A letter of credit is beneficial to the supplier because:
1.Forces clear written plans from buyers. Allows supplier to know exactly what is expected from them.
2.Guarantees payment if conditions are met. Less risk of a buyer “walking away” due to this formalized contract.
If importers can afford this payment method (the bank generally charges several hundred USD + a small % of value), it is most effective when paired with a reliable quality control plan. As mentioned above, the buyer may establish quality requirements. Many professional QC firms will provide a certificate for the bank that outlines the necessary quality issues before releasing payment.
While indeed a Letter of Credit protects you as a buyer, it is important to realize that risks are not completely mitigated with this payment method. For example, the factory can interpret it very literally. If some instructions or details (even obvious ones!) are missed by the buyer in the contract, a factory will still be paid even if the products are off. It is still as necessary as ever to stay vigilant with the factory in order to ensure that the Letter of Credit accomplishes its intended result.
Practical application of the Letter of Credit
It is not realistic that all of your suppliers will be willing to work under a L/C, especially on initial orders of custom goods and small orders. Initial production runs of new designs tend to have more problems than steady on-going orders. It’s seems like it is often hard for the good factories in China to hit a lead time, and impossible for the sloppy ones. If a L/C is in place and a deadline missed, the buyer has the right to cancel the order. Suppliers know this and try to avoid being pinned down by an L/C. If your order is small, the suppliers may not be willing to jump through all the hoops associated with setting up an L/C. But if your orders are large, steady and made up of “off the shelf” products, then you should certainly be exploring the use of a L/C as you buy from China.
This article was co-penned with Mike Bellamy of the China Sourcing Information Center. Check out the China Sourcing Information Center and their interview about the Letter of Credit from earlier this year.