Letter of Credit for China Imports: How It Works and When to Use One

How a Letter of Credit Works

A letter of credit (LC) is a document issued by the buyer's bank (the issuing bank) guaranteeing that payment will be made to the seller, provided the seller presents documents that comply exactly with the terms specified in the LC.

The mechanics:

• The buyer and seller agree on LC terms in their purchase contract, including the document requirements (commercial invoice, bill of lading, packing list, certificates of origin, inspection reports, etc.), the shipment deadline, the presentation deadline, and the amount.
• The buyer applies to their bank to issue the LC. The bank evaluates the buyer's creditworthiness and, if approved, issues the LC in favor of the seller. The buyer typically provides collateral or draws on a line of credit.
• The issuing bank sends the LC to the seller's bank (the advising or confirming bank) in China, which notifies the seller that the LC is in place.
• The seller ships the goods and prepares the documents specified in the LC exactly as required -- any discrepancy, even a minor one, gives the bank grounds to reject the documents.
• The seller presents the compliant documents to their bank within the presentation period specified in the LC. The bank checks the documents against the LC terms.
• If the documents comply, the seller's bank forwards them to the issuing bank, which releases payment to the seller (or accepts a future payment obligation for a usance/deferred LC).
• The buyer receives the documents, including the bill of lading, which they use to claim the goods at the destination port.

The critical feature: the bank pays against documents, not against actual goods. If the seller presents documents that comply with the LC terms, the bank must pay -- even if the actual goods turn out to be wrong. This is why document precision is essential.

Types of Letters of Credit

Several LC variants are used in China import trade:

• Irrevocable LC: Cannot be modified or cancelled without the agreement of all parties. All commercial LCs are irrevocable by default under UCP 600 (the international rules governing LCs issued by the International Chamber of Commerce).
• Confirmed LC: The seller's bank (confirming bank) adds its own payment guarantee in addition to the issuing bank's guarantee. Used when the seller does not trust the issuing bank's creditworthiness -- more common for buyers in politically or financially unstable countries. Less relevant for US buyers using major banks.
• At-sight LC: Payment is made immediately (within a few banking days) when compliant documents are presented.
• Usance (deferred payment) LC: Payment is made at a specified number of days after document presentation (e.g., 30, 60, or 90 days). Provides the buyer with payment terms similar to net-30/60/90 while the seller still has a bank guarantee.
• Transferable LC: The seller (first beneficiary) can transfer part or all of the LC to a third party (typically their own supplier). Used when the seller is a trading company sourcing from a factory.
• Standby LC: Functions more like a bank guarantee than a payment instrument -- the seller is paid through normal channels but can draw on the standby LC if the buyer defaults. Increasingly used as an alternative to a traditional commercial LC.

The Real Cost of an LC

Letters of credit are expensive relative to T/T wire transfer. The costs include:

• Issuance fee: Charged by the issuing (buyer's) bank for opening the LC, typically 0.1% to 0.5% of the LC value per quarter, with a minimum of $200 to $500 per LC.
• Amendment fees: If the LC terms need to be changed after issuance (shipment date pushed back, document requirements adjusted), each amendment costs $50 to $150.
• Discrepancy fees: If the seller presents documents with discrepancies (which is common -- studies suggest 50% to 70% of first LC presentations have at least one discrepancy), the banks charge a discrepancy fee of $50 to $150 per set of discrepancies, and the buyer must authorize payment despite the discrepancy.
• Confirming bank fees: If the LC is confirmed by the seller's bank in China, the confirming bank charges an additional fee (0.1% to 0.5% per quarter of the LC amount).
• Advising fees: The seller's bank charges a fee for advising (notifying) the seller of the LC, typically $100 to $250.

Total cost for a $50,000 LC: roughly $400 to $1,000 or more in bank fees, plus the buyer's opportunity cost from having funds tied up as collateral. For a $5,000 order, the LC fees may exceed the cost of the goods' deposit in a T/T arrangement.

Processing time: Opening an LC typically takes 3 to 7 business days after the buyer applies. Sellers often need to see the LC before beginning production. This adds lead time to the order.

When an LC Makes Sense

A letter of credit is the right tool in specific circumstances:

• Large first order with an unverified supplier: If you are placing a $200,000 first order with a factory you have never worked with and cannot adequately verify, the LC provides protection that T/T cannot -- the supplier only gets paid when compliant shipping documents are presented.
• Supplier insists on an LC: Some larger Chinese factories, particularly those that supply major international brands, only accept LC payment for export orders. If this is the supplier you need, you will use their preferred terms.
• Usance LC for working capital: A 60 or 90-day deferred LC lets you receive and sell the goods before the payment is due, providing effective trade financing at bank rates.
• High-value commodity orders: For commodity imports where the goods are standardized (metals, chemicals, agricultural products) and the risk of substitution is real, LC document requirements can be written to enforce specific quality certifications and inspection reports.

When T/T is the better choice (which is most of the time for small and mid-size importers):

• Orders under $50,000 where LC fees represent a significant percentage of the order value.
• Established supplier relationships where you have a track record and trust.
• Suppliers who do not accept LCs or charge a premium for LC orders (common among smaller factories).
• When speed matters -- T/T deposit payments process in 1 to 3 banking days; LCs take a week or more to open and require document verification.