This method of payment has become the most popular form in recent times, as the credit and payment risks of the exporter can be eliminated under appropriate forms of documentary credit. Incidentally, this method of payment is the costliest from the standpoint of the importer.
Documentary credits have been described in the following terms: any arrangement however named or described whereby a bank the issuing bank acting at the request and in accordance with the instructions of a customer ( the applicant for the credit) (1) is to make payment or to the order of a third party (the beneficiary), or (2) authorizes such payment to be made or such Drafts to be paid, accepted or negotiated by another bank against stipulated documents provided that the terms and conditions of the credit are complied with.
In simpler terms, under documentary credits the importer approaches his bank which, on the basis of the instructions given by the importer, gives a written undertaking to the overseas exporter that if the exporter presents certain shipment and payment documents covering the goods in the contract of sale within a fixed period, the bank will make payment of the given amount to the exporter. In effect, the credit of the issuing bank is substituted for that of the buyer. There are various forms of letters of credit. It is especially important to distinguish between irrevocable letters of credit and unconfirmed and confirmed letters of credit.
Irrevocable and Revocable Credit:
Revocable letter of credit is not very common in export trade. Under revocable, letters of credit the importer’s bank opens a credit in favor of the exporter, but expressly states that the credit can be revoked at any time without the consent of or notice to the beneficiary. This type of credit obviously does not protect the interest of the exporter who may learn at the last moment or even after shipment may come to know that the credit has been revoked. And once it is revoked he has no means to recover his dues. When the credit is irrevocable, this problem does not arise. The issuing bank in this case irrevocably commits itself to make the payment, if the credit terms as given in the letter of credit are satisfied i.e. the required documents are presented on or before the due date, also mentioned in the letter of credit. The exporter can, therefore feel secure about the payment as this credit cannot be cancelled without the consent of all the parties. According to the Uniform Customs Trade practices all credits should specifically mention whether they are revocable or irrevocable and if not indicated the credit is deemed to be irrevocable under the UCPDC effective January 1, 1994.
Confirmed and unconfirmed credit:
In export business, the buyers and sellers reside on different countries. The exporter may not be familiar about the soundness of the importer’s bank. To reduce his payment risks, he wants that a local bank in his own country irrevocably commits itself to make the payment on presentation of the documents. Again, it is easier for him to deal with a local bank. The system works in the following way: The importer’s bank (issuing bank) asks its correspondent bank in the exporter’s country to confirm the original credit as opened by it. The correspondent bank while advising the exporter about the opening of the letter of credit adds a clause to the effect that:
The above credit is confirmed by us and we hereby undertake to honor the drafts under this credit on presentation provided that all the terms and conditions of the credit are duly satisfied.
When the advising bank adds its confirmation to the irrevocable credit issued by the importer’s bank, the credit becomes confirmed and irrevocable. The advantages of such credit, so far the exporter is concerned is that the payment risks becomes localized i.e. can secure payment from the local bank. The disadvantage is it is important that the credit becomes costlier because the advising bank will ask for confirmation charges from the issuing bank which in turn will receive the same from the importer. This is the basic reasons why many importers would like to open only irrevocable but not confirmed letters of credit.
When the letter of credit is irrevocable but not confirmed the issuing bank asks the correspondent bank to advise about the letter of credit without any confirmation of the latter. In such a case the advice of the correspondent bank will contain a clause that:
This credit is irrevocable on the part of the issuing bank but is not confirmed by us and therefore it does not involve any undertaking on our part.
If the issuing bank is well known and of good standing the exporter need not worry too much about the confirmation. It is unlikely that he will face any problems in negotiating documents if he fulfils the conditions of the credit. However, it should be mentioned that there is a contingency risk involved in unconfirmed irrevocable letters of credit. When the exporter receives the advice from the local bank that it is willing to negotiate the documents, the exporter can present the documents and receive the payments promptly; but in such cases bills are usually drawn on the issuing bank, so that the negotiating bank can have recourse to the drawer (exporter) until the documents have been presented to and bills paid by the issuing bank. The exporter remains contingently liable for this period.