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How to Pay Chinese Supplier by a Letter of Credit to Protect Against Bad Suppliers

Updated on May 25, 2016

A Case For Using Documentary LC Payment In China

Letter of credit is a time tested financial instrument that protects the interest of the parties engaged in international trade. One of the biggest fears that any western company has that they may lose their money paid to an unreliable Chinese supplier. This can happen in any of the following ways

  • The Chinese supplier will take a 30% deposit and produce substandard quality products. They know very well that the buyer is stuck with deposit and only option would be to accept the goods produced or lose the deposit. Given the lax laws that largely favor the Chinese supplier the buyer has no satisfactory recourse.
  • They supplier may disappear after getting deposit.
  • The supplier may produce your order with a substantial delay which may result in financial losses for you due to non delivery of goods to your customers. This is very common with orders for the Christmas season.

In order to avoid all above situations it is better not to pay an advance to the Chinese supplier. The best option will be to pay via documentary letter of credit that has a 3rd party inspection clause. While none of the small traders will agree to LC payment, major Chinese suppliers with large factories would agree to such payment provided the order is over $25000 and there is a chance of getting a repeat order.

How a Documentary Letter Of Credit Protects You Against a Chinese Supplier?

Reason for possible loss
Protection by using a letter of credit
Chinese supplier fails to make a timely delivey
A letter of credit will lapse after a fixed time. The supplier is unable to take payment for goods produced after the deadline, as a result
Chinese factory produces goods which are sub-standard
Importer can put a third party inspection clause. An independent third party will reject sub-standard goods and supplier will not be paid as he will fail to furnish inspection certificate
Supplier fails to give all testing certificates and other necessary documents promised at the time of signing the sales contract
Letter of credit will not be paid for the want of proper documents
Documentary Letter of Credit as Protection Against Chinese Supplier

Risk Associated With a Payment Method

Payment methods and risk
Payment methods and risk | Source

Evaluating Payment Methods

Method of Payment
Pros
Cons
Advance payment
Seller starts production quickly as funds are available. This is suitable for prototype development work
High risk for buyer as he has no satisfactory recourse
30% Deposit, 70% Balance
Most common payment method in China
Same risk as above for losing deposit money
PayPal
Easy to setup and pay
Works for small order
Escrow
Protects buyer against non delivery
High escrow fee, No proper mechanism for dispute resolution
Letter of credit
High buyer protection, fair to both parties
Complex process, high fees
Document against acceptance or open credit
High protection for the buyer
Sellers will not agree unless the buyer is a large, multinational corporation

How Much It Will Cost To Open A Letter Of Credit Favoring Chinese Supplier

The letter of credit cost varies from bank to bank. It also depends on the credit rating of the importer, country where the beneficiary is located and several other factors. On a conservative estimate a L/C should cost between 0.75% to 1.5%. Please remember that these costs are shared between importer (the buyer) and beneficiary (Chinese factory or supplier. As per common trade practices, all charges originating in the country where the importer resides is borne by the L/C opener whereas charges incurred in the destination country will be shared by the exporter.

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Reasons Given By a Chinese Supplier For Not Accepting a L/C Payment

Chinese suppliers are generally reluctant to accept payment by letter of credit. They would try to offer a general 30% advance and 70% upon shipment payment terms. This method of payment is unsafe because the supplier may produce poor quality goods or worse even he may simply disappear with your deposit. An importer, naturally, to protect his interest should offer L/C payment. This is how you should act:

Work with suppliers that accept a letter of credit as payment method. There is no dearth of suppliers in China so cast your search net wide enough to find those willing to work on LC payment. Usually, small supplier or those looking forward to a one-off transaction would not agree whereas a large, reputed supplier will accept documentary LC.

Work with large Chinese companies as they have a dedicated export sales department which is familiar with the documentary letter of credit.

If a small company who is willing to work, but have questions about it. Send them a draft of a letter of credit so that they can show to their bankers and familiarize themselves. Once they understand their payments are assured it is likely that they will work with you.

Many good suppliers are small and they do not have enough resources to fund the initial raw material cost. If the supplier in China is a small business which needs your advance payment to pay for raw material, open a red clause letter of credit. These are LC with a special clause that allows them to get an unsecured loan from a bank on the basis of the LC.

If the Chinese supplier laments that letter of credit is expensive, ask them to give details of the letter of credit charges. It is not that expensive for a company to receive payment via letter of credit. If the supplier does not agree solely because of the cost, you can ask your banker to open a letter of credit where the seller would bear all charges.

Use a reputed bank to open a letter of credit or have a major US/UK bank to confirm your letter of credit. This will remove any doubt that a Chinese supplier’s banker may have regarding the possibility of the documentary letter of credit not being paid.

How Chinese Supplier is Paid by LC?

A process flow chart explaining payment under a documentary letter of credit
A process flow chart explaining payment under a documentary letter of credit | Source

Negotiation Of a Sales Contract Is Pre-requisite For Opening a Letter Of Credit

The terms of a sales contract define terms of the letter of credit
The terms of a sales contract define terms of the letter of credit | Source

The Process Flow Of a Documentary LC

The initial point that triggers the LC process is a sales contract. The importer and the Chinese supplier agree on the commercial terms of the sales, mode of shipment and timely delivery and other commercial terms. Please bear in mind that LC is independent of the sales contract which means payment made by the LC issuing bank does not rely on satisfactory performance of the sales contract as along as criteria stipulated in the letter of credit are met.

Once the sales contract is signed the importer (the applicant) approaches his banker (LC Issuing bank) to issue a documentary letter of credit in favor of the Chinese supplier. The terms of the LC are set forth in accordance with the sales contract.

It is unlikely that the importer’s bank has a branch in the city / country where the Chinese supplier is located. In this event, the importer’s bank outsources his part of the service to a bank in China. This bank is known as the advising bank. As the name suggests this bank merely advises the LC without any undertaking to honor or negotiate. It is responsible for the authenticity of the LC and ensuring advice reflects the terms of the LC accurately.

The advising bank notify’s the beneficiary (the Chinese exporter) who in turns inspects and satisfies himself with the conditions of the LC. At this point, he may ask the importer (not advising bank) to change the clause of the LC if they do not meet the sales contract.

Once goods are produced, checked by the third party inspection service and loaded as per the terms of the sales contract, the Chinese exporter collects the documents, which are requested in the letter of credit and forwards them to the advising bank for collection of payment

The advising bank, on behalf of the Chinese exporter, couriers the documents to the issuing bank. The issuing bank checks the documents in accordance UPC600 standards & the terms of the documentary letter of credit. The issuing bank is bound to honor the payment if everything is in compliance.

The importer pays the issuing bank the amount of the LC and other charges in order to collect the same and apply for the clearance of goods with customs department.

Letter Of Credit Flow Chart

Letter of credit flow chart
Letter of credit flow chart | Source

History and early use of the documentary letter of credit

Nobody knows for sure when the first letter of credit was used. University Museum of Philadelphia displays an ancient Babylonian exhibit dating 3000 BC that has an inscription stating a specified sum to be paid on a specified date with interest. This is probably one of the oldest known evidence of credit instrument.

The rise of roman empire and its insatiable need for grain imports paved way for wealthy merchant device a way where a holder of a credit instrument must travel to Rome to get payment. There are evidence of rudimentary credit instruments use in Egypt in 250 BC.

Marco Polo has also reported use of paper currency and various credit instruments in China during his stay. Later in medieval time Venice was the center of international trade and finance, whichpopularized the use of credit instruments. It was fairly common during 17th century onwards in Europe and England. However, a formal agreement was reached in 1933 by the International Chamber of Commerce to standardize norms of issuing it which is known as UPC (Uniform Customs and Practice for Documentary Credits). Banks in China and elsewhere rely on modern UPC 600 norms for documentary letter of credit.

Financial document in 19th Century

Banks have played an important role in development of letter of credit as payment instrument.
Banks have played an important role in development of letter of credit as payment instrument. | Source

An early example of letter of credit

Source

Guangzhou Port, China In The 18th Century

Guangzhou, China in the 18th century was first to allow trade with the westerner
Guangzhou, China in the 18th century was first to allow trade with the westerner | Source

© 2014 Kamal Mohta

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      Mitchell 2 years ago

      That's an inventive answer to an initeestrng question

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