the letter of credit work

Letters of credit have been used for many years to assist in the payment in international trade. They are governed by ICCUC (International Chamber Commerce Uniform Customs) and practices for documentary credit.

It’s an agreement between the bank (issuance bank) consenting to another bank (advising bank) to make payment the seller/exporter who is providing goods and services. It’s the issuing bank tat opens the letter of credit. It posses elements like:

  • Payment details as provided by the issuing bank.
  • The applicant (buyer/importer) to whom goods/services are delivered.
  • Beneficiary of the contractual agreement; the seller/exporter who is shipping goods/services to the buyer.
  • The contract time limit.
  • Documentations that comply with the letter of credit terms and conditions.

Letters of credit are governed by certain principles to ensure their effectiveness in the international transactions. These principle/doctrines are separability and strict compliance.

Doctrine of separability

The contractual agreement between the seller and buyer in one way or another banks are also in that contract. One of the functions of letter of credit is to make a conceptual payment responsibility between the client and the bank. This principle states that the bank should not become a kind of negotiator between the seller and the buyer in resolving their late payment or delivery disputes as this can result in the making of letters of credit being inadequately used /unattractive in international trade. Therefore, it is significant that the letter of credit is thoroughly monitored or otherwise this will hinder the sustainability of international trade. Because when the documents are handed to the bank for verification the banks do not check up for the quality or quantity of goods being shipped. (John A. Jr. 1991).

Doctrine of strict compliance

These doctrine advocates for the participation of all parties in the documentation involved in the letter of credit and not the goods and services to be delivered to the buyer. That is before the documents are presented by both parties to the respective banks for certification they must strictly adhere to the set terms and conditions in the contract as far as the letter of credit is concerned. These principle calls for strict adherence because, banks have no authority for standard or quality assurance of goods and services and cannot give a synopsis of the terms and conditions between the seller and the buyer (John A. Jr. 1991).

Procedures for Using the Tool

A commercial Letter of credit deals with documents and not the goods and services. Mainly involving the issuing bank (buyer’s bank) and advising bank (seller’s bank).The following is the step by step guideline of using the letter credit.

Before any transaction take place there must be the seller and the buyer. In many instances they do not know each other when it comes to financial commitments. Due to the nature involved in international transactions factors such as time consuming are likely to be encountered due to long distances between the seller and the buyer. As a result of these factors international business law offers an alternative to such issues which is the letter of credit which ensures that the buyers (importer) bank makes payment to the seller (exporter) normally the banks charges interest for their services (Carr, I. 1999).

For instance in this case let’s consider Midwestern bank in UK is the seller’s bank and City group bank in South Africa is the buyer’s bank. The City group bank in South Africa will pay the seller on behalf of the buyer but the buyer will pay the bank late (Macintosh, Kerry L. “Electronic cash 2001). Then the buyer makes a list of provisions and conditions to allow for the transaction involving buying and shipment of goods. Some of these conditions are:

  • Description of the goods the import (buyer) wants to buy from the seller indicating the quantities.
  • Technicality of goods the buyer wants if any
  • Documents the buyer may require from the seller such as packing list, bill of lading and the commercial invoice among others.
  • Details of the seller’s bank in this case they will be details of Midwestern bank in UK this is essential because this bank will be in charge of goods till the buyer makes payment.
  • Details of the buyer’s bank; in this context is the City group bank in South Africa as they will be informed by the seller’s bank to notify the buyer that his/her shipment has arrived.
  • Delivery date of goods: this is crucial because it assists the buyer to arrange with his/her bank which is City group to make the necessary payment arrangement. In short is the buyer making remitting full payment or the city bank covering half of the payments to be reimbursed later by the buyer.
  • Shipment line: in most cases buyers choose their own shipping line, port and transportation mode (Murray et, al 2002).

The letter of credit is then issued to the issuing bank (buyer) which is later sent to the seller’s bank.Afer receiving the letter of credit the seller goes on to prepare goods and documents as may be required by the letter of credit and its time to ship goods to the buyer. For illustration, City bank issues the letter of credit, sends to the Midwestern bank which will give to the seller to enable him/her prepare goods and arranges for shipment, (Fazio, S.2007).

Once the shipment has been completed, seller takes copies of all documents as required by the letter of credit to his/her bank. The bank verifies for authenticity and accuracy of these documents. For, example the seller takes the document to Midwestern bank to enable them verify the documents. If at all the documents presented are correct, the advising (Midwestern bank) will claim the funds through;

  • Debt the issuing bank account
  • Wait for the issuing bank to dispatch payment after the goods or services are received.
  • Compensate as required by the letter of credit. (John A. Jr. 1991).

After which the seller bank then pays the seller the amount agreed upon between the seller and buyer. When verification is complete and found accurate Midwestern bank then pays the seller the payment settled by him/her and buyer. After making payment to the seller, the bank (Midwestern) sends documents to the buyer’s bank (City group) which also does the verification for correctness upon which they refund the seller’s bank. (Murray, Carole and Cleave, Barbara, 2002)

At this point the buyer’s bank informs the buyer shipment of goods has been done and they have the documents related to the goods. The buyer arranges to pay his/her bank the payment they made to the seller’s bank. After the buyer has reimbursed his or her bank, which is City group, it then approves the lading bill so that goods can be released to the buyer. Therefore, professional international trade should be familiar with letter of credit to facilitate international transactions and they should review the process carefully to ensure the exporter and the importers fully understands and abide by with all the principles and doctrines, (Gutterridge, H and Megrah, M.1984).

Advantages of letters of credit

Letters of credit are the most preferred mode of payment in international trade by the exporter and the importer because of the following:

  • The exporter is paid upon submission documents stated in the letter of credit.
  • Allows the importer to plan the payment of goods and services.
  • The exporter is able to reduce risks in production process in situations where the importer cancels the order.
  • Importer is assured of making payment after confirmation documents show shipment of goods (Bennett, B. 1986).

Even though the letter of credit is considered as the most safe and efficient mode of payment buyers who use it are sometimes disappointed because the documents involved are prepared by other people who may not meet the terms and conditions of the banks. These banks (seller and buyers bank) have inadequate principle of letter of credit that makes it difficulty for refund. On regular occasions these banks have been sustained in courts because the seller has not adhered to the terms in letter of credit (Macintosh, Kerry L.2005). Economic and political stability from the buyers side has also affected the efficiency of letter of credit leading to the delay in payment especially incases where the buyer’s bank is not an international bank, (Goode Ray et al, 2004).

Controlling problems related to the Letter of credit

To maximize the efficiency of Letter of credit the seller /buyer must know the principles of LC.One of the major aims of the LC is to protect the banks form liability in International transactions. The only important aspect is for the bank to confirm that the documents provided by the seller’s and the buyer’s bank are in uniformity and not the contract existing between the buyer and the seller (Gilligan, Colin and Hird, Marin 1998). Therefore, it is vital to help both the buyer and the seller to understanding the procedures involved through.

Choosing the Issuing Bank (Buyer bank)

The issuing bank’s responsibility is to make payment and to be refunded by the importer upon completion of terms and conditions of the letter of credit. According to the provisions of the Uniforms customs and practices for documentary credit the issuing bank is given a certain period of time to honor payments, (John A. Jr.1991).

Its role is to offer assurance to the exporter that it will make payment as soon as the documents in the letter of credit meet the necessary requirements. Normally the documentations in the letter of credit include commercial invoice, transport documents such bill of lading /airway bill, an insurance document among others.

When sealing the contract the seller should convince the buyer to take up the bank of the sellers choice to issue LC.Preferably an International bank since this will ensure that the LC process is on the right track as in the bank is well known and tracking its financial status is also easy.Therefore, choice of bank is very essential as it helps will the buyer cover for the cost of goods. (Collins, L. 1999).

Advising bank (exporters/Seller’s bank)

In many instances the advising bank is usually a foreign bank but in some way connected to the issuing bank. As far as the case of letter of credit this bank has no responsibility apart from ensuring that documents are sent to the issuing bank. Advising bank is not compelled to pay in cases where the issuing bank does not pay the seller (Bennett, B. 1986).

Confirming the Letter of Credit

This is also crucial because in cases where the seller does not have assurance in the buyers bank or political environment of the buyer’s country then the LC can be confirmed by the sellers bank takes the responsibility to pay the seller.Hence, because of the economic and political situation on the part of the buyer the sellers bank responsible to pay the buyer under the LC or alternatively the seller bank can advice the buyer to get the LC outside the political unstable bank. That is why it’s important for the buyer to choose LC with a bank which has international appeal (Goode Ray et al, 2004).

Keeping Documents Simple

Keeping the document simple is another way of controlling LC.Before the issuance of LC the seller and buyer must agree exactly what documents should be presented to their respective banks. This helps to avoid problems during verifications by the respective banks before payment and delivery can be made. Some of the documents that need to be kept simple are the commercial invoice and the bill of lading (Ziegel et al, 1998).

Commercial Invoice: mainly include the bills for goods and services, including description of goods, their prices, name and addresses of the exporter and importer. The details of the exporter and importer must reflect what is on the letter of credit. Bill of Lading: it shows the evidence that goods or services have been shipped and act as a receipt for shipped good and proof the responsibility of the carrier to deliver goods to the right destination (Murray et,al, 2002).

Meeting the deadlines

There are three essential dates in the issuance of an LC; shipment date, document presentation date and LC expiry date. All these dates should be met by the seller or else the respective banks of the seller and the buyer wont not provide them with an LC.When dealing with LC its very crucial for both the buyer and seller to acquire for advice so that they learn the principle of LC.

Nevertheless, the exporter has to communicate with the importer to well be conversant with all the details before applying for the letter of credit. In cases where the letter of credit calls for third party to provide documentations then the exporter has to provide adequate time for such. Inaddition,consider of the letter of credit is necessary for the transaction and Sent the importer a copy of letter of credit to check for the compliance of terms and conditions (Ziegel et al, 1998).

Conclusion

The application of the letters of credit as minimizing tools in the risks involved in international trade has developed to a large extent over the past decades. They realize their function by substituting the credit of the bank to enhance worldwide transactions.

The advents of globalization have brought about enormous progression on the transnational commerce; consequently international trade has burgeoned as a result. The edict governs transactions that have aided the global expansion through integrating of global bazaar. Transnational commerce is eligible only when various nations take part. Throughout this paper it was noted that CISG, is an edict that manages suppliers as well as buyer’s dealings. Advance payment, where the buyer sent money to the seller before he/she receives goods. This mode of payment is safe to the seller and buyer. Documentary credit, is an imperative mode of payment, since it guarantees the seller and the buyer because in integrates banking institutions. A dispatch of credit in monetary institution is employed fundamentally as the basis of payment in transactions and it presents an irreversible payment activity in transnational trade, (Murray, et,al, 2002).

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