A letter of credit is a vital tool for facilitating international trade. It benefits both the importers and exporters. An import letter of credit enhances the importer’s creditworthiness, while an export letter of credit mitigates the credit risk for the exporter and helps improve his cash flow.
Import Letter of Credit
Import letter of credit is issued by the importer’s bank on behalf of the importer, with the exporter being the beneficiary. It is guaranteed by the importer’s or buyer’s bank that the payment will be given to the exporter or seller. The credit capacity of the importer is substituted by the credit capacity of the issuing bank. This improves credibility and reduces the risk of fraud. There are terms and conditions regarding the type, quantity, place of delivery, and delivery time mentioned in the import letter of credit. It also mentions the documents to be submitted as proof of shipment. The exporter has to submit some specified documents fulfilling these conditions before the payment can be released to him.
Advantages of Import Letter of Credit
The biggest advantage of an import letter of credit is fraud risk mitigation. The exporter has to submit valid documents as proof of shipment of agreed-upon goods before making the payment. The terms and conditions under the import letter of credit cannot be changed unless all the parties agree, so it’s legally binding. An import letter of credit increases the importer’s creditworthiness because credit capacity is transferred to the issuing bank. This enables importers to get a better bargain on the prices of imported goods and also access extra funding for expanding their business. Since an import letter of credit is of immense help in less established trade relationships, it provides a safe way to expand sourcing into new geographies to get lower prices and increase the importer’s business margins.
Disadvantages of Import Letter of Credit
The issuing bank is required to pay the exporter as and when he presents the documents covered in terms and conditions of the import letter of credit. There is a risk of receiving bad or damaged goods even if the documents are satisfactory. An importer can mitigate this risk by verifying the exporter’s reputation and checking a sample of goods beforehand. He can also hire an independent third party to do the physical inspection of goods before they are shipped. Issuing a letter of credit adds to the cost of doing business.
Export Letter of Credit
An importer issues an import letter of credit with the exporter being the beneficiary. The same letter of credit, when received by the exporter’s bank, becomes an export letter of credit. So, both the import and export letters of credit are materially the same; it’s just a different perspective. The exporter needs to fulfill the terms and conditions and submit the required documents as mentioned in the letter of credit before receiving payment.
Advantages of Export Letter of Credit
It reduces the credit risk as the issuing bank is liable to pay even if the importer defaults. Export letters of credit can be tailored to the exporter’s needs; hence it provides flexibility in terms and conditions as long as they are fair and legally binding. Since the exporter needs to submit documents as proof, an export letter of credit enables the exporter to receive the payment before the shipment has reached the importer. This capability improves the cash flow of the exporter.
Disadvantages of Export Letter of Credit
Although the exporter is protected if the importer defaults on payment, he may still face credit risk if the issuing bank also defaults. He can get additional protection by getting a confirmed letter of credit. Where the receiving bank guarantees the payment if issuing bank defaults. This will add to the cost of getting a letter of credit, which is already high.
Export Credit Insurance vs Letter of Credit
An exporter takes export credit insurance to insure the foreign accounts receivables in the case of commercial and political risks. The exporter has to pay a premium to get insurance cover. This is different from a letter of credit, where the importer has to cover most of the expenses. A letter of credit has strict terms and conditions regarding the goods shipped and documents to be presented before the payment is made. Export credit insurance just needs proof of non-payment of accounts receivables by the foreign party. A letter of credit covers 100% of the amount, while export credit insurance works on risk-sharing and covers only a part of the amount (usually up to 90%).
Read more about other Types of Letters of Credit.