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Letters of Credit Remove the Risk of International Payments Glastonbury, CT
By Richard B. Lockwood III
Every transaction involves a degree of risk. A buyer expects to receive goods or services as promised; a seller expects to be paid in full for goods or services rendered.
In our global marketplace, that risk is magnified. Agreements between buyer and seller are often reached without any human interaction-via email, the Internet, or fax. While this may encourage a more seamless flow of goods and services, the method of payment, particularly in international trade, is often an issue. When we don't have an existing relationship with someone we're doing business with, we want some form of assurance the transaction will be successful. Adding to this potential confusion are currency disparities as well as cultural and language barriers.
Such risks, however, have done little to impede the flow of international trade between the United States and other countries. The world's volume of merchandise exports (agricultural, mining, and manufactured products) increased at an average annual rate of 6.3 percent from 1950 through 2001, while world output (GDP) increased at a rate of 3.8 percent. More than 200,000 small businesses in the U.S. are engaged in international trade. In 2001, the U.S. Department of Commerce reports 89 percent of U.S. exporters were considered small businesses. Whether it's a specialty store in Connecticut importing furniture from India or a manufacturer in New Hampshire shipping parts to a factory in Germany, the world is truly becoming a global village.
Many businesses overcome their concerns about international trade risks by relying on the letter of credit for payment. In use for hundreds of years, the letter of credit replaces the risk of the buyer with that of their banks. It's this ability to shift the risk of non-payment from the buyer to their bank in the eyes of the exporter (the party to be paid) that makes the letter of credit such a popular and powerful payment tool.
When a buyer/importer must provide a seller/exporter with a letter of credit, he applies to his local bank in the same way that he or she would apply for a short-term loan. With the increase in global commerce, community banks are increasingly active in international services, and many offer international letters of credit for their commercial accounts.
Once the buyer and the seller have agreed on the terms of the sale, a letter of credit is drafted incorporating those terms and is transmitted by the issuing/opening bank to the exporter's bank. That bank will authenticate the letter of credit and advise (deliver) it to their customer, the exporter. Once the importer's credit is approved and the terms of sale are known, the actual preparation and transmission of the letter of credit to the exporter's bank can be accomplished in as little as two or three days.
After shipment is effected by the exporter, the shipping documents will find their way back to the buyer's bank. If they compare favorably with the terms of the letter of credit the buyer's account will be debited and the funds transferred to the exporter's bank for credit to the exporter's account. If the documents contain any discrepancies they buyer will be asked to waive them. If the buyer refuses, no payment will be made. This is the reason it is so important to ensure documents presented under letters of credit are exactly correct.
Letters of credit can also be used to accommodate flexible payment terms between the buyer and seller. A letter of credit may be especially attractive to a buyer who needs terms to come up with the means to pay for his imported goods. If the seller agrees to accept payment in 90 days, for example, that may allow the buyer an opportunity to put the goods into the sales stream and thereby generate the funds to pay for the merchandise.
Overseas (not generally the U.S.) exporters often find the letter of credit a useful tool as well. An exporter may sometimes borrow against a letter of credit from their bank. In developing countries where access to capital may be limited, the letter of credit may be viewed by the exporter's bank as needed assurance the exporter has a deal and will be paid if he can comply with the terms of the letter of credit.
Letters of credit are typically in dollar denominations and are utilized for transactions above US$10,000. Below that amount, payment is usually better handled by credit card, wire transfer, or some cash in advance with the remaining balance paid upon receipt of goods.
Without a letter of credit, small businesses may be reluctant to pursue overseas sales. The risks may appear to be too great. One small business owner says a letter of credit gives him the ability to negotiate agreements with new clients without having to insist on onerous payment terms. When the risk of non-payment is shifted to a bank, it's easier to do business.
Before issuing a letter of credit, the bank requires the buyer and seller to agree upon the terms of sale. For complex transactions, the services of a freight forwarder may be helpful. A freight forwarder can help the exporter and/or the importer to agree on and secure proper documentation, resolve customs issues, and book space on ships.
The divergent interests of the buyer and seller can often be met in the terms of a carefully prepared letter of credit. No other instrument so elegantly reduces the risk by the substitution of a bank's credit for the credit of a buyer.
Richard B. Lockwood III is the Executive Vice President/Director of Sales & Marketing for the Bankers' Bank Northeast. The Glastonbury, CT-based financial institution provides correspondent products and services to 110 community banks in New England and New York. He can be reached at 508-881-4954.