The Reserve Bank of India has announced that it is banning banks from issuing letters of undertaking, or LOUs, a form of credit guarantee often used between Indian banks and their offshore branches. It is as a result of a recent multi-billion dollar fraud uncovered at Punjab National Bank, presumably without the bank’s knowledge.
According to the report, while the gems and jewelry segment was the heaviest user of LOUs, every sector including metals, pharmaceuticals, and petroleum was likely to be affected. Monthly $6 billion of LOUs were issued by Indian banks. Letter of credit, or LOC, will be the only allowed credit guarantee process.
While larger traders and corporations already rely on LOCs, which follow a more stringent process, the effect on import transactions and the economy is expected to depress the rupee and sharply raise costs for many smaller importers. Dollar based contracts are expected to place the rupee exchange under pressure. According to some economists, the net effect on the rupee could extend for the next three to four months, and lead to higher loan delinquencies.
“It will definitely increase costs of funding,” said Nikunj Turakhia, President of the Steel Users Federation of India. The LOU’s would be processed at a cost of 2.5-3 percent offshore, while LOC may cost as much as 12 percent since companies will be forced to borrow from local banks in India. Additionally, a buyer’s credit transaction under LOUs could be completed in 3 days while establishing LOC can take up to a month.