Parliamentary panel is right in calling out RBI’s wrong; it was idiotic to kill LoUs for one Nirav Modi

A Parliamentary panel’s suggestion to restore one of the popular trade credit instruments – Letter of Undertaking/ Comfort (LoU/LoC), will bring cheers to a number of companies engaged in cross-border trade, particularly small and medium enterprises (SMEs). These instruments, used widely till a while back to avail trade credit from foreign branches of Indian banks, were banned by the Reserve Bank of India (RBI) in the aftermath of the Rs 13,000 cr Punjab National Bank scam orchestrated by Nirav Modi and his uncle Mehul Choksi. A blanket ban was wrong in the first place. It almost appeared like the RBI was in a hurry to cover up its failure to regulate the instrument effectively, leaving room for fraudsters to turn the instrument into a tool to perpetrate fraud.

By banning this outright, RBI committed another major mistake; it denied small companies access to cheaper, easier credit abroad.

When the RBI banned “the practice of issuance of LoUs/ LoCs for Trade Credits for imports into India by AD Category–I banks with immediate effect," it had said that Letters of Credit and Bank Guarantees for trade credits for imports into India may continue to be issued subject to compliance with the provisions. [caption id=“attachment_4495283” align=“alignleft” width=“380”]  File photo of RBI. Reuters.[/caption] The problem here is that the alternative instruments suggested by the RBI in the place of the LoUs carried bigger costs for the importer and processes were more complicated. LoUs have been a simplified form of other instruments, easier to use to get buyers credit for importers and hence widely used. LoCs and bank guarantees too can do this job, but not in the same way. Importers have already raised an alarm about the central bank’s decision saying that this will impact them and even exporters who use the imported material to make goods for exports. Not just bankers, but rating agencies, too, had sounded caution on the LoU ban. India ratings and research, the Indian unit of global rating agency, Fitch, had said that banning LoUs will reduce the financial flexibility of importers, lead to liquidity pressure and result in higher funding costs for small companies. But none of these warnings made the central bank correct its mistake. Now a Parliament panel has repeated the argument in favour of LoUs. The point here is that Indian traders aren’t responsible for a Nirav Modi’s fault. Already, Indian traders aren’t having a good time fighting global restrictions (protectionist policies in developed markets/ trade wars), problems in the domestic market (demand, labour), currency imbalances across markets. The banning of LoUs also hit exporters hard since they use these instruments heavily to buy raw materials that are used to make export materials. The Parliamentary panel’s proposal should act as an eye-opener for the RBI to correct a major mistake urgently.