How is a documentary credit created, and what are its advantages to exporters and importers?

What will be an ideal response?

Documentary credits (D/Cs) are designed to solve the problems caused by the fact that importers and exporters want to pay and be paid at different times. Documentary credits also provide a way for exporters to finance the production of their goods. With a documentary credit, at least one commercial bank stands between the importer and the exporter. The exporter must assess the credit risk of this international bank, not the credit risk of the importer. Because the involvement of commercial banks in the transaction is extensive, using a documentary credit is the most expensive of the methods of payment.
The steps in the creation of a documentary credit are the following:
1 . The importer orders goods from the exporter and asks whether the exporter is willing to ship the goods under a documentary credit containing a time draft.
2 . The exporter and importer agree to ship the goods under a documentary credit. The two parties negotiate the price of the goods and the other aspects related to how the goods will be shipped.
3 . The importer applies for a documentary credit to its commercial bank, designated in Exhibit 18.5 as "Bank IMP." The D/C is issued, with the exporter named as the beneficiary, and the D/C specifies the information associated with the deal.
4 . Bank IMP issues the documentary credit, with the exporter named as the beneficiary. The D/C is sent to an advising bank, "Bank EXP," in the exporter's country.
5 . Bank EXP advises the exporter that the documentary credit has arrived. If the exporter so desires, Bank EXP confirms the documentary credit for a fee and adds its guarantee to Bank IMP's guarantee.
6 . The exporter ships the goods to the importer using a common carrier.
7 . The exporter presents a time draft, with a maturity of, say, 90 days in the future, to Bank EXP. The draft is drawn on Bank IMP, as specified in the documentary credit from Bank IMP. The exporter also presents the documents required by the D/C, including the order bill of lading. The exporter endorses the order bill of lading "in blank" so that the title of the goods passes to the holder of the endorsed bill of lading, which is Bank EXP at this point in the transaction.
8 . Bank EXP presents the draft and the export documents to Bank IMP, which accepts the draft and takes possession of the documents. A banker's acceptance, B/A, with a maturity of 90 days is created.
9 . Either Bank IMP returns the accepted draft to Bank EXP, or Bank EXP could ask for the discounted cash value of the B/A, in which case Bank IMP would deduct a discounting fee. The interest rate in the B/A market is used to take the present value in the discounting process.
10 . Assuming that Bank EXP receives the B/A, it now either gives the B/A to the exporter or pays the exporter. In the latter case, Bank EXP can either hold the B/A in its own portfolio or sell the B/A to an investor in the international financial markets.
11 . Normally, the exporter receives the discounted cash value for the B/A less any bank charge for a discounting fee rather than wait for 90 days to receive a cash payment.
12 . Bank IMP informs the importer that the documents have arrived. The importer either signs a promissory note or follows through with some mutually agreed-upon plan for paying Bank IMP, at which point Bank IMP releases the documents, including the order bill of lading, to the importer. Often, the maturity of the promissory note is the same as the maturity of the B/A, which is 90 days in this case.
13 . When the goods arrive, the importer collects them from the common carrier, using the order bill of lading.
14 . At the maturity of the promissory note, the importer pays Bank IMP.
15 . At the maturity of the B/A, Bank IMP pays the holder of the matured banker's acceptance. The investor receives the face value of the B/A. The holder may present the B/A directly to Bank IMP, or it may have Bank EXP collect the amount through its normal banking relationships with Bank IMP.

Documentary credits offer a number of advantages to exporters:
1 . The most important advantage of a D/C is that it substitutes the creditworthiness of the bank for the credit risk of the importing firm. The exporter therefore must only be concerned with the credit risk of the bank that issues the D/C. If the exporter satisfies the requirements of the D/C, the exporter will be paid by the bank.
2 . Establishing a documentary credit enhances the probability that the exporter will not experience delays in payment due to the imposition of foreign exchange controls or other political risks. Countries are well aware of the importance of international trade. As a result, governments generally permit banks to honor existing documentary credits. Failing to do so severely damages a country's reputation and its ability to borrow in international financial markets in the future.
3 . A D/C reduces the uncertainty of a transaction by clearly establishing the acts that the exporter must carry out in order to receive payment.
4 . Because a D/C is a legally binding document between a bank and an exporter, the exporter is protected if the importer desires to cancel the contract during the production processes. This is especially important if the goods are being made to order.
5 . A D/C makes it easy for an exporter to receive early payment because a time draft can be accepted by the bank, which creates a banker's acceptance. This is a tradable document, and the bank typically sells it and pays the exporter the discounted value of the draft immediately.

Documentary credits also have advantages from the importer's perspective:
1 . The foremost advantage for an importer is that a D/C clearly indicates a time frame by which the goods must be shipped. The importer knows that the exporter must ship the goods by a certain date and must provide certain documents to the bank if the exporter wants to be paid. The importer is thus assured of having the goods when they are needed for the importer's production process or for resale in the importer's market.
2 . Another advantage of a D/C from the importer's perspective is that an importer's bank assumes responsibility for checking the documents provided by an exporter. Hence, if the exporter does not properly ship the goods, the bank will not pay the exporter, and the importer is protected from having to pay for goods that are not valuable. Eventually, if the importer takes possession of the goods and it is discovered that there is a problem with the shipment that should have been caught by examining the shipping documents, the bank is responsible for this oversight.
3 . The fact that a D/C substitutes the bank's credit standing for the importer's credit standing means that the importer may be able to command better payment terms. In fact, because many exporters will refuse to export without either cash in advance or a D/C, the D/C may simply ensure that the deal actually gets done.
4 . If some form of prepayment is required by an exporter, an importer is better off depositing money in an escrow account at its domestic bank than with a foreign company. If the exporter encounters some difficulty that limits its ability to follow through on its contractual commitments, the importer can recover its deposit from a local bank more easily than it could from the foreign exporter.