A cross-section of industry on Wednesday expressed concerns over the Reserve Bank of India’s (RBI) move to discontinue the usage of letters of understanding (LoUs) and letters of comfort (LoCs) instruments, which they expect will lead to an increase in borrowing costs for genuine players engaged in overseas trade. Terming the sudden move “highly detrimental” to trade, Nikunj Turakhia, president of Steel Users Federation of India (SUFI) said, “There will be sudden funds crisis and companies who avail bank credit for ‘at sight’ import documents will face the music.” Turakhia said that the move will impact companies with longer trade cycles, as they will face issues regarding funding of transactions. “The cost of funds are going to go up substantially. This seems a knee-jerk reaction to the NiMo (Nirav Modi) fraud, but it will have highly negative impact on trade and industry,” he said. Meanwhile, in light of the Modi fraud, the Indian diamond industry has stated that the usage of LoUs is not a common practice in the diamond trade. Colin Shah, vice-chairman, Gems and Jewellery Export Promotion Council (GJEPC), said, “LoUs are not used widely by diamond traders.” In fact, in a recent presentation made to media persons, GJEPC said that less than 1% of Indian diamond traders avail LoU facilities.
However, the move may impact gold traders, as market experts say that most of them procure gold using LoUs. Now, they will have to shift to instruments like letters of credit or bank guarantees, which could increase their borrowing costs by about 0.5% to 1%, thus impacting margins. On its part, Confederation of Indian Industry (CII) has said that the move will adversely impact small and medium enterprises (SMEs). CII president Shobana Kamineni said, “The RBI could have strengthened and tightened the existing regulations on LoUs and LoCs rather, or could have announced a phasing out mechanism, rather than completely discontinuing a legitimate and established product.”
In a report on the impact of the discontinuation of LoUs/LoCs, brokerage Kotak Securities noted: “Near-term margins for corporates could decline till they adjust to newer levels of profitability or is passed to consumers. These borrowers would need to use rupee source of funding raising the cost of debt.” The RBI on Tuesday disallowed banks from issuing LoUs or guarantees for trade credits for imports into India. The move comes in the aftermath of a Rs 14,000-crore LoU-linked fraud unearthed at Punjab National Bank (PNB).
However, letters of credit and bank guarantees for trade credits for imports into the country will be permitted provided they meet RBI conditions. An LoU is issued as an undertaking that the issuer will honour a lender’s obligations if the borrower fails to do so. While bank guarantees are internationally accepted instruments, LoUs are mostly issued by banks in India and used by importers to raise money from foreign branches of Indian banks.