Letter of Credit (LC)

Definition

Imagine you're a Chennai-based auto parts manufacturer and a buyer in Germany wants Rs 3 crore worth of components. You've never dealt with them before. They don't want to pay upfront; you don't want to ship without guaranteed payment. A Letter of Credit bridges that gap. The German buyer's bank issues an LC promising to pay you once you present the right documents, commercial invoice, bill of lading, packing list, certificate of origin, inspection certificates. The bank's creditworthiness replaces the buyer's. That's why LCs have been the foundation of international trade for over a century.

In India, LCs are regulated under FEMA, 1999, and RBI's trade finance guidelines. Indian importers open LCs with their banks to reassure foreign exporters; Indian exporters receive LCs from overseas buyers' banks. The international rulebook is UCP 600 (Uniform Customs and Practice for Documentary Credits), published by the International Chamber of Commerce and referenced in virtually every LC worldwide. Types matter: irrevocable LCs (the default under UCP 600) can't be changed without everyone's consent. Confirmed LCs add the beneficiary's local bank as a second guarantor. Standby LCs work more like bank guarantees, triggered by default, not performance.

Here's what trips up even experienced trade finance teams: document compliance. Banks examine LC documents with surgical precision. A misspelled company name, an invoice total that's off by a dollar, a bill of lading dated after the LC's latest shipment date, any discrepancy can trigger rejection, delaying payment by weeks. The cost stack is also significant: issuance commission, amendment charges, negotiation fees, and forex conversion costs all add up and must be baked into your landed cost calculations. LC discounting (where an exporter gets early payment from a bank against a confirmed LC) is a widely used working capital lever.

Key Points

• An LC substitutes bank creditworthiness for buyer creditworthiness: the seller gets paid once compliant documents are presented.
• Governed by FEMA, 1999, RBI trade finance guidelines, and the globally accepted UCP 600 standard.
• Irrevocable LCs (standard under UCP 600) can't be amended without consent from all parties including the beneficiary.
• Document compliance is everything: banks reject non-compliant presentations regardless of the underlying trade's legitimacy.
• LC discounting converts a confirmed LC into immediate working capital for exporters who can't wait for the payment cycle.
• Factor in issuance commission, amendment fees, negotiation charges, and forex costs when calculating true landed cost.