What are documentary credits?
Also known as “letters of credit”, documentary credits are amongst the safest methods of payment in exporting (other than payment in advance). Your customer arranges a letter of credit with its bank (known as the “issuing bank”). In this letter of credit will stand all the instructions that you must follow and documentary evidence that you must supply to a correspondent bank (which will normally be specified in the letter of credit) in South Africa (known as the “advising bank”). The correspondent bank may be a different bank to your own bank (it is in fact the local representative of the overseas issuing bank) As the exporter, you will receive a copy of the letter of credit, as will the South African advising bank.
The need for accurate documentary proof
Once you have dispatched the goods and attended to all of the requirements as stated in the letter of credit, you can approach the advising bank and submit to them all of the documentary evidence (such as the shipping documents, phytosanitary documents, inspection certificates, etc.) of what you have done and as is set out in the letter of credit. If your documentary evidence exactly meets the requirements as specified in the letter of credit, the advising bank will pay you as per the payment instructions (which may be immediately, or after a certain period of time or on a specific date). It is important, however, that the documentary evidence that you supply to the advising bank meets the requirements as stipulated in the letter of credit, exactly – even a spelling mistake or a missing comma can result in their refusal to pay.
Irrevocable and confirmed letters of credit
Letters of credit can also be both “irrevocable” and/or “confirmed” An accurate and authentic “irrevocable” letter of credit, verified by your own bank (not necessarily the advising bank), carries little credit risk. As long as your documentary evidence is accurate and in keeping with the requirements of the letter of credit, the issuing bank guarantees to pay you within the stipulated time. By “confirming” the letter of credit, your bank agrees to pay you even if the issuing bank (i.e. the importer’s bank) defaults. Your bank will charge a commission based on how creditworthy the issuing bank is. Of course, letters of credit can also be unconfirmed and/or revocable, but these options are much more risky for you as the exporter because it allows the importer (or his/her issuing bank) to renege on the payment.
Term credits and financing
A letter of credit can specify any credit period that you have negotiated with your customer. A letter of credit that that incorporates a payment after a given term (e.g. 60 days) is known as a term credit. A term credit will require you to finance the gap between delivery and payment.
You can use a valid, current letter of credit to raise additional finance in a similar way to using a bill of exchange. Your customer is responsible for the cost of issuing the letter of credit. The customer may want to pass these costs on to you as part of the price negotiation. Documentary credits are typically used for exports to customers you have not sold to before and for customers and countries that present particular credit risks.