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Advantages and Disadvantages of Letter of Credit

Advantages of Letter of Credit. To the exporter the advantages are:

1. The first advantage is from the financial point of view. The exporter can easily discount the bills under a letter of credit with his bank. As such bills carry an undertaking to pay by a bank, bills drawn under letter of credit are readily discounted by banks. Thus the exporter gets payment immediately on shipping the goods. Further, rates quoted for bills under the letter of credit are more favorable than for other bills.

2. The exporter is safeguarded against the failure of the importer to pay. On presentation of documents as required the importer’s bank has to make payment whether or not the importer pays.

3. The exporter is absolved of the botheration of knowing in detail the exchange control regulations of the importer’s country and is also insured to some extent against changes in such regulations. The bank which issues the credit would take care to see that the goods covered by the letter of credit would be allowed to be imported and that payment for the imports would be permitted under exchange control regulations. Even in case there is a subsequent change in Government poli-cies, the Government would think twice before restraining the bank from executing its commitment under the letter of credit.

4. On the strength of the letter of credit the exporter may raise loans from his bank for procurement and processing of raw materials and their export (pre-shipment finance).

To the importer the advantages are:

1. The letter of credit enables him to purchase materials (especially in seller’s market) without making full advance payment. Further, on the strength of the superior credit of the bank he is able to finalize contracts which the seller may not agree had he to rely on the importer.

2. If he takes certain safeguards, like calling for packing certificates, etc., the quality and quantity of the goods consigned is assured.

3. Provided the buyer has a high credit with his bank, he may get goods released by the bank under trust (without payment) and pay for them on sale.

The objective of a documentary credit is to provide a guarantee of payment to the seller. It is not and cannot be a guarantee to the buyer that he will receive the goods he has ordered.

Disadvantages of Letter of Credit

A letter of credit is not a cent per cent safe deal either for the exporter or for the importer. To the exporter, the undertaking of the issuing bank is only conditional. The documents tendered should strictly comply with the requirements of the credit. It is only the bank that would decide if the documents are as per the terms of the credit; any slight variation or non-fulfillment or excess detail in the documents tendered gives scope for the bank to claim that the documents are not as per the terms of the credit. Moreover, the credited does not protect the exporter from the governmental action that may deter payment .

To the importer, the major disadvantage is that it does not ensure that he would be receiving the goods of the specific condition and order. In letter of credit transactions , all parties deal with documents and not in goods. He stands committed to reimburse the issuing bank when documents as required are tendered to him. But this does not ensure the receipt of proper goods. Though the risk is safeguarded against by calling for specialized documents like packing list, etc., the risk of falsification  of documents still remains.

But it should be understood that the limitations do not in any way undermine the advantages that result from using letter of credit in the international dealings. They only point out the areas where the parties cannot find protection by using letter of credit; nor do they get the desired protection by any other method.

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