Explainer: What is a letter of credit?

BusinessDay recently reported that several Nigerian businesses relying on imports have been cut off by their foreign suppliers who rejected letters of credit and refused to deliver goods without payment as foreign currency shortages worsened in Africa’s biggest economy.

A letter of credit (LC), according to the International Trade Administration, is one of the most secure instruments available to international traders.

An LC is a commitment by a bank on behalf of the buyer that payment will be made to the exporter or supplier, provided that the terms and conditions stated in the LC have been met, as verified through the presentation of all required documents.

An LC is simply a contract between a beneficiary, a bank, and the bank’s client. The letter, which is often issued by an importer’s bank, assures the beneficiary that payment will be made once the terms have been satisfied.

What is the significance of LCs?

Letters of credit are used to reduce risks in international transactions between the buyer and seller.

If you are an importer, having an LC will help you make sure that your business will only make payments for purchases once the supplier has supplied proof that the products have been transported. Due to the fact that you are not to make any deposits or advance payments to the exporter, it also enables you to conserve your cash flow.

The LC establishes your trustworthiness and gives you quick credibility with an exporter, an analyst said.

Who are those involved in a letter of credit?

A bank customer who is the buyer or importer/applicant requesting LC to be opened by his bank.

The foreign supplier or the seller, or the exporter/beneficiary, who is at the receiving of the LC.

There is the issuing bank that opens the LC on behalf of the customer.

Also, there is an advising bank or seller’s bank that advises the LC to the beneficiary.

When a buyer defaults on a letter of credit

Read also:Trouble looms as foreign suppliers reject letters of credit

Muda Yusuf, chief executive officer of the Centre for the Promotion of Private Enterprise, said: “Having lodged your application for a letter of credit, your bank debited your account because it has opened an LC for you, helped you to apply for foreign exchange and when it’s time to pay the foreign suppliers there’s no dollar to pay. That is default and that is why Nigerian letters of credit are being rejected by foreign banks.

“There has been a series of defaults and because of that many banks abroad are not honouring our LCs anymore. The normal channel of trade is that you open LC, your account is debited, the money is remitted to your customer.”

He added: “Some foreign suppliers used to give credit before, for up to 30 days or 60 days, and you can even do business within this time before you pay.

“But people are defaulting, not because they do not have the money but because there is no FX. So many credit lines have been lost; everything is now cash and carry.”

Yusuf said: “The implication is that you lose credibility. You do not get supplies easily. Many Nigerians have lost credit lines and now the suppliers are insisting on ‘cash and carry’.

“It affects ordinary people. If those who produce cannot get raw materials to produce, how will they produce? It will create scarcity of goods. So it affects the production flow and once there is scarcity of goods prices will go up.”