SWATI R 130 DOCUMENTARY CREDIT Abstract Of the $13.

6 trillion of goods traded worldwide, 90 percent rely on letters of credit or related forms of financing and guarantees such as trade credit insurance, according to the Geneva-based World Trade Organization. Letters of credit are centuries-old instruments that allow far-flung partners to complete large transactions. An importing company gets its bank to issue the letter, guaranteeing payment for a delivery. That bank provides the letter to the exporter's bank, which then guarantees payment to the exporting company. The system breaks down when banks don't trust one another and are unwilling to accept a letter of credit as proof that payment is coming. Introduction Letters of credit of various sorts are essential for trade. Imagine the difficulty, of a Indian manufacturer who wants to sell his goods to buyers overseas. How can he be sure the goods he ships will ever be paid for? Imagine the considerable difficulty and cost of chasing a deadbeat in an alien country. Letters of credit. issued by banks, assure payment. They can also serve to finance the shipment. This is the reason why they have become popular instruments of trade finance over a period of time. FIGURE 1 Trade credit transaction volumes Letter of Credit 42% Standby Letter of Credit 7% Guarantee 15% Collections 23% Open account 11% Other 2% Source: global survey 2011(published by ICC) While open account trade is clearly here to stay, the events of the past couple of years coupled with the credit crisis have encouraged the corporate financial managers to 1

reconsider the merits of the letter of credit (LC). The credit crisis and the subsequent global economic downturn, Led to shrinkage in the trade volumes. At the same time, liquidity from both banks and insurers dried up and funding surcharges shot up, making short-term financing out of reach for many traders and exporters. As corporates have become more cautious regarding the financial stability of their trading partners, the LC has begun enjoying something of a revival. Indeed, many corporates have come to realize that documentary trade business offers a more secure and efficient and comparatively risk free means of trade credit. Recovery and Risk Transfer LCs offer a better potential for recovery in situations of distress. It provides easier access to funding and cheaper funds as well as risk transfer because the counterparty to the transaction is a bank. Its effectiveness in covering the counterparty and country risk has transformed in into an attractive alternative for cross border risk management. The costs of processing the documentation associated with LCs have fallen considerably over recent years, as banks and other service providers have developed tools to manage these processes more efficiently. LCs can now be processed and monitored online, and this has increased the processing speed and rate of money transfer. The errors prone to physical documentations has almost been eradicated. The Complexity of Open Account Open account settlement requires elaborate vouchering, reconciliation and tracing processes. Also, the credit assessment of the counterparties to a transaction require full disclosure and honesty from all parties. Corporates and other traders have to compare their own risk assessment and management capabilities with the the fees associated with an LC. More then often

it is seen that an LC is a more secure alternative then any other form of risk management techniques. Despite the issues raised by recent events, trading on open account remains attractive. For large well funded projects it offers a greater integration between the physical and financial supply chains. This provides transparency, and can help generate additional liquidity in the credit sector. However, the problems that open account presents for suppliers also cannot be ignored, specially during a financial crisis. Without an LC, many suppliers find themselves unable to offer strong security to their banking partner in order to attain working capital funding. Documentary credit and the financial crisis The years 2008 and 09 saw a dramitc change in the credit marker. The shrinkage of liquidity made investors and financial vary and more stringent in their trade practices. The banks were apprehensive of lending to each other for much longer than overnight. They also started refusing to honor letters of credit from other banks. At the end of the day, if every counterparty is bad then there is no market and you dont have an economy. The evidence is piling up in the world's ports GRAINS SHIPMENT CASE The credit crisis is enveloped the grain industry also. International buyers were unable to come up with payment, forcing sellers to shoulder substantial losses. This happened because the buyers typically had to produce proof they are good for the money before cargoes could be loaded at port. However the analysts opine that most of the transaction fell apart as sellers decide they dont trust the financial institution named in the buyers letter of credit,. Access to credit is key to the survival of maritime trade and insiders now say the supply is being severely restricted Omar Nokta, an analyst at investment bank Dahlman Rose, said in an interview with Reuters that the credit crisis has made banks nervous and the last thing on their minds was issuing loans or honoring LCs. 3

The risisng costs for LCs This ICC website reports showed a trend of rising costs and fees for letters of credit in the oil trade. These higher costs simply reflect a perceived higher credit risk during the crisis phase. Banks unwilling to issue LCs to their customers. This grain shipment case tells us that vessels loaded with US grain are sitting at buyers ports waiting to unload because importers cant get a letter of credit. Even collateralized loans seem to be difficult to get. The grain has already arrived and can be easily liened, but the banks ask for more. Bankers who drunkenly handed out cash to any agency have become stringent practitioners who soberly review credit applications over and over again without finding it in themselves to approve THE LUMBER COMPANY CASE Richard Burnett's lumber company had started loading wood onto ships heading for Chinaon 29th july 2008. More was en route to the docks. It was all part of an order that would fill 100 40-foot cargo containers. Then Burnett got a call from his buyer at Shanghai VIVA Wood Products Co. The deal was dead. He told Burnett, president of Cross Creek Sales LLC in Augusta, Georgia, he couldn't get a letter of credit to guarantee payment for at least six months. The inability of buyers in China and Vietnam to get letters of credit has cost the lumber company as much as $4 million that year, a third of projected revenue, forcing the company to lay off 15 of 35 employees. An Iranian oil tanker able to carry enough crude oil to supply Ireland for five days arrived at the Turkish port of Ceyhan on Oct. 6. Then she waited eight days before the company that hired her was able to secure a letter of credit that was acceptable to Iraq, the country selling the cargo, according to two people involved in the loading and unloading of the oil. Real impact on LCs From 2000 through 2008, the use of letters of credit declined to about 10 percent of global trade transactions, the IFC's Stevenson said. Over the six months of crisis, they began ``roaring back into fashion'' as sellers sought to guarantee payments from buyers 4

they no longer trusted, he said. At the same time, liquidity problems caused banks to increase charges. The cost of a letter of credit has tripled for buyers in China and Turkey and doubled for Pakistan, Argentina and Bangladesh Banks are now charging 1.5 percent of the value of the transaction for credit guarantees for some Chinese transactions. Current situation and Future prospects in Trade Finance Traders in many low-income countries still have considerable difficulty accessing trade finance at an affordable cost, particularly for import finance. One positive development is that the average price for L/Cs in large emerging economies fell from 150-250 basis points in 2009 to 70-150 basis points in 2010. The greatest number of L/Cs were issued in the Asia-Pacific countries, with most of this traffic consisting of intra-regional transactions. The region has been using L/Cs more than any other. At the same time, the average value of an L/C in the region is not the highest (516,000 USD for imports). The financial institutions responding to the global survey published by ICC, 58% reported an increase in export L/C volume and 66% an increase in import L/C volume. Considerable increases were also reported for guarantees (42% on the export side and 48% on the import side). Increases of 49% were seen for collections on both the export and import sides, and this may still reflect the fact that corporates sought a change from open account transactions by having the banking system act as custodians for their documents Trade finance instruments gained prominence Many respondent banks to the ICC Survey continued to comment on an increase in demand for documentary credits (L/Cs). These instruments are considered to substantially reduce risks for both the exporter and the importer. Not surprisingly, therefore, the documentary credit today is seen as the classic form of international export payment, especially in trade between distant partners. Other trade finance instruments were mentioned by respondents, including guarantees. With the greatest economic crisis since the Great Depression still a fresh memory, guarantees were said to provide greater security in trade, as they are designed to restore confidence by protecting the parties

against performance breaches without the need for businesses to post onerous cash deposits to secure their performance duties. Loss experience of traditional trade products versus general banking facilities Banks continued to report that customers are asking for confirmed letters of credit, though they previously had worked with unconfirmed L/Cs, documentary collections or open account. However, bank perception of risk is still leading to a tightening of liquidity in some instances, which is causing difficulty in obtaining bank confirmations in some regions. In March 2011, this situation still prevailed, but not at the levels experienced in 2009 FIGURE 2 Amount traded in L/C

SOURCE: ICC GLOBAL SURVEY In accordance with SWIFTs Data Retrieval Policy, all retrieved data is presented in aggregated and anonymous form. For comparative purposes, the average value of a documentary collection was 83K against 565K for a documentary credit. In December 2010, Asia-Pacific was the region that initiated 64% of the import transactions, because it sent almost 64% of the MT 700 (in volume), followed by EuropeEurozone with 11%. But in average value (converted in K USD), these two regions were not the highest.

The highest number of L/Cs was issued by Asia-Pacific, and most of the Asia-Pacific traffic is intra-regional. Asia-Pacific is using this instrument much more than any other region. This can explain why the average value of an L/C in this region was not the highest (516,000 USD for imports).