It never ceases to amaze me how the financial crisis spills into areas not before considered “risky.” And yet talk to a steel importer or some other importer and the financial crisis has created a no-man’s land for goods which have been technically purchased and shipped but not delivered. What could I be referring to? The trusty letter of credit, a financing vehicle used to pay for goods from global suppliers. The credit crisis has taken another victim – this time, the letter of credit. According to this recent Wall Street Journal article entitled: Shippers Hit By Credit Crunch, not only are shipping companies being impacted by slowing demand from the world’s economies (we reported on that story previously) but the buyers and suppliers of those goods also feel the hit.
The article describes but does not completely call out the two problems associated with the use of letters of credit today. The first and more obvious issue relates to the fact that banks are tightening credit making it more difficult for companies to use letters of credit to finance their overseas shipments. Though alternatives exist (e.g. pre-payment or cash against documents) letters of credit have become the preferred finance instrument because they offer protection to both buyer and seller. The credit crisis will also choke international trade. Not only does it harm imports but exports too rely on trade finance as well.
The second and much more disconcerting issue relates to an example from the article. Specifically a steel shipper has opened up a letter of credit (typically putting up collateral against that letter of credit); the supplier has produced the goods and shipped the goods but the bank, “tells a suppliers’ customers that it will no longer release orders based on letters of credit from a customer’s bank.” In addition, the customer’s bank refuses to pay for the goods via cash up front. The result? An awful lot of cargo sitting at the ports. Longer term, the ramifications of less global trade will be bad for everyone’s economy. Let’s hope this bailout works.