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Using Letters Of Credit With China Suppliers

Posted in China Business

This is a guest post from Renaud Anjoran.  Renaud runs a product quality inspection business in Shenzhen and he also writes the truly excellent and perinially helpful Quality Inspection Tips.   My firm has worked with Renaud on a number of China product matters and we have consistently found him to be highly knowledgeable about China product sourcing.  This post arose from a long email “conversation” between co-blogger Steve Dickinson and Renaud, which ended as so many of those do: with me suggesting that it be turned into a blog post.

So here’s the blog post, written by Renaud Anjoran.

 

Most transactions with Chinese suppliers are done through bank transfers. This payment method was described in a previous China Law Blog post, China Manufacturing Payment Terms. Limit Your Risks.

Many importers/foreign manufacturers are not familiar with Letters of Credit (LC) as an alternative to bank transfers. Letters of Credit were designed to protect both product buyers and product supplier in international trade. In practice, they are usually more favorable to the buyer.

How a letter of credit protects the buyer

An importer that pays by LC does not have to wire a deposit before production and it usually has the option to cancel the payment in the following cases:

  • If a supplier does not ship at the right time.  Typically if this happens, the LC simply expires, but the buyer still has the choice to pay if it wants the goods.
  • If a supplier does not honor the product specification or if there are too many defects. One of the conditions of the LC should be that the LC will not be paid on unless and until the product buyer has signed off on product quality or a specified third party QC agency has issued its certificate of inspection.
  • If the seller fails to provide any document listed as required in the LC or the documents do not fully conform to the LC’s requirements.

Why letters of credit can be cancelled by the buyer in most cases

Even something as small as a typo in the LC, or the fact that a quantity is written in dozens rather than in pieces in the invoice is usually enough to cause a discrepancy in the LC, which in turn allows the buyer to cancel payment.

In practice, a small minority of LCs are “clean,” i.e., without any discrepancy. In all other cases, the buyer has the option to refuse payment and cancel the transaction, even if the goods are already on a boat (in which case the buyer will not get the documents to get the products out of custom).

CLB Note:  We are aware of a Seattle buyer company that refused goods that had already arrived in Seattle because the street address (which was irrelevant) of one of the parties in the letter of credit was off by a single letter.

Tips for negotiating payment by letter of credit

For the reasons mentioned above, Chinese suppliers typically refuse to accept Letters of Credit. Here is how you can increase your chances of finding a Chinese company that accepts this payment method:

  • When sourcing your product, try to identify as many potential suppliers as possible. This will at least increase your chances of finding one that will accept an LC.
  • In your first conversation with your potential suppliers, mention that you always pay by LC on your first order. Try to get the supplier to accept this payment method in writing
  • Sell your project to your potential suppliers. Good manufacturers are inundated with customer inquiries, so you need to make yourself stand out. Explain why they should work with you. Call the Chinese company’s sales manager if necessary
  • Send your potential Chinese manufacturer a draft of the LC before opening it. You will usually need the commercial invoice, the packing list, the certificate of origin and/or GSM form A, the bill of lading, and an inspection certificate. Try to avoid putting “soft terms” into your Letter of Credit that will make it even more difficult for suppliers to collect payment.
  • If possible, use a major international bank. This will tend to reassure your suppliers.
  • Unfortunately, bank fees are much higher for an LC than they are for a bank wire, so an LC only makes sense for transactions of at least USD$30,000.
  • Chinese exporters are good at guessing whether a project is likely to become a source of long-term business. When they see what they think will be a a one-shot deal, they generally insist on getting a deposit and will not agree to an LC payment arrangement.

In summary, Letter of Credit are a payment tool that makes it unnecessary to transfer a 30% (or more) deposit to your Chinese manufacturer. They are usually more favorable to the buyer’s side, and for that reason, many Chinese companies refuse to accept them. But some Chinese product suppliers have been paid via Letters of Credit from some of their foreign customers for years, and sometimes Chinese manufacturers will accept your Letter of Credit if they really want your orders.

 

What do you think?

  • twofish

    I’ve always wondered why more Chinese manufacturers don’t accept letters of credit, and here is my theory….

    There is a standard chicken-egg problem with manufacturing. The manufacturer has to pay workers now, but doesn’t get cash until later, and small companies in China find it extremely difficult to get cash from banks, and informal money lenders charge absurd amounts of money. In the US, a private manufacturer can take a letter of credit to a bank and then use it as collateral to get cash, whereas this doesn’t work in China. Chinese banks are set up to give loans to large state owned enterprises, and if you are a small business and walk in with LC’s in hand, they have no clue what to do with you.

    So the reason that Chinese SME’s want upfront money is that they are using the deposit to pay for their manufacturing costs. Which is one more reason for using an L/C, if someone accepts an L/C as payment, that means that they think that they have the financial reserves to get payment in the end.

    • http://www.qualityinspection.org/ Renaud Anjoran

      Good point.

  • Ayany Alvarado

    I used to work for a bank, at credit and loan department, and I have experience in LC negotiation.

    It’s true that most of the suppliers, after accepting an LC, go to their banks to discount it, which allows them to get enough cash to start the production.

    The bank usually asks them to give some guarantees that prove that they will return the credit. This can be a mortage of the factory or anything else. Sometimes they can get a discount line, so they can discount more than one LC.

    But everything depends on the relation between the supplier and their bank. Some banks work to improve the development on their city or region and give soft credit to the suppliers that can help to achieve this goal.

    On the buyer side, that the suppliers accept the LC, mean that:

    - the supplier have a good financial health, and

    - the supplier is a serious company.

    Anyway, an LC is not only good for the buyer. With the LC the suppliers have the guarantee that they will receive the payment even if the buyers don’t have money at the moment of the payment. Because the LC, on the bank side, is an obligation of payment.

    • http://www.qualityinspection.org/ Renaud Anjoran

      Thanks. I would add two remarks:
      - If the buyer adds some “soft terms” in the LC, the supplier will have a hard time getting an advance from his bank.
      - If the buyer has no money at the time of payment, his bank will probably “manufacture discrepancies” simply to gain a little time. They hope that the buyer can get more cash on his account soon… Or use the fake discrepancies as an excuse to cancel the transaction.

      • Ayany Alvarado

        Yes, it happens sometimes.
        Yesterday I got a new example about this matter. The buyer, when have received the products, deducted from the LC the bad quality claims. So, the buyer just paid for the good quality products.

        • http://www.qualityinspection.org/ Renaud Anjoran

          In the case you mention, the buyer was lucky to get the goods before the LC was paid. He probably negotiated for an LC at 45 days or something similar?

          • Ayany Alvarado

            Yes, the buyer negotiated more than 90 days…