Documentary credits as a method of payment

There are two basic types of documentary credit.

• Revocable credit

• Irrevocable credit

A revocable credit allows the foreign buyer to amend the credit (or even to cancel it) without giving prior notice to the exporter.

The buyer's right to amend or cancel the credit can be exercised at any time up to the payment being made to the exporter. This means that it might be amended or cancelled after the seller has made and shipped the goods, and the seller is therefore at a great risk that the credit (i.e. bank guarantee) will be withdrawn.

If the credit is withdrawn, or amended in an unfavourable way, the exporter will then have the problem of obtaining payment direct from the buyer.

Revocable credits are extremely rare, because they do not provide a satisfactory security to the seller.

In general, exporters should avoid revocable credits at all costs. However, they might conceivably be useful where:

(a) goods are shipped by the exporter over a period, in several 'batches';

(b) payment is required for each separate batch; and

(c) the credit covers all the shipments under the contract.

If the buyer is dissatisfied with the goods received in, say, the first shipment, he can then cancel the revocable credit for the remaining shipments.

An irrevocable credit is a credit that can be amended or cancelled only with the agreement of all parties to the credit (buyer, issuing bank, advising/confirming bank and exporter) - i.e. including the exporter or 'beneficiary'.

An irrevocable credit therefore gives greater security to the exporter, because the issuing bank will continue to guarantee payment even if the buyer changes his mind. The exporter, provided he complies with the terms and conditions of the credit, now relies on the integrity of the issuing bank rather than the integrity of the buyer.

Advantages and disadvantages of letters of credit

Documentary credits are method of payment that offers greater security of payment for exporters than documentary collections. However, there are some advantages for importers too in letters of credit. Study the following tables.

Table 1 Advantages for exporter 1. Only a very small risk of non­payment, or no risk at all, provided that the exporter complies with the terms and conditions of the letter of credit. 2. A letter of credit might be con­firmed, thus adding a guarantee of payment from a second bank. 3. Payment can be arranged through a bank in the exporter's own country. 4. Assistance and advice of the bank. Guidelines of a fairly stringent set of international rules for letters of credit.		Table 2 Disadvantages for importer 1. Banks deal with documents, not goods. The payment will be made provided the exporter presents the stipulated docu­ments in accordance with the terms and conditions of the credit, regardless of the condition of the goods themselves. 2. By using a letter of credit, the issuing bank is given an unalterable commitment to effect payment, regardless of the condition of the goods. 3. The issuing bank is accepting a liabil­ity on behalf of the customer when it issues a letter of credit. It might therefore reduce the other borrowing facilities of the customer. Often it is the importer who ends up paying for the cost and charges for the letter of credit. However, the importer might persuade the exporter to some or all of these costs.
Table 3 Advantages for an importer 1. The importer can obtain the help and advice of the issuing bank in specifying the documents to be presented under the terms of the letter of credit. 2. The exporter will not be paid unless and until he has presented the specified documents in accordance with the terms of the letter of credit. 3. The importer might be able to obtain a longer period of credit with a letter of credit than with a less secure method of payment for the exporter. 4. The importer can insist on shipment of the goods within a reasonable time (or 'on time') by putting a time limit on the bank's letter of credit.

The disadvantages of a letter of credit for the importer can be minimized by several precautions.

(a) The importer should obtain a status report on the foreign supplier, if he doesn't know much about him. This report should indicate that the exporter has a well-established track record in the supply of similar goods to other foreign customers, and to a suitable technical capacity.

(b) The letter of credit should, if possible, be advised to the exporter through an overseas branch or a correspondent bank of the importer's own bank.

(c) Similarly, it might be possible to specify that payment or negotiation of the bill of exchange should be through an overseas branch or a correspondent bank of the importer's own bank.

(d) The documents that the exporter must present under the terms of the letter of credit might include a third-party inspection certificate, to certify the quantity, quality or condition of the goods being despatched.

(e) For maximum protection, the letter of credit should specify that the documents must be presented strictly in accordance with the terms of the credit, and that a banker's indemnity will not be allowed.

Documentary credits are a ‘classic instrument for financing purchases of foreign goods and foreign equipment’.

• They are a means of providing short term finance to an importer from his bank.

• They provide an element of security and confidence in international trade. They are particularly secure from the exporter’s point of view.

• They provide a means by which an exporter can secure payment in a routine manner which help to ‘smooth’ his administration and to secure payment on shipment of goods (and occasionally pre-shipment).

• With the aid of government support documentary credits are also used to provide medium-term finance.