Reserve Bank’s decision to ban LoUs is a knee-jerk reaction; can backfire badly, warn traders

Article in firstpost.com printed with permission: 

An industry-wide practice that worked well until the end of business hours on Tuesday, which allowed D Dhanasekaran’s Tiruppur-based textiles firm — Abi Tex Mills — import machinery from Oman and boost production, has now gone haywire with the Reserve Bank of India’s (RBI) decision to bar banks from issuing guarantees in the form of letters of undertaking (LoUs) and letters of comfort. “My machinery took a year to be imported and has been installed in the factory for a few months now. But now with buyer’s credit cancelled, I am focused on how to make payments instead of my production,” Dhanasekaran said.

Calling the RBI move a ‘knee jerk’ reaction, businesses said they are perplexed by the central bank’s sudden decision, which came in the wake of the nearly Rs 13,600 crore scam in state-owned Punjab National Bank (PNB), which involves jewellers Nirav Modi and Mehul Choksi, who owns Gitanjali Gems. The central bank’s move is expected to hit sectors like gems, precious metals, plastics, oil and gas, electronic goods, solar panels and metals, as they constitute the major basket of items that are imported.

Traders in gold and precious metals seemed nonchalant about the RBI’s decision. They contend that their industry is not using LoUs or letters of comfort (LoC). “It won’t impact trade at all. No one was using it besides Nirav Modi and Mehul Choski,” said Colin Shah, the vice chairman of the diamond panel at industry lobby Gems and Jewellery Export Promotion Council (GJEPC). Buyer’s credit was being availed of by only a couple of large jewellers, said K Srinivasan, Convener, GJEPC. “They can mobilise funds from elsewhere. However, expansion activities will be impacted. But again, those who are undertaking these plans with their own funds will not be affected,” Srinivas added.

The RBI’s decision to discontinue LoUs and LoCs for trade credit for imports into India will impact the jewellery trade and other businesses. But traders ask as to why their business should face the brunt of actions of some jewellers, who cocked a snook at the system. The RBI’s decision will change the course of trade finance for importers. Borrowing costs will also increase post the ban on LoCs/LoUs, as importers will have to explore alternatives that could be more expensive as compared to LoCs/LoUs, said Rachit Sharma, deputy general manager, corporate law, at Taxmann.com.

Entrepreneurs running small and midsize firms rue that the RBI is asking banks to view businessmen, seeking buyer’s credit, with a doubting eye. “Every individual looking for buyer’s credit cannot be viewed as a potential scammer. Banking is the backbone of business. What does the RBI want businesses to do to avail funds when they ban buyer’s credit overnight?” asked Brijesh Lohia, the managing director of logistics firm Global Ocean Group.

“There will be a sudden cash flow crisis and businesses who availed LOU/LOC (popularly known as buyer’s credit) against a presentation of import documents will face tremendous heat due to this sudden change.  Generally, banks provide non-fund based banking limits against collateral securities that can be used to settle import transactions. The funding can be made by issue of LOU/LOC, where import documents are placed before banks. The cost of finance is very low as it comprises of LIBOR plus one to two basis points. Due to the restriction on issue of LOU/LOC, the cost of funds will shoot up substantially at minimum bank lending rate (BLR), making it unviable to carry out trade  due to thin operating margins,” Nikunj Turakhia, President, Steel Users Federation of India (SUFI), told Firstpost.

Across India, firms prefer to use buyer’s credit instead of  letters of credit (LC) as getting the latter is a time-consuming process while the former was available in a couple of days. Also, the rate of interest paid on buyer’s credit was much lower than the existing rates, thus making it more appealing. Buyer’s credit refers to short-term credit available to an importer from an overseas lender, such as banks and other financial institution, for importing goods. The overseas bank usually lends money to the importer based on the letter of comfort, which is a bank guarantee issued by the importer’s bank. A letter of credit is a payment mode used in import-export trade to cover third-party risk. If the importer defaults, the bank that he has an account with and has issued the LC to him will pay on his behalf.

Prashant Agarwal, who runs Delhi-based Raj Polymers, said he is surprised by the short-sighed move by the RBI. “I have a buyer’s credit which is due this month. As it is, the domestic factors in the petro-chemical sector are affecting us. Couldn’t the RBI have given us a time-line of three months or more, so that we could then move to other avenues to seek business opportunities?”

The sudden decision by the RBI is causing panic in the trader community. Importers will be left with no option now, but to start applying for LCs, said Sanjay Mandavia, a Ahmedabad-based trade finance consultant. “The instrument [buyer’s credit] is blamed for taking away the focus from the systemic failure in PNB. Instead, as a solution, the industry is proposing that the RBI bring down the buyer’s credit limit from $20 million dollars per import transaction to $1 million.”