When the Corridor Matters More Than the Firm

This chapter examines how the trading corridor changes the value and feasibility of a letter of credit. The relevant context is not only whether a firm is young, small, or experienced, but whether information about the partner is available, contracts can be enforced, funding currencies are accessible, and the transaction is large enough to absorb bank costs. Readers can use this comparison to distinguish a corridor where private trust is sufficient, one where a bank’s intermediation is especially valuable, and one where risk is so severe that an LC may not restore trade.

Three corridor regimes, not one risk ladder

A letter of credit is not used in direct proportion to danger. The evidence from Vietnamese trade shows an inverse-U-shaped relationship between LC use and two characteristics of the partner country: rule of law and the Vietnamese diaspora share. Rule of law is used as a proxy for contract enforcement. Diaspora share is used as a proxy for the availability of market information, because an established community may make it easier for traders to learn about counterparties and commercial practice.

In a relatively trustworthy corridor, an importer and exporter may be able to rely on open-account trade. Repeated dealings, accessible information, and effective enforcement make the direct alternative safer. Adding a bank would still provide protection, but the incremental benefit may not justify the fee, documentation, and time. LC use can therefore be low in a safe environment without indicating that firms are being denied finance.

As information becomes scarcer and enforcement weaker, the direct alternatives become less reliable. The risk of non-payment or non-delivery rises, and a bank’s monitoring becomes more valuable. This is the intermediate region in which LC use can increase. The instrument substitutes for part of the trust and recourse that the corridor does not provide.

At the extreme, however, risk may become too high for an LC to solve at an acceptable price. An exporter may insist on cash in advance, a bank may not be able to assess the counterparty or settle the transaction, or the firms may decide not to trade. The study’s inverse-U pattern is therefore important: higher use can signal greater need for intermediation in some corridors, but lower use at the most difficult end can signal that the instrument has become too costly, unavailable, or insufficient.

The institutional variable also changes how firm characteristics matter. The CESifo model treats a firm’s ability to screen a counterparty and the partner country’s institutions as partial substitutes. When the country supplies reliable information and recourse, a firm’s private screening advantage matters less. When the country supplies little of either, the difference between a firm that knows how to investigate a supplier and one that does not becomes more consequential.

The empirical interactions follow that logic. For importers, age, size, and productivity have positive main effects on LC use in the settings where lower bank costs appear to dominate.