Is time running out for letters of credit?

Hot on the heels of Export Week, UK Export Finance’s export finance adviser Paul Wright explains how businesses wanting to export in emerging markets should consider the value in using letters of credit to help secure funding.

For as long as international trade has existed there have been concerns from exporters or sellers about releasing goods or providing services before they have been fully paid. At the same time from the buyer’s viewpoint, there are concerns about paying before receipt.

Since the days of ancient Egypt, traders have offered each other formal promises to pay, in advance of the payment itself – letters of credit. The process has evolved and become part-automated but the same principles exist today. A modern documentary letter of credit is a guarantee of payment made by the buyer’s bank to the exporter, subject to certain conditions such as delivery on time and to the specified standards. The idea is that a promise to pay from a bank is worth more than a promise from the buyer themselves.

High street banks and UK Export Finance (UKEF) will often encourage exporters to request a letter of credit from the buyer’s bank because it reduces the risk of non-payment. If the exporter is concerned about the reliability of an overseas issuing bank, the exporter’s own bank may be able to address this concern by “confirming” the letter (adding its own undertaking to pay, after checking the creditworthiness of the overseas bank).

So why has there been a gradual decline in the use of letters of credit in recent years? What might be the problem with using them?

There are several reasons for the decline. One is economic: as markets recover from the banking crisis, firms and banks may feel less need to cover the risks of trade. Also, some buyers do not like to provide letters of credit because they are contingent liabilities and can tie up credit facilities with their bank. The importer and exporter both incur bank fees. And exporters, particularly in the UK, may not like to ask buyers for letters of credit as it might be seen as insulting, showing a lack of trust. This could potentially destroy the long and careful process of personal relationship-building that it took to win the order in the first place.

For businesses with limited export experience, the process of obtaining import or export letters of credit can seem onerous and daunting. What is more, while they are almost always completed eventually, a large proportion of letters of credit presentations fail the first time around. This means the exporter’s funds may be held up, while any problems are sorted out. Reasons for such failure can include late shipment, resulting in late availability of shipping documents; or the exporter’s failure to present all of the other documents required by the letter of credit in the required form or by the required time.

In the wake of such problems, last year saw a 36% reduction in the use of letters of credit worldwide. At the same time, an increase has been seen in open account trading, and a 10% rise in the use of other methods to ensure payment such as digital initiatives designed to offer similar comfort without the hassle of the paper, such as the Bank Payment Obligation.

So as an exporter, should you still consider using letters of credit?

The short answer is yes, though a careful risk calculation needs to be made. Increasingly, UK exporters are looking beyond the UK’s main traditional trading partners of the EU member states and the US, towards emerging markets in Africa, South America and Asia. These markets present great opportunities, but there is often less chance of recovery or litigation following non-payment.

As such when considering letters of credit, the cost of using them should be compared to the risks of not using them, depending on the markets you serve. Ultimately you will have to decide, if you are trading on open account and without export insurance – how much can you afford to lose? You will also need to take advice on how to maximise your chances of having your documents accepted on first presentation. If you are unsure of the best way to proceed or where to seek advice, please ask your UKEF Export Finance Adviser, your bank manager or your local Chamber of Commerce.