ROLE OF LC IN INTERNATIONAL TRADE

GROUP MEMBERS

NAMES ROLL NOS

MANASI GANDHI 70

AMRUTA KHEDEKAR 78

POOJA MUKHERJEE 84

PRAGYA PATRA 93

DHWANI VIBHAKAR 110

LETTER OF CREDIT (LC)

3
A standard, commercial letter of credit (LC) is a document issued mostly by a financial
institution, used primarily in trade finance, which usually provides an irrevocable payment
undertaking.

The letter of credit can also be source of payment for a transaction, meaning that
redeeming the letter of credit will pay an exporter. Letters of credit are used primarily in
international trade transactions of significant value, for deals between a supplier in one
country and a customer in another. In such cases the International Chamber of Commerce
Uniform Customs and Practice for Documentary Credits applies. They are also used in the
land development process to ensure that approved public facilities (streets, sidewalks,
storm water ponds, etc.) will be built. The parties to a letter of credit are usually a
beneficiary who is to receive the money, the issuing bank of whom the applicant is a
client, and the advising bank of whom the beneficiary is a client. Almost all letters of
credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the
beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction,
letters of credit incorporate functions common to giros and Traveler's cheques. Typically,
the documents a beneficiary has to present in order to receive payment include a
commercial invoice, bill of lading, and documents proving the shipment was insured
against loss or damage in transit. However, the list and form of documents is open to
imagination and negotiation and might contain requirements to present documents issued
by a neutral third party evidencing the quality of the goods shipped, or their place of
origin or place.

INTERNATIONAL TRADE

International trade is exchange of capital, goods, and services across international

borders or territories. In most countries, it represents a significant share of gross domestic
product (GDP). While international trade has been present throughout much of history
(see Silk Road), its economic, social, and political importance has been on the rise in
recent centuries.

Industrialization, advanced transportation, globalization, multinational corporations, and

outsourcing are all having a major impact on the international trade system. Increasing
international trade is crucial to the continuance of globalization. Without international
trade, nations would be limited to the goods and services produced within their own
borders.

International trade is in principle not different from domestic trade as the motivation and
the behavior of parties involved in a trade do not change fundamentally regardless of
whether trade is across a border or not. The main difference is that international trade is
typically more costly than domestic trade. The reason is that a border typically imposes
3
additional costs such as tariffs, time costs due to border delays and costs associated with
country differences such as language, the legal system or culture.

Another difference between domestic and international trade is that factors of production
such as capital and labour are typically more mobile within a country than across
countries. Thus international trade is mostly restricted to trade in goods and services, and
only to a lesser extent to trade in capital, labor or other factors of production. Then trade
in goods and services can serve as a substitute for trade in factors of production.

Instead of importing a factor of production, a country can import goods that make
intensive use of the factor of production and are thus embodying the respective factor. An
example is the import of labor-intensive goods by the United States from China. Instead
of importing Chinese labor the United States is importing goods from China that were
produced with Chinese labour.

PARTIES INVOLVED IN AN LC TRANSACTION

Term Definition Activity

Applicant Importer Buy

Beneficiary Exporter Sell

Opening Importer’s Bank Issues L/C

Bank
Advising Exporter’s Bank Advises L/C
Bank
Confirming Advising Bank or 3rd Party Bank Confirms L/C
Bank
Paying Any bank as specified in L/C Pays the Draft
Bank

LC TRANSACTION PROCEDURE
3
LC is an application issued to the buyer by his bank upon request. The buyer has to fill out
the application for LC and send it back to his bank. The issuing bank sends the L/C to the
advising bank (sellers bank) by courier, Airmail or telex. The advising bank informs seller
(beneficiary) of the LC arrival. After receiving the LC, the seller compares the LC with
commercial invoice and makes sure that all the terms and conditions that are mentioned in
the L/C can be satisfied. There should not be any discrepancy and if there is he should
make amendments. The seller will ship the goods within the shipping period specifies in
the LC and prepares all the documents such as invoice, packing list, etc before presenting
the documents to his bank. Advising bank checks all the documents against the LC and if
they match, the advising bank pays the Seller before sending the documents back to the
issuing bank. Then the issuing bank checks all the documents and if everything is fine, it
pays to the advising bank. The issuing bank deducts the same amount from the buyers
account and submits the documents to the buyer so that he can claim his goods from
shipping company.

ROLE OF LC IN INTERNATIONAL TRADE

3
• IMPORT OPERATIONS UNDER LC

The Import Letter of Credit guarantees an exporter payment for goods or services,
provided the terms of the letter of credit have been met.

A bank issue an import letter of credit on the behalf of an importer or buyer under the
following Circumstances

• When a importer is importing goods within its own country.

• When a trader is buying good from his own country and sell it to the another country
for the purpose of merchandizing trade.
• When an Indian exporter who is executing a contract outside his own country requires
importing goods from a third country to the country where he is executing the contract.

The first category of the most common in the day to day banking,

1. Fees And Reimbursements

The different charges/fees payable under import L/C are as follows:

The issuing bank charges the applicant fees for opening the letter of credit. The fee
charged depends on the credit of the applicant, and primarily comprises of :

(a) Opening Charges:

This would comprise commitment charges and usance charged to be charged upfront for
the period of the L/C.

The fee charged by the L/C opening bank during the commitment period is referred to as
commitment fees. Commitment period is the period from the opening of the letter of credit
until the last date of negotiation of documents under the L/C or the expiry of the L/C,
whichever is later.

Usance is the credit period agreed between the buyer and the seller under the letter of
credit. This may vary from 7 days usance (sight) to 90/180 days. The fee charged by bank
for the usance period is referred to as usance charges.

(b)Retirement Charges

• This would be payable at the time of retirement of LCs. LC opening bank scrutinizes
the bills under the LCs according to UCPDC guidelines , and levies charges based on
value of goods.
3
• The advising bank charges an advising fee to the beneficiary unless stated otherwise
The fees could vary depending on the country of the beneficiary. The advising bank
charges may be eventually borne by the issuing bank or reimbursed from the applicant.
• The applicant is bounded and liable to indemnify banks against all obligations and
responsibilities imposed by foreign laws and usage.
• The confirming bank's fee depends on the credit of the issuing bank and would be
borne by the beneficiary or the issuing bank (applicant eventually) depending on the
terms of contract.
• The reimbursing bank charges are to the account of the issuing bank.

2. Risk Associated with Opening Import L/C

The basic risks associated with an issuing bank while opening an import L/C are :

The Financial Standing of the importer

As the bank is responsible to pay the money on the behalf of the importer, thereby the
bank should make sure that it has the proper funds to pay.

The Goods
Bankers need to do a detail analysis against the risks associated with perishability of
the goods, possible obsolescence, import regulations packing and storage, etc. Price
risk is the another crucial factor associated with all modes of international trade.

Exporter Risk
There is always the risk of exporting inferior quality goods. Banks need to be
protective by finding out as much possible about the exporter using status report and
other confidential information.

Country Risk
These types of risks are mainly associated with the political and economic scenario of
a country. To solve this issue, most banks have specialized unit which control the level
of exposure that that the bank will assumes for each country.

Foreign exchange risk

Foreign exchange risk is another most sensitive risk associated with the banks. As
the transaction is done in foreign currency, the traders depend a lot on exchange
rate fluctuations.

• EXPORT OPERATIONS UNDER L/C

3
Export Letter of Credit is issued in for a trader for his native country for the purchase of
goods and services. Such letters of credit may be received for following purpose:

1. For physical export of goods and services from India to a Foreign Country.
2. For execution of projects outside India by Indian exporters by supply of goods and
services from Indian or partly from India and partly from outside India.
3. Towards deemed exports where there is no physical movements of goods from
outside India But the supplies are being made to a project financed in foreign
exchange by multilateral agencies, organization or project being executed in India
with the aid of external agencies.
4. For sale of goods by Indian exporters with total procurement and supply from
outside India. In all the above cases there would be earning of Foreign Exchange or
conservation of Foreign Exchange.

Banks in India associated themselves with the export letters of credit in various capacities
such as advising bank, confirming bank, transferring bank and reimbursing bank.

In every cases the bank will be rendering services not only to the Issuing Bank as its agent
correspondent bank but also to the exporter in advising and financing his export activity.

1. Advising an Export L/c

The basic responsibility of an advising bank is to advise the credit received from its
overseas branch after checking the apparent genuineness of the credit recognized by
the issuing bank.
It is also necessary for the advising bank to go through the letter of credit, try to
understand the underlying transaction, terms and conditions of the credit and advice
the beneficiary in the matter.

The main features of advising export LCs are:

1. There are no credit risks as the bank receives a onetime commission for the advising
service.
2. There are no capital adequacy needs for the advising function.

2. Advising of Amendments to L/Cs

Amendment of LCs is done for various reasons and it is necessary to fallow all the
necessary the procedures outlined for advising. In the process of advising the
amendments the Issuing bank serializes the amendment number and also ensures that
no previous amendment is missing from the list. Only on receipt of satisfactory
information/ clarification the amendment may be advised.
3
3. Confirmation of Export Letters of Credit
It constitutes a definite undertaking of the confirming bank, in addition to that of the
issuing bank, which undertakes the sight payment, deferred payment, acceptance or
negotiation.
Banks in India have the facility of covering the credit confirmation risks with ECGC
under their “Transfer Guarantee” scheme and include both the commercial and
political risk involved.

4. Discounting/Negotiation of Export LCs

When the exporter requires funds before due date then he can discount or negotiate the
LCs with the negotiating bank. Once the issuing bank nominates the negotiating bank,
it can take the credit risk on the issuing bank or confirming bank.

However, in such a situation, the negotiating bank bears the risk associated with the
document that sometimes arises when the issuing bank discover discrepancies in the
documents and refuses to honor its commitment on the due date.

5. Reimbursement of Export LCs

Sometimes reimbursing bank, on the recommendation of issuing bank allows the
negotiating bank to collect the money from the reimbursing bank once the goods have
been shipped. It is quite similar to a cheque facility provided by a bank.

In return, the reimbursement bank earns a commission per transaction and enjoys float
income without getting involve in the checking the transaction documents.

reimbursement bank play an important role in payment on the due date ( for usance
LCs) or the days on which the negotiating bank demands the same (for sight LCs).

CHARACTERISTICS OF LETTER OF CREDIT

Negotiability
Letters of credit are usually negotiable. The issuing bank is obligated to pay not only the
beneficiary, but also any bank nominated by the beneficiary. Negotiable instruments are
passed freely from one party to another almost in the same way as money. To be
negotiable, the letter of credit must include an unconditional promise to pay, on demand
or at a definite time. The nominated bank becomes a holder in due course. As a holder in
3
due course, the holder takes the letter of credit for value, in good faith, without notice of
any claims against it. A holder in due course is treated favorably under the UCC.

The transaction is considered a straight negotiation if the issuing bank's payment

obligation extends only to the beneficiary of the credit. If a letter of credit is a straight
negotiation it is referenced on its face by "we engage with you" or "available with
ourselves". Under these conditions the promise does not pass to a purchaser of the draft as
a holder in due course.

Revocability
Letters of credit may be either revocable or irrevocable. A revocable letter of credit may
be revoked or modified for any reason, at any time by the issuing bank without
notification. A revocable letter of credit cannot be confirmed. If a correspondent bank is
engaged in a transaction that involves a revocable letter of credit, it serves as the advising
bank.

Once the documents have been presented and meet the terms and conditions in the letter
of credit, and the draft is honored, the letter of credit cannot be revoked. The revocable
letter of credit is not a commonly used instrument. It is generally used to provide
guidelines for shipment. If a letter of credit is revocable it would be referenced on its face.

The irrevocable letter of credit may not be revoked or amended without the agreement of
the issuing bank, the confirming bank, and the beneficiary. An irrevocable letter of credit
from the issuing bank insures the beneficiary that if the required documents are presented
and the terms and conditions are complied with, payment will be made. If a letter of credit
is irrevocable it is referenced on its face.

Transfer and Assignment

The beneficiary has the right to transfer or assign the right to draw, under a credit only
when the credit states that it is transferable or assignable. Credits governed by the
Uniform Commercial Code (Domestic) maybe transferred an unlimited number of times.
Under the Uniform Customs Practice for Documentary Credits (International) the credit
may be transferred only once. However, even if the credit specifies that it is
nontransferable or no assignable, the beneficiary may transfer their rights prior to
performance of conditions of the credit.

Sight and Time Drafts

All letters of credit require the beneficiary to present a draft and specified documents in
order to receive payment. A draft is a written order by which the party creating it, orders
another party to pay money to a third party. A draft is also called a bill of exchange.

There are two types of drafts: sight and time. A sight draft is payable as soon as it is
presented for payment. The bank is allowed a reasonable time to review the documents
before making payment.
3
A time draft is not payable until the lapse of a particular time period stated on the draft.
The bank is required to accept the draft as soon as the documents comply with credit
terms. The issuing bank has a reasonable time to examine those documents. The issuing
bank is obligated to accept drafts and pay them at maturity.

TYPES OF LETTER OF CREDIT

Revocable

A revocable letter of credit allows for amendments, modifications and cancellation of the
terms outlined in the letter of credit at any time to an importer without the consent of the
exporter or beneficiary. Because this places the exporter at risk, revocable letters of credit
are not generally accepted.

In order to safeguard the interest of the exporter in a revocable L/C, a clause is included
that “any drawings negotiated against the L/C prior to notification or revocation or
3
amendment will be honored on presentation.” Still this type of L/C is of limited utility
and, hence, not very popular.

Irrevocable
an irrevocable letter of credit requires the consent of the issuing bank, the beneficiary and
applicant before any amendment, modification or cancellation to the original terms can be
made. This type of letter of credit is commonly used and preferred by the exporter or
beneficiary because payment is always assured, provided the documents submitted
comply with the terms of the letter of credit. Irrevocable letters of credit can be both
confirmed and unconfirmed.

Confirmed & Unconfirmed L/C:

A confirmed letter of credit is when a second guarantee is added to the document by

another bank. The advising bank, the branch or the correspondent through which the
issuing bank routes the letter of credit, adds its undertaking and commitment to pay to the
letter of credit. This confirmation means that the Exporter / seller / beneficiary may also
look to the credit worthiness of the confirming bank for payment assurance. If no
confirmation is added it is unconfirmed. If an intermediary bank adds its confirmation, it
binds itself to negotiate documents under the particular credit confirmed. Confirmation
constitutes a definite undertaking of such bank (confirming bank), in addition to that of
the issuing bank, provided that the stipulated documents are presented and that the terms
and conditions of the credit are compiled with. It may also be noted that if any bank
confirms an L/C without an authorization from the issuing bank, it will continue to be
unconfirmed.

With Recourse & Sans (without) Recourse:

In a “With Recourse” L/C, the exporter is bound to refund the money back to the bank
which has negotiated his bills in the event of refusal by the importer to honor the bill”
where the importer fails to pay after the specified period or unduly delays his payments,
the bank can have recourse to the exporter for payment of not only the bill amount but
also expenses. However, in a “without recourse L/C” the liability of the exporter ends
after the bill is negotiated.”

The best form of L/C is therefore – “IRREVOCABLE, CONFIRMED AND SANS

RECOURSE.”

Back-to-Back Letters of Credit

Back-to-back letters of credit is a domestic letter of credit. It is an ancillary credit created

by a bank based on a confirmed export LC received by the direct exporters. The direct
exporters keep the original LC (received from issuing bank) with the negotiating or some
other bank in India, as a security and obtains another LC in favor of domestic supplier.
3
Through this route the domestic supplier gains direct access to a pre-shipment loan based
on the receipt of domestic or back-to-back LC.

Transferable LC: A transferable LC is one, which can be transferred by the beneficiary

named therein in favor of another party. The issuing bank can transfer a credit only if it is
expressly designated as transferable.

Non-Transferable LC: The beneficiary cannot transfer the LC to a third party. Usually
all letters of credit are non transferable unless it is expressly stated that LC can be
transferred.

Revolving L/C: When LC is issued for fixed amount and for a fixed period, it is called a
fixed LC. Under this credit the beneficiary has the right to draw the bills upto the specified
amount within the specified period. The validity of the LC gets over as soon as the bills
upto the specified amount have been paid within the specified time.

Under revolving type, the amount of credit is automatically renewed after the bills are
negotiated. A revolving credit is a credit, which is available for a fixed amount only for
fixed period, but when the fixed amount is withdrawn, the credit is renewed automatically
for the same initial amount. Thus, a revolving credit is used to provide transactions are
more or less regular and continuous atlest over a certain period of time.

Red Clause LC: The red clause LC is the usual irrevocable LC, which further authorizes
the negotiating bank to make advances to the beneficiary for the purpose of processing the
export goods. Thus, the red LC enables the exporter to obtain Packing Credit Facility for
the purpose of processing the goods. It is called a red-clause LC because it is generally
printed in red ink.

Standby Letter of Credit

The standby letter of credit serves a different function than the commercial letter of credit.
The commercial letter of credit is the primary payment mechanism for a transaction. The
standby letter of credit serves as a secondary payment mechanism. A bank will issue a
standby letter of credit on behalf of a customer to provide assurances of his ability to
perform under the terms of a contract between the beneficiary. The parties involved with
the transaction do not expect that the letter of credit will ever be drawn upon.

The standby letter of credit assures the beneficiary of the performance of the customer's
obligation. The beneficiary is able to draw under the credit by presenting a draft, copies of
invoices, with evidence that the customer has not performed its obligation. The bank is
3
obligated to make payment if the documents presented comply with the terms of the letter
of credit.

Standby letters of credit are issued by banks to stand behind monetary obligations, to
insure the refund of advance payment, to support performance and bid obligations, and to
insure the completion of a sales contract. The credit has an expiration date.

The standby letter of credit is often used to guarantee performance or to strengthen the
credit worthiness of a customer. In the above example, the letter of credit is issued by the
bank and held by the supplier. The customer is provided open account terms. If payments
are made in accordance with the suppliers' terms, the letter of credit would not be drawn
on. The seller pursues the customer for payment directly. If the customer is unable to pay,
the seller presents a draft and copies of invoices to the bank for payment.

The domestic standby letter of credit is governed by the Uniform Commercial Code.
Under these provisions, the bank is given until the close of the third banking day after
receipt of the documents to honor the draft

ADVANTAGES OF L/C TO AN IMPORTER (BUYER)

Reduce your commercial risk by ensuring that your supplier will not be paid until
evidence has been provided that the goods have been dispatched. Import L/Cs will also
help you:

• Conserve your company's cash flow by eliminating the need to make advance
payments or deposits

• Demonstrate your creditworthiness to your supplier

• Support your supplier's access to bank credit (in many countries, L/Cs are pledged by
exporters as security against working capital loans).

ADVANTAGES OF AN L/C TO AN EXPORTER (SELLER)

• Assure that you get paid (if the buyer doesn't pay, the bank that issued the L/C is
obligated to pay)
• No blocking of fund. Once the exporter fulfills all the conditions of L/C and
presents as per the terms and conditions of L/C. the exporter is entitled to receive
the amount of exports. L/C ultimately reduces the bad-debt of an exporter.
3
• L/C enables an exporter to avail pre-shipment finance, which is granted by
commercial banks. The strength of L/C helps exporter to avail pre-shipment
finance.