RBI's LoU ban, a fallout of the PNB fraud perpetrated by Nirav Modi and Mehul Choksi, may deal a blow to trade financing and raise credit costs for importers
Mumbai: The Reserve Bank of India (RBI) on Tuesday barred banks from issuing letters of undertaking (LoUs), the instruments used by Nirav Modi and Mehul Choksi to perpetrate the over $2 billion PNB fraud, in a move that may deal a blow to trade financing in India and raise credit costs for importers.
RBI also barred lenders from issuing letters of comfort (LoC) as trade credit for importing goods into India with immediate effect. It, however, allowed banks to continue to issue letters of credit and bank guarantees.
The move is likely to lead to a freeze in trade financing activities in India, increasing costs for importers who have relied on these instruments to get cheaper overseas credit to pay suppliers. It will also put companies that have received credit based on LoUs in a spot, as they have to now repay their borrowings since there will no rollover of existing LoUs.
Importers prefer taking loans based on LoUs as they are denominated in foreign currency and are cheaper. A letter of credit, on the other hand, is used to establish the credit worthiness of the buyer in the purchase of goods.
“LoUs and LoCs don’t come under a normal credit sanction. It has been understood as giving just a letter. In the case of PNB, it looks like bank officials issued these instruments without proper credit assessment," said R. Gandhi, a former deputy governor of RBI.
Lenders will have to look at alternative instruments like bank guarantees. “Banks are now exploring alternative instruments like bank guarantees which are typically used as a guarantee to raise loans from other banks," an official with a private sector bank said, requesting anonymity.
LoUs and LoCs are used widely in several industries including gems and jewellery, oil and gas, electronic goods, solar panels and metals. Ajay Sahai, director general at lobby Federation of Indian Export Organisations, however, said, RBI’s move will have only a limited impact.
“I see only limited impact because gems and jewellery sector was the main sector availing LoUs/LoCs. That, too, was limited to major players. Other sectors have alternative instruments in the form of bank guarantees," said Sahai.
Until the PNB fraud surfaced, buyers’ credit was seen as a safe business because of its short-term nature and the risk of default was essentially on another lender. It also provided the LoU-issuing bank with a source of fee income.
Charges on such credit had already started rising as banks became more cautious following the PNB fraud. The interest of buyers’ credit is linked to London Interbank Offered Rate.