Trade Finance in India: Letters of Credit, Bank Guarantees & Export Finance

Introduction: The Bridge Between Buyers and Sellers

A textile exporter in Tirupur receives an order from a buyer in Germany worth $100,000. The buyer wants goods first; the exporter wants payment first. Neither trusts the other completely. How does this trade happen?

Enter trade finance—the banking mechanism that bridges this trust gap. Letters of credit, bank guarantees, and export finance enable global trade worth trillions of dollars. Here’s how it works.

What is Trade Finance?

Definition

Trade finance refers to financial instruments and products used by companies to facilitate international and domestic trade transactions.

Purpose

• Bridge trust gap between buyers and sellers
• Provide working capital for trade
• Mitigate payment and delivery risks
• Enable cross-border commerce

Key Players

Letter of Credit (LC)

What is an LC?

A written commitment by a bank (on behalf of buyer) to pay the seller a specified amount upon presentation of compliant documents.

How LC Works

1. Buyer and Seller agree on LC terms
       ↓
2. Buyer requests LC from bank (Issuing Bank)
       ↓
3. Issuing Bank issues LC
       ↓
4. LC sent to Seller's bank (Advising Bank)
       ↓
5. Advising Bank notifies Seller
       ↓
6. Seller ships goods
       ↓
7. Seller presents documents to bank
       ↓
8. Bank checks documents
       ↓
9. If compliant: Payment made
       ↓
10. Documents sent to Buyer for goods release

Key Documents in LC

Types of Letters of Credit

1. Sight LC

• Payment upon document presentation
• Immediate payment after verification

2. Usance/Deferred LC

• Payment after specified period (30/60/90 days)
• Credit period for buyer

3. Confirmed LC

• Second bank (confirming bank) adds guarantee
• Extra security for seller

4. Irrevocable LC

• Cannot be cancelled without all parties’ consent
• Standard in international trade

5. Revolving LC

• Reinstates after each use
• For regular shipments

6. Back-to-Back LC

• LC opened based on another LC
• Intermediary trade

7. Standby LC (SBLC)

• Payment only if buyer defaults
• Functions like guarantee

LC Example

Scenario: Indian importer buying machinery from Japan for $500,000

Terms: Irrevocable LC, 90 days usance

1. Importer approaches HDFC Bank
2. HDFC Bank issues LC for $500,000
3. LC advised through MUFG Bank (Japan)
4. Japanese exporter ships machinery
5. Exporter presents documents to MUFG
6. MUFG sends to HDFC Bank
7. HDFC Bank accepts (agrees to pay in 90 days)
8. Importer gets documents, clears goods
9. After 90 days, HDFC pays MUFG
10. HDFC debits importer's account

LC Costs

Bank Guarantee (BG)

What is a Bank Guarantee?

A promise by bank to pay a specified sum if the party on whose behalf guarantee is issued fails to fulfill obligations.

BG vs LC

Types of Bank Guarantees

1. Performance Guarantee

• Contractor will complete work
• Amount: % of contract value
• Invoked if work not completed

2. Financial Guarantee

• Payment will be made
• Covers financial obligations
• Backup for credit

3. Bid Bond/Tender Guarantee

• Bidder will honor winning bid
• Typically 1-5% of bid value
• Returned after contract signed

4. Advance Payment Guarantee

• Protects buyer’s advance payment
• If seller doesn’t deliver
• Common in projects

5. Deferred Payment Guarantee

• Covers deferred payments
• Equipment, machinery purchases

BG Example

Scenario: Construction company bidding for ₹100 crore government project

Requirement: EMD (Earnest Money Deposit) of ₹2 crore

Instead of Cash: Company submits Bank Guarantee

Bank Guarantee Details:
- Issued by: SBI
- Amount: ₹2 crore
- Beneficiary: Government Agency
- Validity: 180 days
- Purpose: Bid security

If company wins and backs out:
Government invokes BG, SBI pays ₹2 crore

BG Charges

Export Finance

Pre-Shipment Finance (Packing Credit)

Definition: Loan to exporter before goods are shipped.

Purpose:

• Purchase raw materials
• Manufacturing costs
• Packaging, labeling

Types:

Process:

1. Exporter receives export order/LC
2. Applies to bank with documents
3. Bank sanctions packing credit (up to 180 days)
4. Exporter manufactures goods
5. Ships and submits documents
6. Bank realizes export proceeds
7. Packing credit adjusted

Post-Shipment Finance

Definition: Finance after goods are shipped, before payment received.

Types:

1. Purchase/Discount of Export Bills

• Bank buys export documents
• Pays exporter immediately
• Collects from foreign buyer

2. Advance Against Export Bills

• Loan against export documents
• Export proceeds used for repayment

3. Export Bills Negotiation

• Under LC: Bank negotiates (pays against documents)
• DA (Documents against Acceptance): Usance bills

Interest Subvention Scheme

Government Subsidy on Export Credit:

• Currently 3% interest subvention
• Makes export credit cheaper
• Available for specified sectors

Effective Rate: Often below domestic rates

Import Finance

Import LC

Process:

1. Importer applies for LC
2. Bank issues LC (margin: 5-25%)
3. Foreign exporter ships
4. Documents reach bank
5. Importer:
   • Pays immediately (sight LC), or
   • Accepts for later payment (usance LC)
6. Gets documents, clears goods

Buyer’s Credit

Definition: Foreign currency loan arranged by importer through overseas bank.

Benefits:

• Lower interest rates (LIBOR/SOFR based)
• Extended credit period
• Forex rate management

Process:

1. LC opened for import
2. Supplier paid at sight
3. Importer gets buyer’s credit from overseas lender
4. Repays in installments
5. Indian bank provides guarantee

Import Bill Finance

• Bank pays foreign supplier
• Importer pays bank later
• Interest charged for credit period

Bill Discounting

Domestic Bill Discounting

What: Bank purchases trade bills (invoices) at discount before maturity.

Example:

Seller Invoice: ₹10,00,000
Payment Terms: 90 days
Seller Needs Cash Now

Bank Discounts Bill:
Amount Received: ₹9,85,000 (approx)
Discount: ₹15,000 (interest for 90 days)

After 90 days:
Buyer pays ₹10,00,000 to Bank

Types

1. Bill Purchased

• Clean bills (without documents)
• Higher risk, higher rate

2. Bill Discounted

• Documentary bills
• Lower risk (documents as security)

Invoice Discounting/Factoring

Factoring:

• Sell receivables to factor
• Factor collects from buyers
• Immediate cash for seller

Invoice Discounting:

• Loan against invoices
• Seller still collects

Trade Finance Products Comparison

Documentary Collection

What is D/P and D/A?

D/P (Documents against Payment):

• Buyer gets documents only upon payment
• Sight payment

D/A (Documents against Acceptance):

• Buyer gets documents upon accepting bill
• Pays later (usance)

D/P vs LC

Trade Finance for MSMEs

Challenges

• Limited credit history
• Lack of collateral
• Complex documentation
• Higher perceived risk

Solutions

1. TReDS (Trade Receivables Discounting System)

• Online platform for bill discounting
• Multiple financiers bid
• Better rates for MSMEs

2. CGTMSE Cover

• Collateral-free loans
• Government guarantee

3. Export Credit Guarantee Corporation (ECGC)

• Insurance against export risks
• Credit insurance

4. Factoring

• Sell receivables
• Better cash flow

TReDS Platforms

• RXIL (Receivables Exchange of India)
• M1xchange
• Invoicemart

How TReDS Works:

1. Seller uploads invoice
2. Corporate buyer accepts
3. Multiple financiers bid
4. Best bid wins (lowest discount)
5. Seller gets immediate payment
6. Buyer pays financier on due date

Trade Finance Risks

For Banks

For Traders

Key Takeaways

1. Trade finance bridges trust – Enables trade between unknown parties
2. LC guarantees payment – Bank pays if documents comply
3. Bank guarantee assures performance – Payment on default/claim
4. Export finance is subsidized – Interest subvention available
5. Multiple products for different needs – LC, BG, discounting, factoring
6. TReDS helps MSMEs – Better rates through bidding
7. Documentation is critical – Discrepancy = delayed payment

Disclaimer

This article is for educational purposes only. Trade finance products have complex terms and conditions. Consult your bank for specific requirements. Interest rates, charges, and regulations change frequently. This is not financial advice.

Frequently Asked Questions

Q: What’s the difference between LC and BG? A: LC is a payment mechanism (bank pays on document presentation). BG is a backup guarantee (bank pays if party defaults).

Q: Who bears LC charges? A: Usually importer bears opening charges; exporter bears advising/negotiation charges. Terms can be negotiated.

Q: Can LC be cancelled? A: Irrevocable LC cannot be cancelled without consent of all parties. Revocable LC (rare) can be.

Q: What is margin in LC? A: Percentage of LC value that importer deposits with bank as security. Typically 5-25% based on creditworthiness.

Q: How long does LC take to open? A: 1-3 working days for documentation and issuance, subject to credit approval.

Q: What is ECGC? A: Export Credit Guarantee Corporation—provides insurance against export risks like buyer default, political risks.

Trade finance is the invisible machinery that keeps global commerce moving. Every time you buy imported goods or see “Made in India” products abroad, trade finance has played a role. Understanding these instruments helps businesses navigate international trade confidently.