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

I have over a decade of experience in international trade. I currently live in China and India where I own a successful business.

A Case For Using Documentary LC Payment In China

A letter of credit is a time-tested financial instrument that protects the interests of the parties engaged in international trade. One of the biggest fears that any Western company has is 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 the deposit and their 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 the 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 third-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 lossProtection 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

Risk Associated With a Payment Method

Payment methods and risk

Payment methods and risk

Evaluating Payment Methods

Method of PaymentProsCons

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, an 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.

What Is Your Preferred Way of Payment?

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 will often 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, 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 a 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 suppliers or those looking forward to a one-off transaction would not agree, whereas a large and 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 you find small company who is willing to work, but have questions about them, 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 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.

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

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

Negotiation of a Sales Contract Is a 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

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 a payment made by the LC issuing bank does not rely on the 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, sends 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

History and Early Use of the Documentary Letter of Credit

Nobody knows for sure when the first letter of credit was used. The University Museum of Philadelphia displays an ancient Babylonian exhibit dating from 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 the 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 is evidence of rudimentary credit instruments for use in Egypt in 250 BC.

Marco Polo had also reported the 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, which popularized 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 are known as UPC (Uniform Customs and Practice for Documentary Credits). Banks in China and elsewhere rely on modern UPC 600 norms for a 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.

An Early Example of Letter of Credit

how-to-pay-chinese-supplier-letter-of-credit-lc-payment-china-as-protection-against-bad-chinese-supplier

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

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2014 Kamal Mohta

Thank you for reading it, please leave your comments.

Haider from Melbourne on May 17, 2017:

It would be good to give more information about LC. I really like the idea. I got the basics but there are things unclear to me.

Mitchell on January 10, 2015:

That's an inventive answer to an initeestrng question

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