What does one do when you get a muddy flow from a tap instead of clear water? The knee-jerk reaction would be to shut it and the other more workable option is to fit a high-grade filter to ferret out impurities.
The Reserve Bank of India’s (RBI’s) move to ban the issuance of letters of undertaking (LoUs) for availing of buyers credit is being seen as closing the tap.
But it is nothing but a filter.
In all fairness, there is indeed a drying up of dollars as importers who have been funneling money into their operations through this route have been hit hard.
An LoU guaranteed cheap money and in many genuine small enterprises, it provided an easy means to conduct business. Now, the option to roll over existing LoUs or letters of comfort (LoCs) is no longer available. Hence the demand for dollars has shot up.
The immediate impact has already manifested on the rupee but even that seems to be fading as the exchange rate recouped its losses by the fag end of the day.
Who will be the biggest losers?
For some, especially the gems and jewellery sector, the pain would be prolonged because LoUs were the main source of funding. Small and medium enterprises would be hurt more as banks are otherwise reluctant to increase their funding limits to these companies or lend at lower rates.
Textiles and automobile component makers come in this category. Industry bodies and lobbyists are already estimating two quarters of pain for these segments.
But for most others, business would be back to usual through letters of credit and bank guarantees. These are still allowed as bona fide methods of availing credit.
Moreover, estimates of how much trade finance is garnered through the now besmirched method of LoUs range from 5-10%.
The Federation of Indian Export Organisations, the apex body of the country’s export promotion organizations, estimates about 4% of financing would be hinging on LoUs. Therefore, at the aggregate level, the impact on imports would be minimal.
Given that the bulk of these contingent liabilities are within the public sector bank network, these lenders would be hit as well since foreign operations would thin out and fee income would be dented.
On a final note, the LoU route to garner foreign exchange loans was very unique to Indian borrowers as the lenders involved were Indian banks. RBI’s move to do away with this modus operandi should be seen as a step towards aligning with globally accepted standards.