Trade between the United Kingdom and its international trading partners can be split regionally, with the method of payment being based upon:
- risk profile of the buyer and country;
- long term trading practice; and
- competition.
Other factors can sometimes encourage exporters to use more secure terms, such as political and economic instability and influences exerted by credit insurers. Exporters need to be aware of the internal and external factors impacting on their overseas markets and have a flexible payment strategy that can change according to the risk profile of the buyer's country. Information about the major factors influencing trade in particular markets can be obtained through newspapers and trade press, the internet and from credit insurers and banks.
The following map demonstrates the predominant global trading patterns for open account, documentary collections, letters of credit and payment in advance.
| Europe/North America | Open Account |
| S. America/Middle East/Asia | Letters of Credit |
| South Africa/Australia | Documentary Collections/Open Account |
| Africa/Russia | Adv Payment/Letter of Credit |
The following list shows the volume of letters of credit use by geographic region.
| Region | Letters of Credit Usage by Geographic Region |
|---|---|
| European Union | 9% |
| Rest of Europe | 20% |
| North America | 11% |
| Latin America | 27% |
| Middle East | 52% |
| Asia Pacific | 43% |
| Africa | 49% |
| Asia | 46% |
| Aust. & New Zealand | 17% |
Why Use a Letter of Credit?
Letters of credit may be used in international trade for a number of reasons, some of which are detailed below.
- New Trading Relationship
It may often be advisable to use a letter of credit in a new trading relationship as security is given to both the exporter and the importer. The exporter knows that he will get paid if he complies precisely with the letter of credit and the importer can ensure that he requests all the documentation required by the contract of sale and purchase and knows that the exporter will not be paid unless he complies with the letter of credit terms. However, for the exporter, this decision should be made carefully with thought given to the cost of using a letter of credit and the fact that competitors may be prepared to trade on more flexible payment terms. Once a stable trading relationship is established the situation should be re-assessed and consideration given to more flexible and competitive payment terms, where possible. - Letters of Credit Required by Credit Insurers
Credit insurers will specify the need for sellers to trade on letter of credit terms to buyers in certain markets. When exporters are required to trade on irrevocable letters of credit (not confirmed), the underwriters will be at risk in the event that documents are presented to the advising bank in compliance with the terms of the letter of credit and funds are not available to make payment under the letter of credit. - 'Always Traded This Way'
Exporters may have always used letters of credit for a particular customer or region without periodically re-assessing the reasons for requesting this method of payment. It is important to examine carefully the reasons for using a letter of credit to ensure that they are using the most competitive and cost effective methods possible in the circumstances. - Legal Reasons
Some countries insist that imports are paid for under letter of credit to help manage exchange control regulations. - Recommended by Banks
Domestic bankers may advise exporters that the best method of payment is a 'confirmed irrevocable letter of credit' irrespective of the country, strength of issuing bank and without much regard to the value of the consignment. Although this is, other than advance payment, the most secure method of payment it is not always suitable and can place the exporter at a significant price disadvantage if they are competing against other suppliers selling on less secure terms. - Strategic Decision Made by the Exporter
Unfortunately, few companies have a clearly defined strategy on how they will sell to certain buyers in specific markets. The strategy should be flexible to adapt to the changing risk profile of both the country and the buyer. A strategic approach to risk management will allow the exporter greater flexibility in protecting the payment risks and will inevitably lead to reduced bank costs because the most effective and cost efficient solution will be adopted.
Payment Strategy
It is important for exporters to be certain that it is necessary to use a letter of credit. As well as the cost of using such a method of payment, there is also the time that is used to check and present the documents under a letter of credit, and, if the presentation is rejected, to correct any errors.
As discussed earlier a letter of credit does provide security to both the exporter and the importer. The security offered, however, must be weighed against the additional costs and the exporter must understand the conditional nature of the letter of credit - payment will not be made unless the terms of the credit are met precisely.
When planning a payment strategy, the following issues should be examined when the use of a letter of credit is being considered.
- Is it a legal requirement in the importing country?
- What is the value of the order - will the bank charges be out of proportion to the value?
- Does the importer insist on a letter of credit or would they prefer an alternative method of payment?
- What is the credit rating of the importer and are they a new customer or has a trading relationship already been established?
- What is the country risk of the importing country (would a confirmed letter of credit be more suitable)?
- What is the standing of the issuing bank (would a confirmed letter of credit be more suitable)?
- What is the usual practice in trading with that country and in that particular commodity?
- Are there any other measures that could be taken to protect the exporter (e.g. credit insurance)?
When looking at the charges involved in using a letter of credit, it should be remembered that confirmation costs, if required will be on top of the usual costs. Confirmation costs will vary according to the country involved, but for many countries considered a high risk will be between 2%-8%. There also may be countries issuing letters of credit which banks do not wish to confirm - they may already have enough exposure in that market or not wish to expose themselves to that particular risk at all.
Having considered the above issues along with company policy, exporters should be in a better position to decide if they should use a letter of credit and if so whether it is necessary to have it confirmed. In some cases other options may be more appropriate.
- Advance payment
Under these terms the goods will not be despatched until payment is received in full. This type of transaction involves no credit risk and is the most secure method of payment (more secure than a letter of credit) for the exporter. However, it is uncompetitive and the majority of importers will not wish to trade under these terms. The exporter may well need to be prepared to offer a discount to encourage an importer to accept this method of payment. - Open account
This is the least secure method of payment for exporters, where after a credit limit and period have been agreed, consignments are despatched and the buyer is invoiced. This procedure will generally be used where there is a good trading relationship between the exporter and importer. Geographically open account is generally used when trading with the rest of Europe and North America (although more secure terms may be needed for parts of Eastern Europe). If an exporter is happy that they do not need the security of a letter of credit, they may wish to consider using open account transactions (perhaps backed up by credit insurance which is explained below), especially for smaller value consignments. - Documentary Collection
This method is more secure than open account but less so than a letter of credit and can provide a viable, and cheaper alternative to using a letter of credit. Documents, along with a bill of exchange, are sent through the banking system. The buyer is offered the documents by the bank in exchange for payment or acceptance of the bill of exchange (if payment is due at a later date). In this system there is no guarantee of payment from the bank, and the buyer may refuse to take up the documents, but the exporter still retains some amount of control over the goods by sending the documents through the banking system. The ICC Rules for Collections (URC522) provides guidance for banks and other parties involved in documentary collections. - Credit Insurance
In certain cases exporters may be able to obtain credit insurance to protect themselves against the commercial risk of the buyer not paying or indeed against the country risk of the importing country. Although usually only up to 90% of the invoice value can be recovered the process is much less time consuming than using a letter of credit. There may, however, be times where the credit insurer will not insure without a letter of credit, or indeed, will not insure at all. Although credit insurance will not provide as much security as a letter of credit it is worthwhile for exporters to consider using this tool.
- Contents
- Executive Summary
- Section 1 - Introduction
- Section 2 - Letters of Credit - An Explanation
- Section 3 - Global Payment Patterns - Return to top of page
- Section 4 - The Survey
- Section 5 - Demonstrated Best Practice
- Section 6 - Conclusions
- Glossary of Commonly Used Terms in Documentary Credits
- Appendix 1 - List of Discrepancies and Frequency
- Appendix 2 - Organisations Providing Letter of Credit Training
- Appendix 3 - Checklist for Compiling Documents Under a Letter of Credit
Return to Policy Development: Reports
