LoU/ LoC should be restored with proper safeguards: Standing Committee Report

Department Related Parliamentary Standing Committee on Commerce Chaired by Shri Naresh Gujral, presented it report on 06 August 2018 on “Impact of Banking Misappropriation on Trade and Industry

The report extensively covers  RBI Ban on LOU / LOC and its impact on the Industry and committee’s recommendations. In summary,  Committee  has recommends that LoU/ LoC should be restored at the earliest albeit with proper safeguards.”

Relevant extract from the report are given below.

DISCONTINUATION OF LETTERS OF UNDERTAKING / LETTERS OF COMFORT

2.1 The banks assign both fund based and non fund based credit limits for the purpose of trade finance. The traditional and the most commonly used methods of non-fund based trade finance is a Bank Guarantee or a Letter of Credit. The importers have also been availing Buyers Credit against Letters of Undertaking (LoUs) issued by their banker. Inasmuch as fund based trade finance is concerned, credit instruments like working capital loan/Rupee Export Credit Loans have been in vogue. Another way of financing the trade is through assignment of receivables i.e. factoring, which is in infancy in the country.

2.2 The RBI being mindful of the need to simplify the procedures related to trade finance to bolster trade and to liberalise the foreign exchange regime has progressively delegated more powers to Authorised Dealers (banks) for undertaking foreign exchange related transactions. Accordingly, one of the measures adopted on November 1, 2004 in order to promote investment activity and to further liberalise the procedures related to trade credit for imports, was to grant general permission to Authorised dealers to issue Guarantees/Letter of Undertaking (LoU)/ Letter of Comfort (LoC) in favour of overseas suppliers, banks and financial institutions up to an amount of USD 20 million per transaction.

2.3 The RBI has, however, discontinued the practice of issuance of Letters of Undertaking (LoUs)/ Letters of Comfort (LoCs) for Trade Credits for imports vide Para 2 of RBI Circular No 20 dated March 13, 2018. Para 2 reads as under:

On a review of the extant guidelines, it has been decided to discontinue the practice of issuance of Letters of Undertaking (LoUs) and Letters of Comfort (LoCs) for Trade Credits for imports into India by AD Category –I banks with immediate effect. Letters of Credit and Bank Guarantees for Trade Credits for imports into India may continue to be issued subject to compliance with the provisions contained in Department of Banking Regulation Master Circular No. DBR. No. Dir. BC.11/13.03.00/2015-16 dated July 1, 2015 on “Guarantees and Co-acceptances”, as amended from time to time.

2.4 The Committee was informed that the Buyer’s Credit has been disrupted on account of the RBI Circular dated 13 th march, 2018. Buyer’s credit is a short term credit available to an importer (buyer) from overseas lenders such as banks and other such financial institution enabling the importers to make good of the payments in due dates against goods they have imported. Buyer’s credit helps local importers gain access to cheaper foreign funds that may be closer to LIBOR rates as against local sources of funding which are more costly due to higher rates of interest and suffers with  uncertainty in terms of availability. Buyer’s credit has several advantages for the importer. On the one hand the overseas exporter gets payment on due dates, on the other hand, the importer gets extended date for making an import payment as per the cash flows. The importer can negotiate a better discount and use the buyer’s credit route to avail financing.

2.5 As per a study of India Ratings published in Hindu Business Line (Apr 23, 2018), the total outstanding buyer’s credit of the top 160 importers as of 31st March 2017 was over INR 330 billion of which INR 312 billion of credit was availed by large importers and remaining (INR 19 billion) by SME importers. It also stated that unlike large corporate, the level of dependence on buyer’s credit in total debt of SMEs is very high.

2.6 The Committee was informed that there is a decline in export credit to the tune of 24.4% ending fiscal 17-18 and as a percentage of priority sector lending (PSL) it was only 1.74%. The Year-On-Year decline in export credit was 29.6% in 2018. The Committee felt that such a sharp decline in exports credit along with discontinuance of the issuance of LoU/LoC might not augur well for the future and will impact exports adversely. It is a matter of deep concern and deserves immediate attention in order to avert likely disruption to trade and industry.

2.7 In response to the Committee’s concern over the likely disruption to trade and industry on account of discontinuation of issuance of LoUs/LoCs, the Department of Financial Services has stated that discontinuation of issuance of Letters of Undertaking (LoUs)/ Letters of Comfort (LoCs) does not mean discontinuation of trade credit as a means of Trade Finance. Trade Credits, including Buyer’s credit can be availed of as a form of clean credit, apart from availing Bank Guarantee for Trade Credit, subject to extant trade credit guidelines and RBI circulars. It has been further stated that as before, Letters of Credit (LC) and Bank Guarantee continue as forms of Trade Finance. Existing LoUs/LoCs (Letters of Understanding / Letters of Comfort), issued prior to the RBI Circular dated 13.03.2018, discontinuing LoUs/LoCs, may also continue till their original validity, although no roll-over is permitted.

2.8 The Committee held interactions with FIEO, Chambers of Commerce, Export Promotion Councils, Industry Associations, etc. to understand the disruption, if any, caused to the trade and industry in the context of the ban imposed by the RBI on issuance of LoUs/LoCs.

*** For Industry view recommendation, please refer attached report

Committee Views and Recommendations

2.31 In view of the above submissions, it is amply clear that after the discontinuation of issuance of LoUs/LoCs, there has been a decline in trade finance as well as rise in the cost of credit. It is feared that such a development will hobble the performance of our trade and industry. The Committee notes that though the exports figure as of now does not show a downward slide as a result of the ban on LoUs/LoCs yet it is not too far in time when the effect of the ban on LoUs/LoCs will reflect in terms of decline in exports. The  Committee, however, has been informed that there has been a slight dip in diamond trade.

2.32 The Committee finds that the immediate casualty on account of the ban on LoUs/LoCs has been the ability of importers to secure a low interest short term credit in foreign currency. The curb on LoUs severely impacts their liquidity and raises the funding costs. The Department of Commerce has shared an analysis carried out by FIEO which shows that the cost of credit for industry has increased:

2.33 Even the banks during interaction with the Committee have unanimously agreed that the impact of discontinuation of LoU/LoC on the cost of credit is to the extent of 2 to 2 1⁄2 per cent which is substantial in absolute terms and is much costlier than the LC products or the funded limits made available by the Indian banks as a substitute to the LoUs and LoCs.

2.34 Besides the considerable increase in the cost of funds for domestic exporters/importers, the Committee notes with concern that as for the LoUs already issued, a “risk premium” has already been set in for any Indian paper. The Committee was informed that foreign lenders have reduced credit exposures for short term dollar loans to local counterparts. Accordingly, foreign lenders have become reluctant to accept the guarantees from their local counterparts. Banks such as, Citigroup Inc., Deutsche Bank AG, Standard Chartered Plc and HSBC Holdings Plc are declining / reducing exposure to these transactions, used by smaller companies to access short-term dollar funding. It was informed that the premium on Indian paper has shot up by 10-50 bps. LoU-based short-term loans are coming in at a premium of 10-30 basis points, and in some cases it has gone up to even 50 bps. Similarly in case of Supplier’s credit, there is a marginal hike in the interest loaded by the Supplier. But since the LoUs were issued against all types of imports such as Import Bills under Collection, Direct Imports done by the Importer apart from the FLC bills, its prohibition has led to decrease of finance for such imports. It has also put the competitiveness of the local businesses vis-à-vis traders from other countries under strain. Further in the aftermath of the fraud, the overseas financial lenders are keenly monitoring the aspects such as Regulatory Compliances, KYC details and detailed verification of underlying transactions.

2.35 The embargo on issuance of LoUs has caused imports bills getting pending for payments and clearance of import consignments have got stalled. It has been submitted that companies have already started considering cutting down on their raw material sourcing due to increased costs and this will have an impact on their overall turnover.

2.36 Moreover, after the discontinuation of LoU/LoC, the importers will have to convert their rupee loans into foreign currency to make payments to their foreign suppliers. This will cause a spurt on the spot demand of the dollar in currency market. There is all likelihood that the spurt will lead to high conversion cost causing hardship to the importers. On the other hand, the Banks have the ability to raise foreign currency from overseas at a very reasonable rate due to their credit worthiness and capital adequacy. The banks could pass on the benefit of low interest rate raised by them through LoUs/LoCs. Now, the importers are left to fend themselves. The Committee expresses its deep concern on the present situation when the rupee is weak, the rise in spot demand will prove to be onerous on importers. It recommends that RBI may take measures to enter into bilateral currency swap agreements with major trade partners to meet spot demand and buy back exporters’ receivables. This will enable the smooth currency movement in the market and further it will not impact the forex reserves.

2.37 The Committee enquired about the accessibility of other trade finance instruments and it was informed that getting letters of credit (LC) is a time-consuming process as various rules need to be complied by the beneficiary and verified by the bank. A lot of documentation is required which results in consumption of huge resources of the applicant. These instruments involve a commission fee along with a so called acceptance charge which is not the case with LoUs as they only involve a guarantee fee. The Committee recommends that necessary interventions may be made to streamline and simplify the procedure in processing of LCs. The Committee also desires that maximum concessions may be offered on LC charges especially to MSMEs.

2.38 The Committee further notes that no banks except State Bank of India (SBI) have come up with an alternate instrument which could be as cost effective and accessible to the importers as LoUs/LoCs. The Committee welcomes that State Bank of India has developed a new reimbursement product with systemic and compensatory controls which is being extended presently to the AAA and AA rated large corporate customers and will gradually over a period of 6 months be extended to the SME borrowers as well. The Committee recommends that SBI must ensure that SME borrowers are not left out for want of desired credit ratings and hopes that other banks shall also come up products which can provide convenience similar to LoUs/LoCs.

2.39 The Committee enquired about the reasons/basis for the RBI to discontinue issuance of LoU/LoC and the likely impact of such a measure on the trade and industry of the country. The RBI has informed that subsequent to their interaction on 5 th March, 2018 with the Foreign Exchange Dealers Association of India (FEDAI) it was advised to the RBI that there was neither a standard format for LoUs/LoCs nor a standard protocol like the one prescribed by the ICC in respect of LCs/Documentary Credit (viz., Uniform Customs and Practices for Documentary Credits). In the interest of the stability of the banking system and to strengthen the existing mechanisms, it was decided to discontinue issuance of LoUs/LoCs for trade credit with effect from March 13, 2018. The RBI has stated that since LCs and Bank Guarantees, which are standardized and internationally used instrument of trade credit, are readily available to the trading community through the banking system and are also subject to well-recognised norms of the ICC, it is expected that the needs of the industry would be catered to adequately.

2.40 The RBI has further stated that due to the sizable fraud recently reported by the Punjab National Bank, related to misuse of LoUs, the Department of Financial Services, Ministry of Finance requested on March 6, 2018 the RBI to consider the need to continue LoUs, especially since an option like Letter of Credit (LC), governed by a set of rules issued by International Chamber of Commerce (ICC), Paris was already available for supporting international trade.

2.41 The Committee is not convinced with the justification proffered by the RBI for discontinuing issuance of LoUs/loCs. The Committee notes that the RBI has stated that it was advised by FEDAI to discontinue LoUs/LoCs as there was neither a standard format for LoUs/LoCs nor a standard protocol like the one prescribed by the ICC in respect of LCs/Documentary Credit (viz., Uniform Customs and Practices for Documentary Credits).

2.42 During its interaction with the representatives of both public and private sector banks, many of whom being FEDAI members, the Committee was told that LoUs/ LoCs has been an effective instrument for raising short term credit in foreign currency. All the banks, including FEDAI PSB members, have unanimously accepted that the LoUs/ LoCs were not flawed instruments. Instead, these were means of raising cheaper finance for trade. They informed that LoUs and LoCs which were made available were within the sanctioned LC limits of the various borrowers. These were unique to India though the same is not approved under the UCPDC. The fraud was localized to only one bank, one branch and was committed and perpetuated by one family. It is significant that the other bankers have not suffered any loss under the LOUs and LOCs issued by them. The Committee notes that in line with the RBI instructions most of the banks have reduced their exposures under the LOUs and LOCs by more than 75 per cent.

2.43 The Committee strongly feels that the RBI has perhaps not held enough consultations before deciding to discontinue issuance of LoU/ LoC. The Committee notes that the RBI has in a response to the comments sought by the Department of Financial Services about the impact of discontinuation of LoUs/ LoCs on credit cost for short term foreign currency loan has stated that there is no comparative reporting to RBI of quantum or cost of trade finance through LoUs/ LoCs vis-à-vis other available avenues of raising short-term foreign currency finance. If this be the case, then the Committee is constrained to say that the RBI should have done more scrutiny before proceeding with the decision to ban LoUs/ LoCs. The Committee is of the view that the discontinuation of issuance of LoUs/ LoCs is a knee-jerk reaction by the RBI to the recent frauds. It is a typical case of throwing baby along with the bath water and it must be stopped. The Committee, therefore, recommends that LoU/ LoC should be restored at the earliest albeit with proper safeguards.

Conclusion

5.3 The Committee notes that RBI has responded to the banking misappropriation committed through fraud related to LoU at one branch of the Punjab National Bank by discontinuing the practice of issuance of Letters of Undertaking (LoUs) and Letters of Comfort (LoCs) for Trade Credits for imports into India. The Committee is of the considered opinion that discontinuation of the practice of issuance of LoU/LoC for trade credit by the RBI was a knee-jerk reaction. The Committee feels that the RBI got unnerved with the PNB fraud and it hastened the decision to ban LoU/LoC without much thought and consideration. It is significant to note that none of the stakeholders representing trade and industry including banks with whom the Committee held deliberations have suggested that LOU/LoC was a flawed trade document. Everyone has been unanimous that LoU/LoC was a widely accepted bank instrument globally. Its efficacy as a source of cost-effective short term credit of foreign currency for importers was unmatched. Its preference by the foreign supplier in comparison to LC is also well-recorded. Moreover, RBI has itself promoted it after thorough verification more than a decade ago. The Committee notes that there is also a unanimity that the ban of LoU/LoC has resulted in rise in the cost of credit by 2 to 2 1/2 %. This will certainly affect the cost competitiveness of country’s trade and industry and have a cascading effect on jobs. The loss of jobs is something the country can ill-afford.

5.4 The Committee strongly feels that the RBI should have engaged more in consultations with stakeholders on the matter before resorting to discontinuation of LoU/LoC. It is of the considered opinion that LoU/LoC should be restored at the earliest albeit with proper safeguards. Its restoration assumes more significance in the face of the fact that the content of imports is over 20% of India’s total exports. In present times when the currency is witnessing high depreciation, it is imperative that the cost of credit for imports must be minimal. The ban on LoU/LoC takes away the benefit of cheap source of funds availed by the importers. Costly imports shall lead to higher costs of production and erode the competiveness of the domestically produced goods. The loss of competitiveness takes away the gains that might have accrued to export on account of rupee depreciation.

5.5 The Committee also feels that discontinuation of LoU/LoC as a response to the fraud and misappropriation has set in a contagion of conservatism in banking sector. The banks have become very stringent in their operation and credit exposures. The caution has inadvertently made banks becoming inaccessible to MSME sector. The Committee is concerned that such an approach has the dangers of making banking services elitist and subservient to a few large corporates leaving out the vast majority of MSME units which are not able to measure to the standards and parameters laid down by external credit rating agencies for getting ‘AAA’ or ‘AA’ ratings. The MSME units are getting burdened with high cost of loan which is further accompanied with the demand of unreasonably high collateral by the banks. The Committee is constrained to state that such an approach also crowds out innovative, high risk, growth segments, which is not good for the economy in the long run. It recommends the Government to set things right and take necessary measures in all earnest for the purpose.

Reference

  1. Report: Impact of of Banking Misappropriation on Trade and Industry
  2. RBI Stops Buyers Credit Transactions (LOU & LOC)

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