In the era of Globalisation, businesses all over the world rely on each other, be it for raw materials, consultation services, marketing or capital goods. This led to an increase in international payments, especially with increase in exports. Some of the most common methods of international payments include- International cheque, Wire transfer and the safest and the most convenient method preferred by most exporters- Letter of Credit.
Letter of Credit is a bank guarantee given by the buyer’s (importer) bank to seller’s (exporter) bank. It is the most secure instrument, also known as Documentary Credit. The main concern of most exporter is safety which is why they prefer Letter of Credit over other modes of payment. It is guaranteed by the bank and the verification of all necessary documents including the inspection certificate is also done by the bank.
Documents required by the bank includes Bill of Lading, Marine insurance, Custom attested Packing list and invoice, Pre-shipment Inspection certificate and Certificate of origin.
Merits of LC
- Exporter is assured of payment as it is guaranteed by the buyer’s bank.
- Exporter can get advance payment from bank if the LC is confirmed and irrevocable.
- It eliminates commercial risk.
- It enables the importer (seller) to expand their sources of supply as exporters are always willing to supply against Letter of Credit.
- It prevents blockage of funds and bad debts.
Types of LC
There are 10 types of Letters of Credit. Different LCs have different terms of payment associated with them and hence, it is important for exporters and importers to assess and wisely decide which type suits them the most.
- Sight LC: In a sight LC, the exporter immediately receives payment after goods are received.
- Usance LC: With a Usance LC, the exporter grants a credit period for payment which is jointly accepted by both banks.
- Confirmed LC: Confirmed LC does not allow the Issuer bank (importer’s bank) to modify the terms of LC. Ideally, LC should be confirmed as it is safer.
- Unconfirmed LC: Unconfirmed LC allows Issuer bank to modify the terms of LC.
- Red clause LC: In a Red clause LC, the importer must make partial or full advance payment.
- Green clause LC: Green clause LC allows the importer to make the payment after dispatch of the shipment.
- Negotiable LC: Issuing bank (importer’s bank) authorises any bank to be the Nominated bank (exporter’s bank) to negotiate the terms of the LC and receive the payment on behalf of the exporter.
- Revolving LC: For regular transactions between the same two parties, one can get a Revolving LC. It allows the parties to set a limit and use the same LC for multiple payments till the limit is reached.
- Transferable LC: This type of LC allows the exporter to endorse the LC in favour of a third-party which simply implies that the amount owed to the exporter by the importer is paid to the third-party directly, on behalf of the exporter.
- Back-to-back LC: This LC involves 3 parties and two payments under one LC. For example, payment to vendor by manufacturer for raw material and payment to the manufacturer by the retailer under the same LC. It eliminates the need for applying for two LCs.