A letter of credit is a great way for exporters to protect themselves against nonpayment risk, as long as they are prepared and able to present the documents called for. If they don’t, the issuing bank might not pay.
The exporter should provide the importer with explicit guidelines for what the letter of credit is to include.
Discrepancies should and can be avoided by reading every credit in advance, getting amendments when necessary, and preparing the documents exactly as specified.
Payment can be obtained almost immediately and at lower cost, even when documents are discrepant, by working with one’s relationship bank and using shippers’ indemnities.
Letters of credit also serve as a vehicle for very inexpensive financing.
Letters of credit (LofCs) are a time-honored means of payment for international shipment of goods. Although the vast majority of letters of credit get paid when drawn upon, it is a mistake to think of them as guarantees. Rather, LofCs have specific rules governing how payment works. If sellers do not comply with these rules, they risk not being paid when shipping goods—which is precisely the risk that letters of credit are supposed to guard against.
In addition to providing risk protection, LofCs serve as a vehicle of payment. A knowledgeable seller can obtain LofCs that provide immediate funds.
The Purpose of Letters of Credit
When selling goods, a seller must take into account and manage the risk of not being paid. In the case of exported goods, these risks include not just the risk that a buyer will not have enough cash to pay, or will dispute their liability to pay, but also the risk that something will happen in the buyer’s country that prevents payment. Letters of credit were developed as a means of payment that, when properly structured and drawn upon, sidesteps these risks.
- Page 1 of 8
- Next section How Letters of Credit Work