By Vishwanath Nair
The Reserve Bank of India today decided to discontinue issuance of letters of undertaking (LoU) and letters of comfort (LoC) for trade credit for imports into India.
Authorised dealer-1 (AD-1) category banks will not be allowed to issue LoCs and LoUs for this line of business, the regulator said in a notification on its website. Most universal banks, domestic and foreign, come under this category, according to two bankers in the know.
Banks may continue to issue letters of credit and bank guarantees for trade credit for imports into India as per the current guidelines applicable, the notification added.
This is part of a series of moves from the RBI after details of the Nirav Modi scam came to light. In the case, Nirav Modi’s associates approached the domestic branch of Punjab National Bank to issue fraudulent LoUs to foreign branches of other Indian banks through the SWIFT network. These LoUs were not registered in the core banking system for PNB. This means that the bank was virtually unaware of any such transactions taking place.
According to the two bankers quoted above, LoUs and LoCs were largely issued by domestic branches of Indian banks for customers to avail trade credit from foreign branches of other Indian banks. Globally though, letters of credit and bank guarantees are the followed norm.
The difference between these products is that LoUs and LoCs were issued by domestic banks at the behest of the importer. The importer would negotiate the right price for these loans from the foreign branches of other Indian banks and then get these letters issued by a domestic bank. The exporter, or seller, would be paid from the nostro account.
In the case of letters of credit and bank guarantees, domestic banks issue these in favour of the exporter, or seller’s, bank. Typically in these transactions, the seller would take the foreign exchange cost and would build that into the price of the product.
The move to discontinue LoUs and LoCs will have some impact on smaller importers, Chief Executive Officer of Indian Banks Association, VG Kannan told BloombergQuint. Here are more highlights from the interview.
- Buyers were able to enjoy credit for a year using the LoU facility
- RBI now wants companies to go directly through letters of credit for a period up to 1 year
- There won’t be any change in requirement of funding limits
- If suppliers refuse to give credit for one year, domestic buyer will have to arrange for rupee funds or foreign currency funds
- RBI notification will in effect lead to more funded facilities being made available to domestic companies
- Domestic buyers may have to make arrangements for funds to make good payments on due date
- Companies having regular exports can use exports to make payments
- LoU was a good product; suited both buyers and bankers, suppliers were also getting money on due date
- Discontinuing LoUs, LoCs not the ideal solution; bank guarantees can also be misused
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