Documentary credit in financing international trade

With other methods of payment such as bills of exchange or payment after the buyer receives the goods, the exporter takes the risk that the buyer may be unwilling or unable to pay. In some cases the buyer may be unable to pay because of political or economic factors beyond his control. If he is not prepared to accept these risks, the exporter may request the buyer to arrange for a documentary credit to be established in the exporter’s favour.

Documentary credits are considered where payment to the exporter by way of a creditworthy overseas bank’s irrevocable credit is a satisfactory method from the exporter’s point of view. Exporters may experience difficulty with buyers who are tardy in arranging for documentary credits to be issued. In such cases the exporter is faced with the decision whether to ship goods without adequate protection. The exporter’s position will be clearer if the contract of sale includes a latest date by which the exporter must receive the credit.

In a transaction involving the use of a banker’s irrevocable documentary credit, the strength of the issuing bank replaces that of the buyer and with credits issued by banks of good standing in a country with a stable political and economic climate the credit risk is negligible. The same situation applies to irrevocable credits issued by any overseas bank which are confirmed by a bank in Bangladesh. However, revocable credits are issued subject to Uniform Customs Practice for Documentary credits (UCP) can only be relied upon after a drawing has been made and this reliance is qualified by the strength of the issuing bank. Where usance credits provide for drafts to be drawn on an accepting bank, that bank’s standing after acceptance is added to the transaction.

If the exporter has agreed to accept payment from the buyer in an overseas currency, a primary exchange risk exists. This extends from the date of the contract of sale until the exporter receives payment. A contingent exchange risk is also incurred on drawings negotiated under documentary credits on which the local bank of the exporter retains recourse to the beneficiary. If such a drawing is not paid by the paying bank then the exporter will usually be required to purchase sufficient overseas currency at the current exchange rate to repay the drawing under the credit. This introduces a contingent exchange risk from the date of negotiation of the drawing until payment is made. It is therefore, important, to ensure that all the terms of a credit are complied with, especially since dishonor of the drawings is usually on grounds of non-compliance with such terms.

Where such exports are financed by an overseas currency loan (in the currency of sale) the same contingent exchange risk exists until the overseas currency is received and the paying bank has paid the drawing. However, the ‘primary’ exchange risk ceases on date of drawdown of the overseas currency loan and on receipt of the proceeds in local currency by the exporter.

Whether a transfer risk exists, is a question of the fact depending on the overseas country concerned. However, in countries having exchange control, it is generally the case that approval to issue a documentary credit means that transfer of funds will be approved
when required.

The exporter is normally able to obtain disbursement of the amount of the drawing from local bank of the exporter immediately. But depending on the terms of the credit, the bank may then have to wait to be reimbursed by the issuing bank.

The beneficiary receives the face amount of the drawing if interest charges are for the account of the buyer. Where drafts are to be drawn at sight on the advice of exporter’s local bank, the negotiating bank is normally able to receive immediate value for the drawing. This is done by arrangement with the overseas issuing bank and by debiting its local currency account maintained with a local bank. However, if sight or term drafts are drawn on an overseas party, interest may be applicable from the date of negotiation until the date of receipt of payment from the issuing bank.

When credits are received in local currency of the exporter, it is desirable that the exporter ascertains from the relevant local bank of the exporter whether interest will be charged or not. If so, the exporter may not be able to include the charge in the drawing under the credit and may therefore wish to seek amendment to the credit to enable the exporter to do so. The matter of interest on local currency drawings should always be specifically covered in the contract of sale.

The local bank claims its commission from the issuing bank, unless the credit otherwise specifies. Also the beneficiary is not responsible for any overseas bank’s commission charges unless the credit so specifies. If the L/C is not specific and the negotiating bank is unable to collect charges, these will be claimed from the beneficiary. The buyer, in all cases, has to pay the overseas bank charges for issuing   the credit and in some countries these charges are high. Thus it makes documentary credits a costly method of payment for the buyer.

Documentary Credits in Overseas Currency

The beneficiary receives the local currency equivalent of the overseas currency amount of drawing, which is converted at the applicable buying rate for the currency concerned. Interest is not charged on telegraphic transfer drawings. For ‘on demand and term’ drawings, interest for the term of drawings is charged to the beneficiary by the local bank in the buying rate of exchange applied in converting the amount of the drawing to local currency. When a negotiation under a documentary credit is at the telegraphic transfer buying rate, the local bank makes a separate commission charge to the beneficiary. For a negotiation at sight or at a term after sight, a separate commission in the buying rate of exchange applied. The beneficiary is not normally responsible for any overseas bank’s payment commission charges unless the credit so specifies. The buyer has to pay bank’s charges for issuing the credit and in some countries the charges are high and make this method of payment costly to him.

There are other methods of collecting payment for exports. These can be discussed in some other time.

The writer is former Director General, Export Promotion Bureau. He can be contacted at [email protected]