The
scam based on misuse of the system of Letter of Undertaking (LoU) issued by
banks in India has created a setback for the lenders and regulators in the
country. The incident has affected the lending confidence and raised questions
on monitoring and compliance. It has recently resulted in ban of LoUs and Letter
of Comfort (LoCs) instruments for trade credits for imports in India by the banking
regulator. The regulator has kept the use of Letter of Credits (LCs) and Bank
Guarantees open for trade credit imports (subject to compliance with the
provisions). More clarity is expected to emerge from regulators in future on
trade facilitation through LC/BG. Much is being talked about the ban since its
announcement. While industry bodies have complained of liquidity crunch,
possible defaults, profitability impact etc., its supporters have claimed that
now the financial system would be more opaque and restriction will help in
improved discipline.
In
the above context let’s have a simple case analysis how and why LoU/LoC come
into the process:
Company
XYZ is in a business where it needs to import some raw materials (RM). It has a
cash credit facility sanctioned from its bank at rate of interest say of 9%
p.a. and also has sanctioned LoU line.
It
issues a import order to the supplier and on the date of payment, has two
options (subject to its operating cycle) : (1) Use Rupee based cash credit (CC)
facility at 9% p.a., buy foreign exchange (FC) and make payment (2) Provide LoU
from the bank to a foreign bank outside India (or foreign branches of Indian
banks) and avail foreign currency (say USD) short term loan @ 3.5% p.a. (plus
some marginal LoU commission), and use the loan (say 3 months tenor) for
payment to supplier. By the end of 3 months, make finished goods from the RM
sourced, supply it and realize revenues. Use revenues to make repayment of FC
loan. Thus, XYZ Co. got saved from using the comparatively costly Rupee based
cash credit facility for 3 months, resulting in huge saving of 5.50% interest
cost (excluding the hedging cost if not naturally hedged). The saving in cost
not only resulted in improving profit margins but also helped in remaining
competitive in the global market where competitors have access to low cost
funding. Additionally, the unused Cash credit also helped in readily available
stand by line for managing liquidity.
XYZ
Co. has been continuously working under the above mentioned two options
depending on its need and managing its business, cashflows and liquidity. Now,
say XYZ had planned its payments to suppliers under the option two above while
managing its liquidity. But on the date of making payment to supplier, its bank
refuses to allow using LoU line (due to regulatory ban or uneasy market
conditions). Its a catastrophe like situation for XYZ because its cash credit
line might be already fully used (or planned for other different payments) and has
no other freely available cash flow. This results in loss of market reputation,
affects the whole business cycle, business goes for a toss and XYZ defaults to
its lenders and creditors.
It
would not be difficult to say that in the absence of LoUs, companies like XYZ
can plan their business with the other available cash credit, short term/long
term loans, ECB loans and bank guarantees etc. other products depending on
guidelines. However, unplugging LoU suddenly has a heavy bearing on any MSME or
Mid/Large corporate and they can be devastated. Hence, it is clear that it
would have been better if six to nine months time was provided to corporates before
banning LoUs so that they could adjust to the new situation and manage their
cash flows. Not providing sufficient time may increase stressed accounts in
banking industry which is already suffering from mounting NPAs.
As
per Department of Economic Affairs (DEA), Ministry of Finance (MoF) data, the
short term external debt of the country as on September 30, 2017 was about USD
93 billion of which USD 92 billion was related to trade credits. Of this, USD
60 billion has maturity between six months to one year while USD 32 billion has
maturity within six months. With such huge size of trade credit debt, discontinuation
of significant instruments like LoUs could create mayhem in the credit and
forex market. With the unexpected ban on LoUs, corporate will have unplanned need
of buying foreign exchange for either paying to suppliers or to foreign lenders
(since not being allowed to roll over LoUs now). This is expected to create
pressure on Rupee in near term because the planned payments at a distance of
six to one year will now fall for payment immediately. Their hedging, forward
booking etc. and all other planning may go to toss and it may also create additional
cost burden. Already regulator has been pushing hard corporates in taking
action for hedging their foreign currency risk. Corporates would be discouraged
in the hedging expenditure in future when these planning fail.
Resorting
to the other options in a severely affected banking industry fighting with NPAs
and low confidence on credit side would not be easy. Further in this credit tight
scenario, sanction of any fresh loans/facilities takes time, followed by other
procedures like documentation, charge creation, pre disbursement compliances,
collateral arrangements etc. LoUs/LoCs have been one of the key businesses of
the off-shore banking units of the Indian banks in abroad. Ban on this business
would also affect profitability of these centres.
Government
has supported by many schemes improving competitiveness of Indian businesses in
the globalized trade. Increase in the cost due to ban of LoUs/LoCs would result
in demand for other subsidies and schemes from government by corporate India in
order to survive and remain competitive. Any such new scheme will have bearing
on tax payers money.
Technology
development in banking sector is in advance stages and various new concepts
like artificial intelligence and block chain are reported to be supportive in
conducting a safe and secure trade finance business. It would have been better
that when banks have learnt a painful lesson from the LoU fiasco, they could be
encouraged in adopting these new technologies in order to facilitate safer and
faster business.
(Note: Views expressed are Personal)
