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‘LoU ban to hit importers as costs rise’
What happened?
The Reserve Bank of India’s directive barring banks from issuing Letters of Undertaking (LoUs) has brought the $85 billion buyers’ credit market — a key source of low-cost trade finance for the country’s importers — to an abrupt standstill.
What is a LoU?
Letter of Undertaking is a bank guarantee and is issued for overseas import payments. A bank, while issuing LoUs for a client (like Nirav Modi), agrees to repay the principal and interest on the client’s loan unconditionally
- When a LoU is issued it involves an issuing bank, a receiving bank, an importer and a beneficiary entity overseas
Hurt importers and exporters
Many exporters used the LoUs to help fund their imports of raw materials and the central bank’s decision would hurt their competitiveness
Cost of Credit will go up
- The traders who have been conducting business through these instruments will now have to necessarily shift their transactions to Letters of Credit and Bank Guarantees
- The result would be that cost of credit may go up, especially for the SMEs
Worst affected sectors
Gems and jewellery sector was likely to be the worst affected by the LoU ban.
LIBOR-based pricing
- LoUs were the cheapest source of funding as the credit provided against them were typically priced 20-30 basis points above the three-month or six-month LIBOR.
- Since the LoU route is no longer available, importers have to provide bank guarantees or letters of credit, which are more expensive.
