Unforeseen circumstances such as late payments, financial problems, and late delivery are associated with international maritime trade. The changing political landscape, long distances, and different rules and regulations in global trade are some of the reasons why it is a necessity for the sellers to receive a payment guarantee to ship the perishable cargo through the sea route. International letters of credit address these concerns by involving a financial institution to reduce credit risks for exporters.
Initially, a Letter of Credit in international trade was written from the buyer's bank to the seller's bank, ensuring payment was made to the seller if the buyer defaulted. In today’s world, the Letter of Credit was introduced to simplify these uncertainties by involving a financial institution as a third party, which enables the exporters to minimize credit risks. With the rise of globalization, letters of credit have overthrown the traditional payment method worldwide.
What is Letter of Credit?
Letter of credit Meaning: A vital document issued by the importer's bank on behalf of the importer. When it comes to conducting international trade between the two parties, the bank ensures the exporter that the transaction will be processed. The importer is the applicant, and the exporter acts as the beneficiary, and the importer is the applicant. Under the Letter of Credit, the issuing bank promises to pay the required amount as per the specified timeline and against essential documents.
A letter of credit states that the issuing bank does not need to verify the goods if the proper documents are provided. Furthermore, the bank has no reason to cancel the payment if the submitted documents meet the criteria of the letter of credit.
Why is a letter of credit important in global trade?
A letter of credit serves needful purposes for both exporters and importers. A LC assures payment to the seller and allows the buyer to negotiate longer payment terms with the bank supporting the transaction.
The importance of a letter of credit (LC) plays a crucial role for both buyers and sellers in international trade. These are as follows:
- Negotiability: In the terms of a letter of credit, the transaction can be changed or modified with the agreement of both parties involved. For a letter of credit to be negotiable, the payment should be made within the specified time.
- Risk Mitigation: An LC makes sure that the sellers get paid if they meet the demanding timelines, thereby minimizing the risk of non-payment, particularly with unknown or distant buyers.
- Building Trust Between Both Parties: Banks' involvement in the letter of credit entrusts an additional layer of trust to the transaction. Buyers and sellers can count on these financial institutions, which can possibly minimize the observed risks involved in international trade.
- Global Trade Facilitation: The Letter of Credit’s Intricacies the complexity of trade in various countries by overcoming legal, financial, and business practice differences that enhance the best method for foreign transactions.
- Compliance and Documentation: The letter of credit specifies the conditions and requirements for payment execution, ensuring both parties are bound by the necessary legal and regulatory procedures.
- Facilitate Cash Transactions: Buyers can streamline their working capital by negotiating payment terms that delay various conditions, like receiving goods or providing the necessary documentation.
- Encouraging New Market Entry: A Letter of Credit serves as a crucial tool for businesses in the perishable export sector by ensuring payment through a recognized financial strategy. This motivates the sellers to pursue new global business opportunities in various regions.
- Resolve Disputes: The terms and conditions mentioned in the Letter of Credit provide a platform for resolving disputes, reducing potential disagreements between buyers, sellers, and even the banks.
The Documents required for a Letter of Credit
- Shipping Bill of Lading
- Airway Bill
- Commercial Invoice
- Insurance Certificate
- Certificate of Origin
- Packing List
- Certificate of Inspection
How does a Letter of Credit work?
A letter of credit directs the issuing bank to act on its own or on behalf of the importer. Based on the terms of the letter of credit, the issuing bank can make the payment to the beneficiary (the exporter) or to their order. On the other hand, the issuing bank can accept the bills of exchange or drafts that are drawn by the exporter. The issuing bank has the authority to advise or nominate banks to pay or accept bills of exchange.
The fees and charges involved with the Letter of Credit process:
When it comes to a letter of credit, various fees and reimbursements are associated with the payment process. Under the letter of credit, the payment is managed by all the parties. The fee structure includes:
Opening Charges : This mainly includes commitment fees, which are paid upfront, and fees for services and perishable goods , charged for the agreed period of the LC.
Retirement Fees
The retirement charges include at the end of the LC period:
- Advising Fee: The payment will be charged by the issuing bank.
- Reimbursements: The applicant provides the payment to the bank to cover duties related to foreign policy.
- Fee for the Confirming Bank: This amount is paid to the confirming bank if it is applicable.
- Bank fees: The fees are paid to the issuing bank to handle the letter of credit process.
What are the steps involved in the process of Letter of Credit?
The process of a letter of credit (LC) involves several stages to provide a secure and organized framework for international trade transactions. The steps are as follows:
Agreement on Terms : The buyer (importer) and seller (exporter) agree on the details of the transaction and the use of a Letter of Credit in the form of payment method. They specialize in the type of LC, amount, shipping terms, and necessary paperwork.
Buyer Letter of Credit Application: The buyer can apply for the Letter of Credit at their respective banks. The application includes the payment information and the terms agreed upon with the seller.
Issuance of a Letter of Credit: The issuing bank determines the buyer’s creditworthiness and, if approved, issues the Letter of Credit. The LC is forwarded to the advising bank (often in the seller’s country) or directly to the seller.
Advising the LC : The advising bank goes through the LC's authenticity and informs the seller of its existence. At times, the advising bank may also confirm the LC, ensuring extra assurance for the seller.
Shipment of Cargo : The seller prepares and transports the perishable goods as per the LC terms. They also provide essential shipping documents like the commercial invoice, bill of lading, packing list, and any other documents mentioned in the LC.
Document Presentation : After the perishable goods are shipped, the exporter (either on their own or through freight forwarders) submits the documents to the advising or confirming bank.
Settlement of Payment : The confirming bank forwards the documents to the issuing bank to check where the payment is made, accepted, or negotiated. The issuing bank reviews the documents and collects payments from the importer. It sends the documents to the importer, who uses them to claim possession of the goods being shipped.
The different types of Letter of Credit are listed below
- Revocable Letter of Credit
- Irrevocable Letter of Credit
- Confirmed Letter of Credit
- Unconfirmed Letter of Credit
- LC at sight
- Usance LC or Deferred Payment LC
- Back to Back LC
- Transferable Letter of Credit
- Untransferable Letter of Credit
- Standby Letter of Credit
- Freely Negotiable Letter of Credit
- A Revolving Letter of Credit
- Red Clause LC
- Green Clause LC
What is the application process for an LC?
Importers have to follow some guidelines for the application of LCs. The process is as follows:
- After a sales agreement is created and signed between the importer and the exporter, the importer applies to their bank to issue a letter of credit for the exporter.
- The issuing bank (the importer's bank) prepares a letter of credit that aligns with the terms and conditions of the sales agreement before sending it to the exporter’s bank.
- The exporter and their bank are required to assess the creditworthiness of the issuing bank. After verifying the letter of credit, the exporter’s bank grants the approval and sends the document to the importer.
- After that, the exporter transports the perishable goods, ensuring timely delivery. A shipping line or freight forwarder helps with the delivery of the shipment.
- Along with the goods, the exporter also presents the paperwork to their bank to adhere to the sales agreement.
- After being approved, the exporter's bank sends the compliant documents to the issuing bank.
- After the documents are verified, the issuing bank releases payment to the exporter and forwards the documents to the importer to collect the cargo.
What are the benefits of Letter of Credit?
A letter of credit proves fruitful for both parties as it assures the seller that they will receive their payments upon fulfillment of the terms of the trade agreement. Additionally, the buyer can illustrate his creditworthiness and negotiate longer payment terms by having a bank aid the trade transaction.
The benefits of a letter of credit are as follows
LC reduces the risk of late-paying or non-paying importers. In some situations, the exporter already ships the order, but on the other hand, the importer might change or cancel the order. The importers can also refuse to pay for the delivered perishable cargo due to a particular complaint. In such a scenario, a letter of credit ensures that the exporter or seller of the goods receives their payment from the issuing bank. In the event that the importer goes bankrupt or doesn't want to make the payment, this vital document handles everything.
LC facilitates importers to prove their creditworthiness. Typically, small and midsize businesses lack the capital resources to conduct payments to ship their perishable goods from one port to another. This is where the letter of credit comes into the picture. A letter of credit ensures that payment is made to the exporters for the seamless export of goods to the desired destination.
LCs help exporters manage their cash flow properly . A letter of credit makes sure that the payment is received on time for both the exporters and the sellers. This implies, mainly, that there is a huge gap between the delivery of perishable goods and payment for them. The letter of credit contributes a lot to helping the exporters manage their cash flow with timely payments. Sellers can obtain short-term financing between shipping goods and getting paid, which can provide them with extra cash.
Things to consider before obtaining a Letter of Credit
Exporters need to keep in mind to submit documents that comply with the terms and conditions of the LC. If you don't abide by the letter of credit, it can lead to non-payment, delay, and disputes in transactions.
The issuing bank should be a bank of trusted reputation and should be capable of presenting the LC when required.
Before using an LC, it's advisable to make it clear who will bear the costs. Assigning costs to the exporter can increase recovery expenses. A letter of credit costs more compared to other payment methods, so it's important to consider the cost-effective options.
Conclusion
In the realm of global trade, the letter of credit is worth the document, providing a robust platform for both buyers and sellers. A letter of credit not only simplifies the transaction process but also helps ship perishable goods while crossing international waters.
Citrus Freight provides the Letter of Credit, the indispensable shipping document, to the buyers and sellers for a hassle-free export venture. At Citrus Freight, a letter of credit is not merely a choice; it opens vast opportunities to gain international market exposure for the best-quality perishable goods.