This post is the second of two Liberty Street Economics posts on trade finance.
Banks play a critical role in international trade by offering letters of credit (LCs) that substantially reduce the risk faced by exporters. As we discuss in our recent New York Fed staff report, the use of LCs by U.S. exporters has been on an upward trend in recent years. Two reasons for this may be that firms rely more heavily on LCs in financing export sales when interest rates are low and when uncertainty in global markets is high. Furthermore, the use of LCs differs across countries. Specifically, LCs largely support exports to countries with intermediate levels of risk. This is likely because the fees for exports to higher-risk countries eventually become too substantial.
Consider a trade between a U.S. exporter and a foreign importer. They have choices in how they settle the transaction. One option is for the exporter to produce the good and the importer to pay upon receipt (open account). Another is to have the importer pay first and the exporter produce the good after receiving payment (cash-in-advance). Finally, they can use a bank to facilitate the transaction with the exporter asking the importer to provide a letter of credit. The importer obtains an LC from a local bank which agrees to pay the exporter if the exporter documents that the goods have been delivered. Typically a bank in the country of the exporter confirms the LC obtained by the importer. The figure below shows in detail how a letter of credit works.
The three payment forms differ in terms of who bears the risk of the trade transaction. With an open account, the exporter is exposed to the risk that the importer doesn’t pay in the end. Under cash-in-advance, the importer accepts the risk that the exporter does not produce or delivers bad quality. A letter of credit reduces the risk of the transaction, but the fee for the letter of credit increases the cost of the transaction.
