When I first heard this question, I really thought it was a trick question. Kind of like, “Who is buried in Grants tomb?” Isn’t the answer obvious? Of the four main payment options, the letter of credit (LC) is definitely the winner when it comes to high cost.

In today’s revenue driven environment, companies are looking for ways to improve profitability by driving down costs whenever possible. Everyone in the business world today feels the pressure to reduce or eliminate all unnecessary expenses. Letter of credit fees are a likely target, especially if you are using LCs on imports from long-time customers with whom you have established an excellent working relationship.

However, sometimes things aren’t what they seem to be at first glance. If you are importing merchandise from the Far East on a letter of credit basis, you can rest assured that the vendor is using that letter of credit to obtain favorable financing from their bank. This is an extremely common practice in Asia.

So before making any changes to your current importing process, let’s take a look at what’s going on behind the scenes.

A vendor may need pre-export financing in order to purchase the raw materials to manufacture the goods that you want to buy. When they approach their bank for financing, the bank works up a credit assessment. They determine how likely it is that the vendor will repay the loan, and then they set the rate for the loan accordingly. This rate is one of those costs that is a big component when the vendor determines its pricing.

However, if the vendor can provide a letter of credit as collateral, the rate of financing will be very different. If the letter of credit issued in their favor is from a well-known, highly rated bank, the vendor’s bank knows that their risk in providing pre-export financing has just dropped dramatically. That will result in a lower interest rate. The vendor can pass this cost saving on to its customers through lower pricing.

By eliminating the LC, you may find that you save on banking charges, but you incur higher unit prices from your vendor.

Proceed with caution if you are contemplating the possibility of removing the LC from the transaction. You will need to do some groundwork first.

Contact your bank, and tell them what you are planning to do. Have a long conversation with your vendor to find out just how this is going to affect their pricing. They will obviously need to work with their bank to determine new interest rates and new pricing.

Once you have all the information, you can do the cost/saving comparison. As surprising as it may seem, using an LC probably will be cheaper.

Banks in Asia are very adept at accepting letters of credit as collateral on pre-export financing loans. However, I can’t say the same for banks in the U.S.

If an exporter located in the U.S. approaches their bank for a loan and offers a letter of credit as collateral, I wouldn’t be surprised to hear that the bank rejected the LC as collateral. It’s just not a common banking practice in the U.S., and most domestic bankers don’t feel comfortable using them as collateral.