Used as a medium of exchange for goods and services, currency is the basis of the trade.
It is expected that each country has its own currency.
As an example the United States Dollar is the official currency of the United States, the Japanese Yen is the official currency of Japan, the Renminbi is the official currency of the People’s Republic of China, the United Arab Emirates Dirham is the official currency of the United Arab Emirates.
EURO is an exception to national currencies, which is the currency of European Union member states.
Please keep in mind that some EU states still using their domestic currencies instead of EURO.
These countries are: Bulgaria, Croatia, Czech Republic, Denmark, Hungary, Lithuania, Poland, Romania, Sweden, United Kingdom.
Today I would like to write about the currencies used in letters of credit transactions.
It turns out that it is both easy and hard to write about today’s post.
It is an easy to write post, because on the operational side the rules are very straightforward: You can use any currency in a letter of credit transaction as long as you are agreed on with your seller or buyer.
On the financial side, however, we should expect nothing less than a financial war between the nations, as each nation would like to use its own currency as much as possible to maximize its own benefits.
Operational Side : Choosing the Currency of the Letter of Credit
Letter of credit rules are silent in regards to which currency should be used in a specific documentary credit transaction.
As a result the buyer and seller can freely decide on which currency will be used in a specific l/c payment.
There are some points that should be take into account on operational side. Let me write down couple of them below:
- Currency stated in the credit should be the one which is agreed by both parties on the sales contract.
- Documents such as commercial invoice, insurance policy etc., must be issued in the same currency as that shown in the credit.
- Especially when you issue the draft or bill of exchange, you should write the amount both in words and figures. On these occasions the amount in words is to accurately reflect the amount in figures when both are shown, and indicate the currency as stated in the credit.
- Currencies in letters of credit should be shown in ISO 4217 format. ISO 4217 is the International Standard for currency codes. The most recent edition is ISO 4217:2008. The purpose of ISO 4217:2008 is to establish internationally recognized codes for the representation of currencies.
Financial Side : Dealing With the Currency Risk
In international trade one country’s currency is another country’s foreign currency. As a result at last one party in an international trade transaction has to work with a foreign currency.
In fact, in some cases both parties may have to be using a foreign currency.
Let me try to explain you what I mean with an example.
USD is the leading global trade finance currency for decades. Just in year 2012 USD is used as a currency more than 80% of all documentary credit transactions.
If an exporter from China selling machines to Saudi Arabia with a letter of credit issued in USD, then both parties have to bear currency exposure risk.
What Can Be Done to Prevent or Limit Foreign Exchange Risks?
- Try to determine the volatility of foreign exchange rates. Are there any political or financial risks on the horizon?
- Follow major central bank decisions. FED (The Federal Reserve), ECB (European Central Bank), BOJ (Bank of Japan) and BoE (Bank of England) decisions may fluctuate Forex markets widely.
- Be aware of not-fully convertible foreign currencies. Indian rupee and the Renminbi are not-fully convertible at the moment. You may have to pay extra charges when exchanging not-fully convertible currencies to your local currency.
- If your company is both exporting and importing at the same time you better try to make both transaction with the same currency. By doing so the matching of inflows and outflows will significantly reduce foreign exchange exposures of your company.
- Forward contracts, futures contracts and options are the most common techniques that used in international trade to prevent foreign exchange risks. Try to learn them.