The Reserve Bank of India (RBI) appears to have overreacted to the Nirav Modi scandal with its decision to discontinue the issue of letters of undertaking (LoUs) and letters of comfort (LoCs). In doing so, it appears to have chosen to throw the baby out with the bathwater. LoUs and LoCs offer exporters, operating on thin margins and hyper-schedules in uber-competitive global markets, a source of cheap and dynamic working capital in a banking system that is clotted with high interest rates and complex procedures. When mobilised legally — with appropriate margin money and bank guarantees logged into the bank’s formal transaction recording system — LoUs have proven to be more convenient sources of funding than the conventional letters of credit (LCs). These instruments, which are used to import goods (uncut, unpolished diamonds, for instance) could be discounted in the overseas markets for the period of the business cycle (usually 90 days) at 40-50 basis points above Libor, offering exporters finance at just 2 per cent a year. Summarily depriving exporters of this instrument can have a disruptive effect on the buyers’ credit market and several adverse consequences for the economy at large. For one, it will raise borrowing costs by between 0.5 percentage point and 1 percentage point, according to one estimate. Second, exporters will be forced to access the dollar market for funds, exerting pressure on the rupee just as oil prices are hardening.
Third, this ban comes at a time when disruptions caused by the goods and services tax (GST) are yet to be sorted out; many exporters have been waiting for months for offset dues from the Integrated GST to materialise. These multiple constraints on access to working capital and, therefore, exporters’ ability to service overseas customers could not have come at a more inopportune time, with global markets emerging from their long slumber after the financial crisis of 2008. A racehorse sector such as gems and jewellery, which accounts for roughly 16 per cent of India’s exports and employs over 5 million workers, could be a particular victim. Although only about 5 per cent of jewellers utilise the LoU/LoC route, these are usually the bigger players that account for the bulk of exports, India being the world’s largest exporter of cut and polished diamonds. On the other hand, the Rs 127-billion, seven-year fraud by Nirav Modi, his uncle Mehul Choksi and mid-level employees in a branch of state-owned Punjab National Bank (PNB) was the result of wilful collusion to misuse the instrument by waiving margin money requirements and suppressing reportage of these transactions in PNB’s core banking system (CBS). This fraud is unlikely to have reached such high proportions had the CBS system been integrated with the worldwide SWIFT, or Society for Worldwide Interbank Financial Telecommunications, system, on which Messrs Modi and Choksi’s LoU transactions were recorded. In fact, it is extraordinary that India’s second-largest state-owned bank had not integrated these two transaction platforms long ago. Surely then, this integration should be the focus of the RBI’s concerns for all banks that are involved in export finance so that disclosure is institutionalised rather than dependent on the integrity of a bank executive. Besides, as the exporters’ association has pointed out, no instrument, whether LoU or LC, can be considered 100 per cent safe, so banning one in preference to another demands much more serious examination.
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