An export letter of credit (LC) is one of the payment methods in international trade. Export LCs are useful when open terms are not granted and to reduce the risk of nonpayment. An LC is a payment method where an irrevocable legal document (the LC) is issued between the buyer (issuer) and the seller (beneficiary) describing the shipping, payment terms, other terms and documents required to be presented at the shipping dock (or other end point).
The most common type of letter of credit used for export is a documentary (sometimes called a sight) LC. This letter of credit authorizes the seller's bank to draw the buyer's bank upon presentation of the required documents (sight). An export LC can also be set up as a term or time draft for a payment at a future date after all documents have been accepted under the letter of credit. A letter of credit should be consistent with the terms and conditions stipulated in the commercial contract.
In some countries, LCs may be used to guarantee accounts receivable carried by the local location. When the balance becomes due and the customer has not paid, you can present the specified documents to the customer's bank and get paid by the bank.
- Offer a higher degree of security and protection for goods being sold abroad.
- Carry the credit risk of the issuing bank and the political risk of the issuing bank's country.
- Foreign issuing bank and country risk can be mitigated via confirmation of the letter of credit.
- Exporter relies upon creditworthiness of the issuing bank and not that of the importer.
- Accelerate cash flow on export sales.
- Payment by advising bank is made upon presentation of complying documents.
- Term/time draft letters of credit can be discounted upon acceptance of drafts, thereby expediting cash flow.
Strengthening the Letter of Credit Process
The paying bank should be a domestic bank you are familiar with and not a bank located in a foreign country where you may have limited recourse, as obtaining a confirmation from the domestic paying back greatly reduces the risk nonpayment by the foreign bank. If unable to find a domestic bank to confirm the letter of credit, you should ensure that the LC is opened at a larger international bank (as opposed to a small local bank).
Before accepting the LC, fully understand the documents required to be presented to the bank for payment as well as where and how to present them. Also pay close attention to any expiration dates or other time limitations in the terms. The banks involved will delay and/or charge a fee to process payment when documents are not in full compliance with the terms of the LC.