Sunday, December 12, 2010

Letter of Credit

Issues in International trade
Buyer & seller not known to each other
Default risk
Different political entities
Different Regulatory system
Different currencies
Different market conditions
Methods of payment
Documentation
Expectations
Seller(Exporter)
Payment on shipment
Payment in own country & currency
Buyer – compliance of regulatory requirements
Documentation as per international standards

Importer ( Buyer)
Payment on reciept of goods
Payment
Seller compliance – terms of sale & regulatory
Documentation
Methods of settlement
Advance Payments
Collection
Open account
Consignment
Letter of Credit


ADVANCE PAYMENT
Advance payment - buyer sends the money in advance to the seller.
For seller- Buyers credibility is doubtful, Political/ economic instability/ no need to lock in working capital funds
Buyers – assurance for supply of goods / blocking of capital / Risk of default
COLLECTION
Seller sends the documents first and gets the paymnet subsquently.
Seller – payment may not be immediate /blocking of funds / Default
Buyer – Advantageous. Payment on receipt of goods/ No blocking of funds
OPEN ACCOUNT
Seller and buyer exchange goods and payments only on the basis of trust. No invoice matching i.e. payment is not as per invoice (normal trade practice) but as per convenience of buyer.

Seller – High degree of trust . Risk of default. Blocking of funds. Uncertain cash flows
Buyer – Beneficial since payment after sales. Flexible cash flow.
Consignment
Seller sends the goods to the agent in over seas market. He receives the goods after the sale of goods.
Trust worthiness of the agent.
Cash flow is uncertain
What is best settlement system for exports and imports ?
Letter of Credit
A letter of credit is issued by a bank on behalf of the importer.
The bank agrees to honor a draft drawn on the importer, provided the bill of lading and other details are in order.
The bank is essentially substituting its credit for that of the importer.
WHAT IS L/C -
An arrangement of making payment against documents.
It is link between buyer & seller established through the banks
It assure seller receipt against delivery of goods and the buyer against payment against delivery
It satisfies aspirations of both
Documentary credits – Letters of credit
Seller – financial security since credit risk is assumed by the bank
Regulations of the importers’ country is taken care.No need for introduction.
Buyer – supply of goods assured. Regulations taken care.
Buyer and seller can extend their area of trade.
LC - Process
Contract between seller & buyer
At the request of buyer(applicant)buyers’ bank(Issuing bank) opens a LC fvg. Seller. Under UCPDC ( Uniform Customs and Procedure on Documentary Credit issued by International Chamber of Commerce, Parris).
UCPDC –Defines the role of importer, exporter, banks , transporters and insurance companies. Under FEMA provisions, every Indian bank opening LC, has to put a notation is subject to UCPDC.
Issuing bank requests a bank(advising) in sellers’ country to advise the LC to the seller(beneficiary)
Another bank may confirm the LC
Seller ships the goods and present the documents either to his own banker or confirming bank
Seller gets the payment
LC - Process
Negotiating the claims the reimbursement
Documents sent to issuing bank
After scrutiny ,issuing bank delivers the doc to buyer.
Buyer makes the payment



Process of a Typical Foreign Trade Transaction
International Trade Finance
Parties to LC
Applicant ( buyer or importer)
Beneficiary (seller or exporter)
LC opening bank (normally buyer's bank)
Advising bank ( informing seller or exporter about opening of LC)
Confirming bank ( payment obligation under taken when standing of LC issuing bank is not acceptable to seller)
Negotiating bank (who handles the documents and gives value to exporter )
Reimbursing bank ( paying bank who acts on behalf of issuing bank)
LC - documentation
LC application by the buyer (importer)
Invoice
Bill of exchange (Hundi)
License if under restricted catageory
Bill of Lading/Airway bill
Certificate of origin to certify that gooods have been originated from the specified country say India E.g. Basmati rice
Inspection certificate to ensure required quality and quantity
Packing list
Insurance





LC – case study
Contract between GE of USA and L & T of India
Contract value USD 1 mn for supply of machinery with in period of 6 months .
SBI opened a LC fvg. GE at the request of L&T
CITI bank in NY is GEs’ banker & advised LC to GE
GE submits documents to CITI . If documents are in order, payment will be made to GE
Documents sent to SBI, India
CITI will claim reimbursement from Bank of America
Bank of America will debit SBI $ a/c maintained with them.
SBI will scrutinse and ensure that all conditions of LC are complied with and then delivers the documents to L & T against payment .


Types of LC
Irrevocable – cancellation is possible only with the consent of all the parties such as banks, buyer, seller etc
Revocable – cancellation with out consent from others
Documents against acceptance – acceptance of documents first and then payment at later date.
Documents against payment - payment and delivery of documents simultaneously done.
Transferable
Red clause – certain amount is permitted to beneficiary (seller) of LC
Green clause – certain amount is permitted for storage expenses to be incurred by the seller
Revolving – automatic renewal of LC
Deferred – payment under LC in installments
Back to back – one LC is opened on the basis of another LC


Stand by LC
A guarantee of payment issued by a bank on behalf of a client that is used as "payment of last resort" should the client fail to fulfill a contractual commitment with a third party.
Standby letters of credit are created as a sign of good faith in business transactions, and are proof of a buyer's credit quality and repayment abilities.
The bank issuing the SBLC will perform brief underwriting duties to ensure the credit quality of the party seeking the letter of credit, then send notification to the bank of the party requesting the letter of credit (typically a seller or creditor).  

BG VS LC


Bank Guarantee A bank guarantee enables the customer (debtor) to acquire goods, buy equipment, or draw down loans, and thereby expand business activity.
http://www.investopedia.com/ask/answers/06/202005.asp
Guarantee from a lending institution ensuring that the liabilities of a debtor will be met. In other words, if the debtor fails to settle a debt, the bank will cover it.

Import finance - means
Suppliers. credit
Buyers’ credit
Shot term loans As per RBI notification – loans up to USD 20 mn – Period – 3 yr for capital goods and 1 yr for others.
Maturit y period exceeding 3 years is treated as ECB
Rupee credit – CC/OD/TL
Foreign currency credit - ECB

Risk Management
Currency risk
Interest risk
Counter party risk
Commercial risk

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