Documentary credit in international banking and trade sustainability

Shah Md Ahsan Habib | Friday, 19 August 2016

In the context of Bangladesh, trade is the key component of international business activities, and trade facilitation is directly connected with the country's global integration. As part of trade facilitation, banks facilitate payment, finance and risk management services to the traders and thus contribute in integration of trade globally.
Changes in global trade were accompanied by parallel developments in trade finance and other trade service activities. Even though there are slowing pattern of trade growth in global economy, is it encouraging that trade finance activity indicates a clear rise in demand for trade finance instruments to cover potential default risk under cross-border commercial contracts. Increasing demand for trade risk coverage products means increased business and free income for trade finance banks, but the underlying key message is that there is an increased perception of commercial, banking, and country risks in global trade markets.
Some commonly used trade services techniques in international trade include cash in advance, open account, documentary collection, documentary credit (LC), standby LC or bank guarantees, bank payment obligation, supply chain financing, factoring, forfeiting etc. Involvement of banks varies in these trade-facilitation or trader service techniques. Open account, i.e., payment following receipt of goods, is the most widely used trade payment technique in globe where involvement of bank is insignificant. Involvement of banks is significantly higher in the trade service mechanisms like LC, bank guarantee, standby LC and documentary collection. Especially, in documentary credit or LC, bank's involvement is significant and through LCs banks offer payment, financing and risk management services to their clients. It is a classic form of international trade services method that substantially reduces risks for both exporter and importer.
In connection with the use of trade service products in global context as a whole, use of documentary credit increased in recent times both in case of exports and imports, as observed in the most recent ICC survey.  LC is particularly popular in Asia-Pacific region. It has been observed that the popularity of LC increases with the increase in uncertainty in Global economy. Over the years, we have been arguing that the use of intermediaries like banks by traders would go down with improved global integration, interconnectivity, interpersonal relationship and free information flows, and thus the use of LC. Moreover, there are opinions that given the progress made in electronic trade payment platforms, expansion of factoring, short term export credit insurance and other supply chain products, popularity of LC may go down sharply. However, as has been proven countless times, the demise of the commercial letter of credit is not imminent by any means, proven repeatedly over a period of several decades, and also observed in the most recent ICC survey.
The most recent BIBM trade review clearly indicates the extensive use of documentary credit in import transactions in Bangladesh, not different from the previous years. In 2015, LC was used for around 90 per cent of total imports in the country. For exports, the use of LC was also at the top with around 60 per cent. Widespread use of LC in the country can be explained by the regulatory restrictions (explicit and implicit) that are imposed in the country's trade and trade facilitation policies and rules. Even though, the Government of Bangladesh has relaxed restrictions on the use of LC in importation, LC remained almost at the same level in terms of use. Such an extensive use of LC may not match with the practice of global economy or with that of our trading partners. Of the different types of LC, back-to-back LC is particularly a popular financing technique that has helped bringing glory in international trade and trade facilitation in the country. Due to the extensive use of LC, in many instances, the word 'LC' is substituted for the term 'trade payment' to many in the country. The method is preferred by banks because of their deep involvement with the process, and relatively greater scope to earn 'fee income' at different stages. Due to the popularity of the method, expertise on UCPDC-- the set of guidelines for LC operation is particularly relevant amongst the trade service providers i.e., bankers. It is really good to observe that the banking industry of the country has successfully developed a pull of experts to facilitate traders through LC operations in recent years.   
Each and every trade service technique has its limitations, and so is also the case with LC. Though it is probably the best one in terms of handling commercial risks, it is an expensive payment method for traders. Making payment based on documents alone may cause malpractices, as observed in several instances. Many traders are not in favour of using LC mainly because of the involvement of high cost.  Probably, it indicates greater inclination of the traders on minimisation of cost, rather than minimisation of risks.  
Current global scenario on the issue presents some positive aspects in favour of the use of LC. In spite of all optimism, ongoing global trends of divisibility, disconnection and mistrust among different parties and countries cannot be overlooked by the stakeholders of the international trade transactions. In addition, regulators and policy makers are much more comfortable with LC than open account to handle the growing concerns with trade-based money laundering. Sometimes, this 'steadiness' in trade service may be termed as 'conservatism'. Rather, this is the desired stability, and probably a country like Bangladesh does not afford much dynamism in this respect. Perhaps we are on the right track, and greater use of documentary credit or LC may prove to be beneficial for Bangladesh's international banking and trade transactions in the long run.
Dr. Shah Md Ahsan Habib is Professor and Director (Training), Bangladesh Institute of Bank Management (BIBM).
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