Why the RBI has banned LoUs, but not the letters of credit

Bank Guarantees and LCs are considered less risky because receiving banks have to conduct their own credit appraisal on companies before accepting them.

Yesterday, Finance Minister Arun Jaitley told the Parliament that a total 1,213 fraudulent letters of undertaking (LoUs) were issued to Nirav Modi's companies between March 2011 and May 2017. That's over 16 fake LoUs a month over the course of six years, which were the modus operandi of the Rs 13,578 crore - and counting - fraud perpetuated by jewellers Nirav Modi and his uncle, Mehul Choksi.

In response, the RBI has "decided to discontinue the practice of issuance of LoUs/ LoCs [letters of comfort] for trade credits for imports into India" with immediate effect. To remind you, both these instruments were a form of credit guarantee, often used by importers to fund their overseas purchases. However, the RBI statement added that banks may continue to issue letters of credit (LCs) and bank guarantees for trade financing, subject to compliance with RBI guidelines.

So, what's the difference between all these instruments?

Bank Guarantees and LCs are considered less risky because receiving banks have to conduct their own credit appraisal on companies before accepting them. "LCs are more secure because they have details of the purchase by the importer, the date of issue, expiry date, the material purchase and other transaction details," explained an executive at a state-run lender. In the case of the now-banned LoUs and LoCs, the receiving banks were entirely dependent on the bank issuing them at the behest of the importers.

But while RBI's latest move will help plug the loopholes in the system, the change in regulations may hit import-dependent businesses. For instance, the cost of financing for companies is likely to go up. A senior banker told MoneyControl that this is because the loans taken in Indian have to be converted into foreign currency while making payments overseas, but the conversion costs would increase because they have to factor in forex risks. Previously, 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 and thus ease the high cost of imports.

The business risk for importers is also poised to go up because they will now need higher finance limits for banks but the latter, still reeling from the country's biggest banking fraud and piling up NPAs, are unlikely to be as generous as in the past.   

However, Ajay Sahai, Director General of the Federation of Indian Export Organisations (FIEO) is a lot more optimistic. According to him, LoUs were generally used by large players in gems and jewellery sector. Moreover, since LCs and bank guarantees continue to be available, he believes the RBI's latest ban will have very little impact on trade.

Only time will tell whether he is right. But it will be a pity if small and medium enterprise players - especially those in the gold business who reportedly face a 0.5-1% uptick in costs in an already low-margin business - are left paying the price for a billionaire scamster's greed.