LETTERS OF CREDIT Once a company decides to export a good, they want to make sure that a

LETTERS OF CREDIT Once a company decides to export a good, they want to make sure that a

payment will be made by the importer of the good. Because it is difficult to enforce contracts across countries, an intermediary is often necessary to enforce the contract. A letter of credit (LOC) is a written instrument issued by a bank at the request of an importer that obligates the bank to pay a specific amount of money to an exporter. The time at which payment is due is specified, along with conditions regarding necessary documents to be presented by the exporter prior to payment. The LOC may stipulate that a bill of lading be presented that evidences no damaged goods. A bill of lading is a detailed list of the content that is shipped, and can be used to identify missing or damaged items. Perhaps some minimal level of damage (like 2 percent of the boxes or crates) is stipulated. In any case, such conditions in an LOC allow the importer to retain some quality control prior to payment.

Figure 9.1 illustrates a simple letter of credit. Note that this is an irrevo- cable LOC. This means that the agreement cannot be modified without the express permission of all parties. Most letters of credit are of this type.

A revocable LOC may be altered by the account party—the importer buying the goods. Since the importer is free to alter the LOC, we might wonder why any exporter would ever accept a revocable LOC. The exporter may interpret the issuance of the LOC as a favorable credit report on the buyer. The exporter will call the issuing bank prior to ship- ment to make sure that the LOC has not been altered or revoked, and then present the necessary documents and collect payment as soon as possible. The revocable LOC is still safer than shipping goods based only on the importer’s promise to pay, with no bank credit backing up the transaction. Still, revocable letters of credit primarily are used only when there is no question of revocation. This form of LOC may save bank

Financial Management of the Multinational Firm 173

[Bank letterhead (Name & Address

of Importer’s Bank)]

LETTER OF CREDIT NO. ACCOUNT PARTY DATE:

(Buyer’s Name & Address) BENEFICIARY

(Seller’s Name & Address) TO: (Seller’s Bank & Address)

WE HAVE OPENED AN IRREVOCABLE LETTER OF CREDIT IN FAVOR OF: (Seller’s Name) FOR THE AMOUNT OF: $

(Dollar amount is written in words here) AVAILABLE WITH US AGAINST THE FOLLOWING DOCUMENTS:

(Required documents are listed here)

TRANSSHIPMENTS: (Permitted or not) PARTIAL SHIPMENTS: (Permitted or not)

THIS CREDIT IS VALID UNTIL (Date) FOR PRESENTATION OF DOCUMENTS TO US. DOCUMENTS ARE TO BE PRESENTED WITHIN (Number) DAYS AFTER DATE OF ISSUANCE OF BILLS OF LADING. PLEASE ADVISE THE BENEFICIARY OF YOUR CONFIRMATION.

THIS CREDIT IS SUBJECT TO THE UNIFORM CUSTOMS AND PRACTICE FOR DOCUMENTARY CREDITS. INTERNATIONAL CHAMBER OF COMMERCE PUBLICATION NO. 500. THIS CREDIT IS IRREVOCABLE AND WE HEREBY ENGAGE WITH THE DRAWERS THAT DRAWINGS IN ACCORD WITH THE TERMS OF THIS CREDIT WILL BE DULY HONORED BY US.

Yours truly, (Signature) International Department

Figure 9.1 Letter of credit.

174 International Money and Finance

modifications must be made before the goods are shipped. Once the exporter fulfills all obligations in delivering the goods, the documentary proof is presented to the bank for examination. If the documents conform to the LOC, payment is made, with the bank collecting from the importer and then paying the exporter.

If the importer does not pay the bank, the bank is still obligated to pay the exporter. The exporter is then satisfied, and any problems must

be settled between the importer and the bank. Banks may or may not require that the underlying goods serve as collateral for the LOC. If the bank does require an interest in the goods, then the bill of lading is consigned to the bank. With an unsecured LOC, the bank assumes the credit risk of a buyer default. With a secured LOC, the bank assumes the risk of changes in the value of the goods and the cost of disposal. Even if the importer is a sound credit risk, the bank assumes the risk that it misses

a document discrepancy and that the importer refuses to pay as a result.

What are the risks for the buyer and seller? The exporter faces the risk of shipping goods without being able to meet all terms listed in the LOC. If the goods are shipped and a document discrepancy exists, then the seller will not be paid. The buyer risks fraud from the seller. The goods may not meet the specifications ordered, but the seller fraudulently prepares documents stating otherwise. The bank is not responsible for such fraudulent documents, so the risk is the buyer’s.

Banks charge a flat fee for issuing and amending letters of credit. A percentage of the amount paid is also charged at the time payment is made. These charges generally apply to the importer, unless the parties agree otherwise.

AN EXAMPLE OF TRADE FINANCING Let’s consider an example that applies some of the issues covered so far.

Suppose a U.S. firm, New York Wine Importers, wants to import wine from a French firm, Paris Wine Exporters. Figure 9.2 illustrates the steps

Financial Management of the Multinational Firm 175

New York 1. Sales contract Paris Wine

5. Ship Goods Wine Importers

Exporters ered

ity

o r LOC aid at Matur or LOC

aft & Shipping Documents Shipping Documents Deliv

BA P yment Made a 2. Apply f 10. 14. 4. Apply f

6. 9. New York First

Bank Dr P 3. Issue LOC

7. Draft & Shipping Documents Delivered Paris Bank

8. BA Created & Funds Sent First Bank

ity

BA Sold a yment P

a BA Presented at Matur yment P 11. 12. 13. 15.

Investor Figure 9.2 Steps involved in a U.S. import transaction.

Bank for payment. The bank draft is like a check, except that it is dated for maturity at some time in the future when payment will be made. Paris Wine Exporters ships the wine and gives its bank, Paris First Bank, the bank draft along with the necessary shipping documents for the wine. Paris First Bank then sends the bank draft, shipping documents, and LOC to New York First Bank.

When New York First Bank accepts the bank draft, a bankers’ acceptance (BA) is created. A banker’s acceptance is a contractual obligation of a bank for

a future payment. At this point, Paris Wine Exporters may receive payment of a discounted value of the BA, as the BA does not mature until sometime in the future. New York First Bank discounts the BA and sends the funds

176 International Money and Finance

receive the face value of the BA from New York First Bank, and New York First Bank will receive the face value from New York Wine Importers.