International banking lesson 09

87 Letters of Credit LESSON 9 LETTERS OF CREDIT CONTENTS 9.0 Aims and Objectives 9.1 Introduction 9.2 Methods of Settling Debts 9.2.1 Advance Remittance 9.2.2 Open Account 9.2.3 Cons

87 Letters of Credit

LESSON

9

LETTERS OF CREDIT

CONTENTS

9.0 Aims and Objectives

9.1 Introduction

9.2 Methods of Settling Debts

9.2.1 Advance Remittance

9.2.2 Open Account

9.2.3 Consignment Sale

9.2.4 Bill for Collection

9.3 Letter of Credit

9.3.1 Parties to a Credit

9.3.2 Advantages of Letter of Credit

9.3.3 Disadvantages/Limitations

9.4 Types of Letters of Credit

9.4.1 Payment, Acceptance and Negotiation Credits

9.4.2 Revocable and Irrevocable Credits

9.4.3 Confirmed and Unconfirmed Credit

9.4.4 With Recourse and Without Recourse Credits

9.4.5 Fixed and Revolving Credits

9.4.6 Transferable Credits

9.4.7 Back-to-Back Credits

9.4.8 Red Clause and Green Clause Credits

9.4.9 Standby or Guarantee Credits

9.5 Let us Sum up

9.6 Lesson End Activity

9.7 Keywords

9.8 Questions for Discussion

9.9 Suggested Readings

9.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to understand:

z The Uniform Customs and Practice for Documentary Credits

z Different methods of settling debts

z Different types of letters of credit

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International Banking 9.1 INTRODUCTION

Article 2 of the Uniform Customs and Practice for Documentary Credits (UCP) defines a letter of credit as to mean "any arrangement, however named or described, whereby a bank (the issuing bank), acting at the request and on the instructions of a customer (the applicant) or on its own behalf,

(i) is to make a payment to or to the order of a third party (the beneficiary), or is to accept and pay bills of exchange (drafts) drawn by the beneficiary; or

(ii) authorises another bank to effect such payment, or to accept and pay such bills of

exchange (drafts); or (iii) authorises another bank to negotiate, against stipulated documents, provided that the terms and conditions of the credit are complied with."

Article 3 of UCP provides: "Credits, by their nature, are separate transactions from the sales or other contract(s) on which they may be based and banks are in no way concerned with or bound by such contract(s), even if any reference whatsoever to such contract(s) is included in the credit Though the letter of credit is addressed to the exporter, it would normally be sent to the correspondent bank of Bank of India in London (Midland Bank) with a request to forward it to the beneficiary The necessity arises because the exporter would not know the signature of the officials of Bank of India and hence he would not be in a position to satisfy himself about the genuineness

of the credit When it is sent to the Midland Bank which, in the capacity of a correspondent bank, is in possession of the signature of the officials of Bank of India, the signatures on the credit are verified before it is forwarded to the exporter Within the stipulated date of shipment, the exporter ships the goods to a port in the importer's country (Mumbai) and obtains bill of lading from the shipping company

The exporter draws a bill of exchange on Bank of India along with the bill of lading and other documents required, presents them for negotiation to his bank (say, Midland Bank) Since it is a bill under letter of credit and payment is assured, any bank in the exporter's country would be willing to pay against it The exporter's bank verifies the documents to make sure that they satisfy the conditions stipulated in the letter of credit and pay the amount to the exporter Then the documents are forwarded to Bank

of India for payment On receipt of the documents and after verifying that they satisfy the requirements of the letter of credit, Bank of India makes payment to Midland Bank The amount of the bill would be recovered by the bank from the importer and the documents would be delivered to him By this time it would have been understood that "in credit operations all parties concerned deal in documents, and not in goods, services and/or other performances to which the documents may relate" (Article 4) Thus, though the seller under a letter of credit is assured of payment, the buyer has no guarantee that the required goods have been exported To overcome this difficulty the

credit may specify some other documents to accompany the bill, viz., weight list,

packing list, quality certificate, etc

9.2 METHODS OF SETTLING DEBTS

Depending upon the relative bargaining power of the importer and exporter, and having in view the requirements of the exchange control in the countries concerned, payment for the international trade may take place in anyone of the following methods:

9.2.1 Advance Remittance

The exporter may require that the importer should make full payment in advance for the goods to be exported This is possible where the goods enjoy sellers' market The exporter would dispatch the goods after he receives the full payment from the

89 Letters of Credit

importer Or, he may even manufacture the goods only after he receives the payment

This is the most beneficial term of payment that the exporter can expect, but it is at the

cost of the importer

The importer has to fully rely on the integrity of the exporter and has capacity to

execute the order in time The transaction is financed solely by the importer which

entails additional cost to him The entire risk of the transaction is shouldered by him

The credit insurance that is available to an exporter is not available to an importer

Because of these factors exchange control regulations in many countries do not allow

advance remittance on imports into their countries In India too, the facility of advance

remittance on imports is allowed only in selected cases on fulfillment of the

conditions stipulated

9.2.2 Open Account

The situation recommending open account business is the reverse of that for advance

remittance Under this method goods are despatched directly to the buyer who takes

delivery of them without making payment He is free to dispose of the goods as he

pleases It is arranged that he will make payment to the seller at a predetermined

future date, say two months after each shipment Open account as a method of

settlement is possible where the commodity commands buyer's market While the

open account business is most advantageous to the importer, the exporter bears the

entire risk and meets fully the financial requirement of the trade The exporter loses

control over the goods and relies on the integrity of the importer to receive payment

The credit risk to some extent is minimized because many countries have developed

credit insurance schemes to protect exporter’s In India we have Export Credit

Guarantee Corporation undertaking this function But exchange control regulations in

India place severe restrictions on open account business for exports

9.2.3 Consignment Sale

The exporter may have his selling agents abroad to whom the goods are despatched

They receive the goods without making any payment The goods are sold by the

selling agents on behalf of the exporter and as and when the sale proceeds are

received they are remitted to the exporter Throughout, the goods remain at the risk

of the exporter The difference between open account system and consignment sale

is that in the former case it is an absolute sale to the importer while in the latter case

the importer receives the goods on behalf of the exporter The ownership of goods in

the case of consignment sale remains with the exporter Consignment sale is

prevalent in export of traditional goods from India

9.2.4 Bill for Collection

The methods mentioned above are biased in favour of either party, viz., the exporter or

the importer A need arose for such a system which would enable the exporter not to

part with the goods or the control over the goods till he receives payment and the

importer does not pay until he gets the possession or control over the goods A method

which could fulfill this condition was the exporter drawing bill of exchange on the

importer for the goods exported The goods are despatched to the importer's country

but the relative documents are sent through a bank for collection The bank hands over

the documents to the importer only on receiving from the latter the value of the goods

as advised by the exporter The bill of exchange system of collecting the export

proceeds is no doubt impartial when compared to open account system and advance

remittance system Still the exporter faces the risk of non-payment by the importer

Even if the exporter does not lose control of the goods, in case of repudiation by the

importer, he has to bear additional costs

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1 What is letter of credit?

……… ………

2 What are the methods of settling debt?

……… ………

9.3 LETTER OF CREDIT

When the exporter draws a bill of exchange on the importer he faces the risk of repudiation of the contract by the importer A superior method of settlement of debt was devised which could assure the exporter that if he exports the goods as per the contract entered into with the importer and produces evidence to that effect, he would receive payment without default Letter of credit is an undertaking by the importer's bank that if the exporter exports the goods and produces documents as stipulated in the letter, the bank would make payment to the exporter Thus the obligation of the importer under the contract is supplemented by a superior obligation of a bank to make payment The exporter now looks to the bank which opened the letter of credit for payment instead of relying on the importer

9.3.1 Parties to a Credit

In the above credit, the importer is the applicant for the credit; Bank of India which issues the letter of credit is the issuing or opening bank; the exporter is the beneficiary under the credit; Midland Bank is the intermediary bank which acts as the advising bank while forwarding the letter of credit to the beneficiary and as negotiating bank while paying against the bill drawn under the letter of credit Under Article 2 of UCP (see previous page), the letter of credit can be opened by the bank on behalf of the importer or on its own behalf Hence the letter of credit can be opened by a bank for its own transactions, in which case the applicant and the issuing bank can be the same party Article 2 also states that for the purpose of the Articles of UCP, branches of a bank in different countries are considered another bank Hence a letter of credit opened by a branch of a bank in the importer's country can be advised by a branch of the same bank in the exporter's country

9.3.2 Advantages of Letter of Credit

A letter of credit offers advantages both to the exporter and the importer The advantages accruing to either of the parties differ depending upon the nature of credit opened However, there are certain common benefits accruing from the use of credit

of various types which are discussed below

To the Exporter

1 The letter of credit provides the sort of assurance that an exporter likes before he

embarks on manufacturing the goods for export In an international deal, the

exporter and the importer rarely meet and it is clinched only through exchange of correspondence The exporter, therefore, requires to ensure himself that on shipping the goods he will receive the payment promptly There is always the risk

of the importer tailing to pay The risk is greater if the antecedents of the importer are not known The letter of credit protects the exporter against failure of the importer to pay A superior undertaking of a bank under the letter of credit assures the exporter that when the documents are tendered as per the terms of the credit,

91 Letters of Credit

payment would be made to him Thus it also helps the seller to expand the

business by enabling him to conclude deals which in the absence of credit he

would be hesitant to do

2 The exporter is absolved of the botheration of knowing in detail the exchange

control regulations of the importer's country and is also insured to some extent

against changes in such regulations The bank which issues the credit would take

care to see that the goods covered by the letter of credit would be permitted to be

imported under the exchange control regulations Even in case there is a

subsequent change in government policies, the government would think twice

before restraining the bank from executing its commitment under the letter of

credit

3 The letter of credit helps easing the financial position of the exporter The

exporter can easily discount the bills under a letter of credit with his bank As

such bills carry an undertaking to pay by a bank; bills drawn under letter of credit

are readily discounted by banks Thus the exporter gets payment immediately on

shipping the goods Moreover, on the strength of the letter of credit, the exporter

may raise loans from his bank for procurement and processing of raw materials

and their export (pre-shipment finance)

To the Importer

1 The letter of credit enables the importer to purchase materials (especially in

seller's market) without making full advance payment Further, on the strength of

the superior credit of the bank, he is able to finalise contracts which the seller may

not agree had he to rely only on the importer

2 If he takes certain safeguards, like calling for packing certificates, etc., the quality

and quantity of the goods consigned is assured

3 Provided the buyer has a big credit with his bank he may get goods released by

the bank under trust (without payment) and pay for them on sale

9.3.3 Disadvantages/Limitations

A letter of credit is not a cent per cent safe deal either for the exporter or for the

importer To the exporter, the undertaking of the issuing bank is only conditional The

documents endeared should strictly comply with the requirements of the credit It is

only the bank that would decide if the documents are as per the terms of the credit;

any slight variation or non-fulfillment or excess detail in the documents tendered give

scope for the bank to claim that the documents are not as per the terms of the credit

Moreover the credit does not protect the exporter from the governmental action that

may deter payment To the importer, the major disadvantage is that it does not ensure

that he would be receiving the goods of the specific condition and order In letter of

credit transactions, all parties deal with documents and not in goods He stands

committed to reimburse the issuing bank when documents as required are tendered to

him But this does not ensure the receipt of proper goods Though the risk is

safeguarded by calling for special documents like packing list, etc., the risk of

falsification of documents still remains

But it should be understood that the limitations do not in any way undermine the

advantages that accrue from using letter of credit in international dealings They only

point out the areas where the parties cannot find protection by using letter of credit;

nor do they get the desired protection by using any other method

Check Your Progress 2

What are the advantages of the letter of credit to the importer?

………

………

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International Banking 9.4 TYPES OF LETTERS OF CREDIT

A LETTER of credit may be a clean credit or a documentary credit A documentary credit requires the documents of title to goods and other documents to accompany the bill drawn under the credit No such documents are necessary for a clean letter of credit

Under a clean letter of credit, the documents of title to goods (bill of lading, for example) are sent by the exporter to the importer direct Only the bill of exchange drawn on the importer is offered to the bank for purchase Neither the exporter nor the bank retains control over the goods covered by the transaction For the bank it remains

an unsecured advance For this reason, clean letter of credit is normally not found in commercial transaction They are used for transfer of funds between banks In exceptional cases they may be accepted from first class customers

Almost all commercial letters of credit (issued for financing foreign trade) are documentary credits Therefore, the UCP deals only with documentary credits A documentary credit may be classified under the following types depending upon the particular provisions it contains:

1 Payment, Acceptance and Negotiation Credits

2 Revocable and Irrevocable Credits

3 Confirmed and Unconfirmed Credits

4 With Recourse and Without Recourse Credits

5 Fixed and Revolving Credits

6 Transferable Credits

7 Back-to-back Credits

8 Red Clause and Green Clause Credits

9 Standby Credits

9.4.1 Payment, Acceptance and Negotiation Credits

Article 10 (a) stipulates: “credits must clearly indicate whether they are available by

sight payment, by deferred payment, by acceptance or by negotiation.” Thus a letter of credit may be

(a) Payment credit (or, sight payment credit);

(b) Negotiation credit;

(c) Acceptance credit; or (d) Deferred payment credit

Payment Credit

A payment credit provides that payment will be made to the beneficiary against the documents to be submitted by him The documents are not accompanied by a bill of exchange; if there is one, it is drawn on the paying bank In certain countries even sight drafts attract stamp duty To avoid stamp duty the parties may agree for a payment credit Therefore payment credits normally avoid drawing bills of exchange

In a payment credit the issuing bank nominates a bank in the exporter's country as the paying bank If the paying bank accepts its nomination, its position is that of an agent

of the issuing bank When the documents under the credit are presented to it, it pays the beneficiary It gets reimbursement from the issuing bank for the amount paid

93 Letters of Credit

Negotiation Credit

In a negotiation credit the documents are accompanied by a sight draft (bill of

exchange) The bill of exchange may be drawn on the issuing bank or any other bank

stipulated in the credit The bank which negotiates documents under the credit

purchases the bill of exchange and pays the amount to the beneficiary who tenders the

documents The negotiating bank is reimbursed by the issuing bank

It may be noted that 1993 Revision of UCP provides [Articles 9 (a) (iv) and 9 (b) (iv)]

that a credit should not be issued available by draft(s) on the applicant If the credit

nevertheless calls for draft(s) on the applicant, banks will consider such draft(s) as an

additional document This provision stresses the point that the obligation to pay under

a letter of credit is primarily that of the issuing bank

Article 10 (b) provides that unless the credit stipulates that it is available only with the

issuing bank, all credits must nominate the bank which is authorised to negotiate In a

freely negotiable credit, any bank is a nominated bank Thus the negotiating bank may

be:

(i) specifically nomin3ted by the credit; or

(ii) any bank where the credit is freely negotiable

(i) Restricted Letter of Credit: The issuing bank may restrict the negotiation of

documents under the letter of credit to a specified bank in the exporter's country

The letter of credit contains a provision: "Negotiation under this credit restricted

to Bank" (name of the bank) The exporter may submit the documents for

negotiation to the bank specified in the credit If the exporter's bank is not the

negotiating bank under the credit, it may still purchase the documents, depending

upon the credit enjoyed by the customer with his bank The exporter's bank which

purchases the documents has to present them to the negotiating bank, to whom the

credit is restricted, to obtain payment

Where a letter of credit is restricted to another bank, the exporter's bank does not

readily agree to purchase the documents under the credit because (0 it is not a

foreign exchange transaction for the bank; it has to present the documents to the

bank nominated in the credit and obtain payment in Indian rupees; (i.e it is not a

negotiating bank and, therefore, does not enjoy the privileges of negotiating bank

under Uniform Customs and Practice

Restriction of letter of credit may be resorted to by the opening bank under

instructions from the applicant of the credit, or it may be done to confine business

to a favoured bank (of the same group or a correspondent bank) If the beneficiary

wishes to negotiate the documents through his own banker, he may require

suitable amendment of the credit removing the restriction

(ii) Open Letter of Credit: The letter of credit contains an open invitation to bank to

negotiate documents under the credit The commitment of the issuing bank may

read as follows: “We hereby engage with drawers and/or bona fide holders that

drafts drawn and negotiated in conformity with the terms of this credit will be

duly honoured on presentation.”

Acceptance Credit

An acceptance credit calls for a usage bill of exchange of a specified period to be

drawn under the credit For instance, the letter of credit may require the exporter to

draw '90 days' bill The advantage under an acceptance credit is that the buyer need

not pay immediately; he pays only on the due date of the bill The seller gets the bill

accepted by the bank and, in case he is in need of funds, discounts it with his bank

Thus the seller can also get payment immediately The duty of the issuing bank under

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International Banking this credit is not only to see that the bill is accepted but also to ensure payment on

maturity

If the bill is drawn on the accepting bank in the exporter's country, the accepting bank will accept the bill and return it to the beneficiary The documents are forwarded to the issuing bank If the beneficiary is in need of funds he may discount the bill with any other bank or finance house Since it is a banker's acceptance, the bill will be discounted readily by other banks and at favourable rates

On receipt of documents the issuing bank will deliver them against Trust Receipt or

on clean basis It may also hold them until the steamer arrives, arranges clearance and then stores the goods under its control A loan against pledge of goods may be given for the importer to pay for the goods on maturity of the bill to be repaid by the sale proceeds of the goods

Deferred Payment Credit

A deferred payment credit carries an undertaking of the issuing bank to pay or to arrange for payment on the date(s) determinable in accordance with the stipulations of the credit It is like an acceptance credit with the exception that no drafts are drawn It

is thus considered inferior to acceptance credit from the beneficiary's point of view because he does not get a banker's acceptance which he could discount and raise performance

Deferred payment credit may be used where the beneficiary wishes to allow the importer time to pay for the documents The documents will be delivered to the importer immediately This type of credit is also used to finance import of plant and machinery and capital goods on deferred payment basis The exporter in such cases can ask the importer to:

(i) effect remittance of the agreed advance payment, and to submit a 'Deferred Payment Guarantee' from his bank for the deferred instalments, or

(ii) open a deferred payment letter of credit providing for advance payment against shipping documents and payment of deferred instalments as and when due

Deferred payment letter of credit is easier to operate and, therefore, the exporter may prefer this to deferred payment guarantee

9.4.2 Revocable and Irrevocable Credits

A credit may be either (i) revocable, or (ii) irrevocable The credit should therefore clearly indicate whether it is revocable or irrevocable

A revocable credit* is one which can be cancelled or amended by the issuing bank at

any time without prior notice, to the beneficiary The cancellation, or amendment, however, takes effect against the bank which has negotiated bills under the credit only

on receipt of notice of such cancellation, or amendment The issuing is liable for bills negotiated conforming to the terms and conditions of the credit before the notice of revocation is received by the negotiating bank

Since there is no definite undertaking by the issuing bank in a revocable credit, there

is not much of a benefit under the credit to the exporter If the credit is advised to him

by the opening bank direct, it may be cancelled by the issuing bank at any time without prior notice Therefore, till he receives payment from the issuing bank the exporter is not sure whether the credit is current He would find it difficult to Article 8

(a) A revocable credit may be amended or cancelled by the issuing bank at any moment and without prior notice to the beneficiary

95 Letters of Credit (b) However the issuing bank is bound to

(i) reimburse another bank with which a revocable credit has been made

available for sight payment, acceptance or negotiation-for such payment,

acceptance or negotiation made by such bank prior to receipt by it of notice of

amendment or cancellation, against documents which appear on their face to

be in compliance with the terms and conditions of the credit;

(ii) reimburse another bank with which a revocable credit has been made

available for deferred payment, if such bank has, prior to receipt by it of

notice of amendment or cancellation, taken up documents which appear on

their face to be in compliance with the terms and conditions of the credit

negotiate the bill with any bank in his country The bank in the exporter's

country is not aware if the credit is cancelled and hence runs the risk of

payment being refused by the issuing bank and hence would be reluctant to

negotiate the bill

If the credit is advised through a bank, generally there would be a clause under which

the issuing bank binds itself liable to reimburse the negotiating bank on any bills

negotiated before the notice of cancellation is received by it Therefore, such bills

have better reception from the negotiating banks Still, the exporter has the risk that

the credit may be cancelled at any time after he procures the goods but before he

presents the bill for negotiation

A revocable credit does not confer the benefit that an exporter expects when he

requires a letter of credit to be opened in his favour, viz., assured payment when he

ships the goods The exporter agrees to a revocable letter of credit only when he has to

choose between a revocable credit and no credit at all In the plywood industry, the

production depends upon a number of factors The actual production may not agree

with the sample provided to the importer In such cases the importer allows partial

shipment and on verifying the first consignment he would like to cancel the contract if

the supply is not as per the sample Only a revocable credit can satisfy the

requirements

A revocable credit indicates its nature by a specific clause, addressed to the advising

bank, on the following lines: "When advising the beneficiaries kindly make it clear to

them that credit is revocable and therefore subject to cancellation We hereby

undertake to reimburse you tar all drafts honoured by you in accordance with the

terms of the credit, prior to your receiving notice of cancellation."

An irrevocable credit* constitutes a definite undertaking of the issuing bank to accept

and/or to pay bills drawn on it or another bank or make payment (without a bill)

provided the terms and conditions of the credit are complied with An irrevocable

credit can neither be amended nor cancelled without the agreement of all parties

concerned

Under an irrevocable letter of credit, the exporter can be safe with the knowledge that

the bills drawn under the credit will be honoured by the issuing bank provided the

conditions of the letter of credit are fulfIlled Any amendment or cancellation of credit

is not effective unless the exporter also consents to such an amendment or

cancellation Bills drawn under an irrevocable credit are readily negotiated by banks

The difference between a revocable credit and an irrevocable credit is quite clear

While a revocable credit can be cancelled or modified without the consent of the

exporter, it is not possible in the case of irrevocable credit

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International Banking * Article 9 (a)

An irrevocable credit constitutes a definite undertaking of the issuing bank, provided that the stipulated documents are presented to the nominated bank or the issuing bank and that the terms and conditions of the credit are complied with:

(i) if the credit provides for sight payment-to pay on the maturity date(s) determinable

in accordance with the stipulations of the credit;

(ii) if the credit provides for acceptance:

(a) by the issuing bank-to accept draft(s) drawn by the beneficiary drawn on the issuing bank and pay them at maturity; or

(b) by another drawee bank-to accept and pay at maturity draft(s) drawn by the beneficiary on the issuing bank in the event the drawee bank stipulated in the credit does not accept draft(s) drawn on it, or to pay draft(s) accepted but not paid by such drawee bank at maturity;

(c) if the credit provides for negotiation - to pay without resource to drawers and/or bonafide holders draft(s) drawn by the beneficiary and/or document(s) presented under the credit A credit should not be issued available by draft(s)

on the applicant If the credit nevertheless calls for draft(s) on the applicant banks will consider such draft(s) as an additional document(s)

(d) if the credit does not indicate whether it is revocable or irrevocable, it shall be deemed to be irrevocable [Article 6 (c)] Prior to 1993 revision of UCP such credits were treated as revocable

9.4.3 Confirmed and Unconfirmed Credit

When a letter of credit is advised to the beneficiary through a bank in the beneficiary's country, it may request the other bank to add its confirmation or merely advise the credit to the beneficiary without adding its confirmation If the advising bank adds

confirmation to the credit, it becomes a confirming bank and the credit a confirmed credit Confirmation is a definite undertaking of the confirming bank, in addition to

the undertaking of the issuing bank, to accept and/or pay bills or make payment (without bills) provided the terms and conditions to the credit are satisfied When the advising bank confirms a credit, it undertakes to negotiate bills drawn under the credit without recourse to the drawer

All confirmed credits are also irrevocable letters of credit It is so because no bank in the exporter's country would be willing to undertake a liability on a revocable credit

on which there is no definite undertaking by the issuing bank

A confirmed irrevocable credit is the best form of credit available to the exporter as it has the following added advantages:

(a) It insures the exporter not only against the failure of the importer but that of the

issuing bank also Though a letter of credit bears the superior credit of a bank in the importer's country, the exporter may not know the financial standing of the issuing bank When the credit is confirmed by a bank which he knows well, he is more secure

(b) It also saves the beneficiary from changes in the Government policies or

disturbances in the political situation of the importer's country Irrespective of these changes the beneficiary is assured of payment by the confirming bank When the advising bank does not add its confirmation, but merely forwards the credit

to the beneficiary, the credit remains unconfirmed The advising of the credit through

a bank serves in such a case to get the signature of the issuing bank on the credit authenticated by the advising bank There is no additional undertaking by the advising bank