Chapter-6: Foreign Exchange and Financing of Foreign Trade

Md. Ariful Hoque

Lecturer, DBA, IIUC
Letter of credit:
Generally Letter of credit is a written commitment to pay, by a buyer's or importer's bank (called
the issuing bank) to the seller's or exporter's bank (called the accepting bank, negotiating bank, or
paying bank). More precisely letter of credit is a document from a bank guaranteeing that a seller
will receive payment in full as long as certain delivery conditions have been met. In the event
that the buyer is unable to make payment on the purchase, the bank will cover the outstanding
amount. That is, L/C is a binding document that a buyer can request from his bank in order to
guarantee that the payment for goods will be transferred to the seller. Basically, a letter of credit
gives the seller reassurance that he will receive the payment for the goods. Letters of credit are
often used in international transactions to ensure that payment will be received. Importers and
exporters regularly use letters of credit to protect themselves. Letters of credit are common in
international trade, but they are also used in domestic transactions. In effect, a letter of credit
substitutes the creditworthiness of a bank for the creditworthiness of the buyer. So we say that
letter of credit is sort of guarantee given by the importer bank with the request of importer to
exporter through the exporter bank after shipment of goods or commodity.
Parties to Letters of Credit:
Applicant or Importer: The person or body(customer of the bank) who requests the
bank(opening bank) to issue a letter of credit. As per instruction and on behalf of the applicant,
bank open L/C in line with the terms and conditions of the sales contract between the buyer and
seller.
Opening Bank / Issuing Bank: The Bank which open / issue letter of credit on behalf of the
applicant / importer. Issuing bank‟s obligation is to make payment against presentation of
documents drawn strictly complied as per terms of the L/C.
Advising Bank / Notifying Bank: The bank through which the L/C is advised to the beneficiary
(exporter). The responsibility of advising bank is to communicate the L/C to the beneficiary after
checking the authenticity of the credit. The advising bank acts only as an agent of the issuing
bank.
Beneficiary: Beneficiary of the L/C is the party in whose favor the letter of credit is issued.
Usually they are the seller or exporter.
Negotiating Bank: The bank which negotiates documents and pays the amount to the
beneficiary when presented complying credit terms. If the negotiations of documents are not
restricted to a particular bank in the L/C, normally negotiating bank is the banker of the
beneficiary.

Types of letter of credit: There are five commonly used types of letter of credit.
1. Irrevocable
2. Revocable
3. Unconfirmed
4. Confirmed
5. Transferable

1
 6. Other types include:
 Standby
 Revolving
 Back-to-back
 Red Clause

Irrevocable Letter of Credit: An irrevocable letter of credit is a letter of credit that

cannot be changed without authorization from all parties involved. Here any changes
(amendment) or cancellation of the LC (except it is expired) is done by the applicant
through the issuing bank. It must be authenticated and approved by the beneficiary.
Almost all letters of credit now are irrevocable, because revocable letters of credit
simply do not provide the security that most beneficiaries want.

Revocable letters of credit: A revocable letter of credit is a letter of credit that can be changed
or cancelled by the bank that issued it at any time and for any reason. That is, the buyer and the
bank that established the LC are able to manipulate the LC or make corrections without
informing or getting permissions from the seller (beneficiaries). Since revocable letters of credit
do not provide any protection to the beneficiary, they are not used frequently.

Confirmed letter of credit: A confirmed letter of credit is one where a second bank agrees to
pay the letter of credit at the request of the issuing bank. While not usually required by law, an
issuing bank might be required by court order to only issue confirmed letters of credit if they are
in receivership.

Unconfirmed letter of credit: An unconfirmed letter of credit is guaranteed only by the issuing
bank. This is the most common form with regard to confirmation.

Transferable letters of credit: A transferable letter of credit can be passed from one
„beneficiary‟ (person receiving payment) to others. They‟re commonly used when intermediaries
are involved in a transaction.

Other types include:

Standby letters of credit: A standby letter of credit is an assurance from a bank that a
buyer is able to pay a seller. The seller doesn't expect to have to draw on the letter of
credit to get paid. Instead of facilitating a transaction, a standby letter of credit
provides compensation when something goes wrong. Standby letters of credit are very
similar to commercial letters of credit, but they are only payable when the payee (or
“beneficiary”) proves that they didn‟t get what was promised. Standby letters of credit
can be used to ensure that you‟ll get paid, and they can be used to ensure that services
will be performed satisfactorily.

2
 Md. Ariful Hoque
Lecturer, DBA, IIUC

Revolving Letters of Credit: A revolving letter of credit is a letter of credit can be used for
multiple payments. If a buyer and seller expect to do business continually, they may prefer not to
obtain a new letter of credit for every transaction (or for every step in a series of transactions).
This type of letter of credit allows businesses to use a single letter of credit for numerous
transactions until the letter expires (typically up to one year).

Back to Back Letters of Credit: A back to back letter of credit allows intermediaries to
connect buyers and sellers. Two letters of credit are used so that each party gets paid
individually: an intermediary gets paid by the buyer, and a supplier gets paid by the
intermediary. The final buyer and the intermediary use a “master” letter of credit, and
the intermediary and supplier use a letter of credit based on the master letter. Back to
back letter of credit is used in a trade involving an intermediary but a transferable
letter of credit is unsuitable. It is actually made up of two letters of credit, one issued
by the buyer's bank to the intermediary and the other issued by the intermediary's
bank to the seller.

Red Clause Letter of Credit: A red clause letter of credit allows the beneficiary to
receive partial payment before shipping the products or performing the services.
Originally these terms were written in red ink, hence the name. In practical use,
issuing banks will rarely offer these terms unless the beneficiary is very creditworthy
or an advising bank agrees to refund the money if the shipment is not made. With a
red clause, the beneficiary has access to cash up front. The buyer allows for an
unsecured loan to be issued as part of the letter of credit, which is essentially an
advance on the rest of the payment. The seller or beneficiary can then use the money
to buy, manufacture, or ship goods to the buyer.

3
 Md. Ariful Hoque
Lecturer, DBA, IIUC

Procedures of L/C opening:

Stage-1: To open an L/C, a customer is required to submit an application in the prescribe form to
the bank. This is called the L/C application form which is also an agreement between the
importer and the bank. L/C application must be completed and signed by the importer or
authorized person of the importer giving the following information:
 Full name and address of the exporter and importer
 Brief description of the goods
 L/C value for US dollar, pound starling, EURO etc which must not exceed the LCA
(letter of credit authorization) value
 The unit price, quality, quantity of the goods
 Origin of the goods, port of loading and port of destination must be mention
 Mode of shipment
 Last date of shipment and negotiation time
 Insurance cover note with money receipt
 Whether trans-shipment is allowed or not
 LCA number, IRC number and H.S. code number
In addition, any other relevant information and instructions must be mentioned in the application.
On receipt of the L/C application, an officer of the foreign exchange section must carefully check
that:
 The terms and conditions as stipulated in the L/C application are consistent with the
exchange control and import trade regulation
 All information required on the documentation has been furnished
 The terms of import are eligible according to importers entitlement
 The goods are not being imported from Israel
 All the cutting, erasing or any alterations are authenticated by authorized person
 The validity of the L/C must not exceed the validity of LCA

Stage-2: The import section of the bank prepares a credit report for studying the character,
capacity, collateral, conditions and capital of the applicant. In addition, one may study the three
“Rs” i.e. reliability, responsibility and resources.
Stage-3: The import section of the bank will see whether there are sufficient funds available in
the customer‟s account to cover the L/C margin, commissions, postage, telex charges and other
expenses. If everything is in order, the L/C will be sanctioned.
Stage-4: The L/C must be typed on the printed form of the bank. After typing, the L/C should be
checked and signed by two officers of the bank.

4
 Md. Ariful Hoque
Lecturer, DBA, IIUC

Documents for opening L/C: Following documents should be submitted by importer before
issuing letter of credit:
 Trade Licence (Valid)
 Import registration certificate, which must be kept in bank custody
 Import passbook
 Income tax declaration
 Membership certificate (Registered trade association)
 Memorandum of articles (in case of Limited Company) and resolution
 Registered deed (in case of partnership firm)
 Photograph (one copy) of the importer

Import financing: The credit facility which is provided by commercial banks to their customer
(Importer) for the purpose of importing merchandise from abroad or other country is called
import financing. Generally

Methods of import financing: There are two methods of import financing such as (a) payment
against documents and (b) loan against imported merchandise. These are briefly discussed
below:

(a) Payment against documents: When shipping documents are found in order or
consistent with the terms and conditions of L/C, then issuing bank must response against
payment for shipment. If importer bank make payment against imported merchandise as a
representative of importer then it s called payment against documents. This payment is
made according to the cost memo which is prepared by importer for retiring import bills.
Normally, outstanding under payment against documents should not take more than 21
days for adjustment. If the importer retires the imported bill against payment, the
transaction ends there and outstanding under PAD stands liquidated.
(b) Loan against imported merchandise: When importer requests the bank for clearance of
goods due to failure for retirement of documents against payment, then the liabilities
under PAD is converted to loan against imported merchandise. The advance against
imported merchandise is a loan where clearance charges such as customs duty, sales tax
or VAT etc is allowed to be added. Loan against imported merchandise is expired, if
importer makes full payment of bank‟s liability and thereby taking all imported
merchandise.

5
 Md. Ariful Hoque
Lecturer, DBA, IIUC

Export financing: When commercial banks provide credit facilities to the exporters for the
export purpose then it is called export financing. Generally export financing is provided after
taking order from importer. That is, export financing is granted against shipment documents or
documents related to letter of credit. Export financing may be pre-shipment and post-shipment.

Pre-Shipment financing: When an exporter seeks financial assistance before loading the goods
on shipment for export, it is called Pre-Shipment financing. Such credit is granted to the exporter
for procurement and processing of raw materials, manufacture of finished products packing and
transporting goods meant for export. In other words, it is facility extended to the exporter before
and till the goods are shipped for export to foreign countries.
Pre-Shipment export financing may be provided into three ways such as:
 Packing credit
 Advance under “Red Clause Letter of Credit”
 Back-to-Back credit

Packing credit: Packing credit is essentially a short-term advance with a fixed repayment date
granted by the bank to an eligible exporter for the purpose of buying, processing, manufacturing,
packing and shipping of the goods meant for export. Such facilities are allowed to an exporter
just at a time when he has the foreign buyer‟s order by way of confirmed export letter of credit or
a firm contract. When the order is executed, the packing credit gets paid out of the proceeds of
the bill drawn on the foreign buyer. A packing credit advance does not normally extend beyond
180 days. The packing credit facilities may be extended in the form of
 Hypothecation of goods
 Pledge
 Export trust receipt

Advance under “Red Clause Letter of Credit”: In a “Red clause” Letter of credit, a special
clause is incorporated into it which authorizes the exporter bank to make pre-shipment advances
to the exporter of the credit to enable him to manufacture or buy goods from local suppliers.
These pre-shipment advances are made after submitting the relative documents under Letter of
credit. Generally advances under such credit are authorized by the buyer when there is close
relationship between the exporter and the importer. The issuing bank takes the responsibility for
advance made by beneficiary‟s bank, in case the exporter fails to repay or delivery the
documents for negotiation.
Back-to-Back credit: A back-to-back credit is essentially a secondary or ancillary credit opened
by a bank on behalf of the beneficiary of the original credit, in favor of a supplier located inside
or outside the original beneficiary‟s country. Here two credits operate “back-to-back”. One being
issued on the security of the other, it is technically called back-to-back credit. Thus a “back-to-
back” credit transaction involves two separate credits, wherein the beneficiary (Exporter) of the
first credit becomes the applicant of the second credit.

6
 Md. Ariful Hoque
Lecturer, DBA, IIUC

Post-shipment financing: The advance made against the shipping documents till the export
proceeds are realized falls under the category of “ post-shipment finance” i.e. finance provided
after the goods gave been shipped. Banks generally finance the exporters at the post-shipment
stage on verification of the creditworthiness and financial soundness of both the buyers and the
sellers. Post-shipment credit ordinaly takes the following shape:
 Negotiation of documents under L/Cs
 Purchase of foreign Bill under D.P and D.A basis
 Advance against foreign bills under collection

Negotiation of documents under L/Cs: After shipment of the goods in terms of L/C, the
exporter presents the relative documents to the exporter bank. When the exporter bank is
satisfied that the documents have been submitted in terms of the Letter of credit, bank may
negotiate the documents and pay the proceeds of the bill to the exporter. Here negotiation implies
that the exporter banker pays to the drawer (Exporter) the value of the bill on the assurance given
by L/C opening banker. The rate to be applied for payment to the customer is the buying rate.
Purchase of foreign Bill under D.P and D.A basis: The export finance by way of negotiation
of documents against payment (D/P) and documents against acceptance (D/A) bills is generally
given to the exporter. Credit facilities in respect of such bills should be granted to customers
after careful scrutiny of the creditworthiness, business experiences, and integrity of the drawer
and the drawee of the bill. The customers of undoubted creditworthiness are considered by the
bank for the facility. In purchasing/discounting the D/A or D/P bills, the bank will have to
scrutinize all the export documents carefully.
Advance against foreign bills under collection: An exporter, whose bill has been taken for
collection by the bank, may require funds urgently. The bank may accommodate him by
allowing an overdraft or granting a loan up to certain percentage of the value of the bill under
collection. The bank might also decide to purchase export bills within the limit sanctioned to the
exporter, after verifying the confirmed order covering each export.