Ideally an exporter would trade only in cash, but in the real scenario, only few business people are initially willing or able enough to do business under such terms. Because of the risk involved of non- payment occurring from insolvency, bankruptcy, or other severe devaluation; processes and documents have been prepared that help to ensure that international buyers honor their contracts.
he most general form of collecting the payment is payment against a letter of credit (L/C). The L/C is the workable method in which an importer’s bank promises that if all the documents are provided in the exact conformity with the conditions of the L/C, it will make the payment to the exporter. The procedure is not hard to understand, and many cities have banks with people familiar with L/C’s mechanism. This method is well known by traders around the global because it is simple and is as good as the bank. Internationally the term documentary credit is equivalent with the term letter of credit. They engage thousands of transactions and millions of dollars every day in any part of the world. They are almost always performed in accordance with the Uniform Customs and Practice for Documentary Credits of the International Chamber of Commerce, a code of practice that is noticed by banking institutions in 156 countries.
An L/C is a document issued by the bank at the importer’s or purchaser’s request in favor of the exporter. It guarantees to pay a certain amount of money upon the receipt by the bank of specified documents within a specified time or at intervals equivalent with shipments of goods. It is a universally accepted and used method of obtaining a commercially acceptable agreement.
You can also think of a letter of credit as a loan against collateral where the funds are deposited in a security account. The amount in the account relies on the relationship between the purchaser and his bank. Commonly, if you don’t have an account already, the bank will need 100 % collateral. With an account already, the bank will settle a line of credit against that account. For example, if you have INR 5,000 in your account and the transaction is estimated to cost INR 1,000, your account will be deducted to INR 4,000 and the line of credit will be settles as INR 1,000. Commercial letter of credit costs are competitive.
In the next post, we will study about different types of letter of credit.
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