Question

When a foreign businessman buys American produce and pays with a letter of credit, the current account: A.) rises b.) stays the same c. Falls

Answer 1

C.

How Letters of Credit Work

The first thing to understand about Letters of Credit is that there are many different variations that have been crafted over the years to meet the requirements of Buyers and Sellers. However, there is a generally accepted format that permeates all Letter of Credit transactions, and that framework will be explained here.

The basic purpose of a Letter of Credit is to comfort buyers and sellers in an international trade transaction by essentially replacing the credit of the buyer with the financial backing of the bank that issues the letter of credit. Two basic types of letter of credit are used:

1. Commercial Letter of Credit - This is the basic payment document guaranteeing the payment for the goods that are being sold and shipped. Also called a Documentary Letter of Credit.

2. Standby Letter of Credit - This is a secondary payment device.

Both types of Letters of Credit will be explained:

1. Commercial Letter of Credit

An issuing bank issues (or opens) a commercial letter of credit at the request of one of its customers, authorizing the advising or confirming bank, to make a specified payment to the seller or shipper, known as the beneficiary. The letter of credit is the bank’s commitment to fund draws covered by the credit. In effect, the credit of the issuing bank replaces the credit of the bank's customer as the party obligated to make the payments under the letter of credit.

Binding guidelines for the issuance and operation of letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits.

Letters of credit that are issued and used solely within the United States are governed by and subject to the Uniform Commercial Code.

Components of a Letter of Credit

• A payment obligation on the part of the issuing bank.
• To facilitate a purchase by the bank’s customer.
• To pay a specified amount of money.
• To the beneficiary seller or shipper.
• Upon the receipt of specified goods.
• In acceptable condition.
• And upon the receipt of specified documents.
• All received according to a specified timing schedule.
• All in compliance with the terms of the letter of credit.
• And received at a certain place.

Parties to a Letter of Credit

Beneficiary

It is important to note that the letter of credit transaction is actually a separate contract from the sales contract between the buyer and the seller. The letter of credit transaction deals in documents and not in the handling of goods, and the bank that issues the letter of credit is not liable for the performance of the sales contract between the buyer and the seller. The bank that issued the letter of credit is obligated to pay the specified amount to the seller/beneficiary if it produces the documentation required by the letter of credit. The issuing bank's obligation to its customer, the buyer, is to examine thoroughly all of the documents to insure that they meet all the terms and conditions required by the letter of credit. When the beneficiary presents the documents for payment, the beneficiary guarantees that all of the conditions of the letter of credit have been met. Then if the issuing bank’s examination of the documents confirms this fact, then the issuing bank makes the specified payment to the beneficiary/seller.

Issuing Bank

Once the issuing bank has received the documents and approved them as complying with all of the requirements specified in the letter of credit, the bank is obligated to make payment to the beneficiary. The Uniform Customs and Practice for Documentary Credits allow the issuing bank a reasonable amount of time after receipt of the documents to examine them and to honor the letter of credit by making the specified payment to the beneficiary. Then the issuing bank completes the transaction by receiving reimbursement from the bank customer for whom the letter of credit was issued.

A letter of credit typically will require at a bare minimum documents such as an official invoice, a bill of lading or airway bill, and an insurance document. However, letters of credit may require additional documentation depending upon the nature of the transaction.

Advising Bank

An advising bank is usually a bank located in the beneficiary’s city. The advising bank’s role is to advise the beneficiary and insure the beneficiary that the letter of credit is valid, usually accomplished by having a relationship with or simply by knowing of and communicating with the issuing bank. Also, it is the responsibility of the advising bank to make sure that the appropriate documents are collected and sent to the issuing bank.

Confirming Bank

Irrevocable letters of credit may be confirmed or unconfirmed. An issuing bank that issues a confirmed letter of credit may require that a confirming bank confirm the letter of credit for the beneficiary, which means that the confirming bank obligates itself to insure payment to the beneficiary under the letter of credit. Before a confirming bank confirms a letter of credit, it performs an evaluation of the issuing bank and the documentation requirements of the letter of credit. Typically, the confirming bank is also the advising bank, but this is not a requirement, and the functions may be separated.