Seems to be running ‘the Great Sparrow Campaign’
Vallari Dubey & Nikhil Jain
The Reserve Bank of India (RBI) via a Notification dated March 13, 2018 has discontinued the use of Letters of Undertaking (LoUs) and Letters of Comfort (LoCs) for Trade Credits with immediate effect.
RBI had accorded general permission to the banks authorised to deal in foreign exchange to issue guarantees/LoUs/LoCs in favour of overseas supplier, bank and financial institution, up to USD 20 million per transaction for a period up to one year for import of all non-capital goods permissible under Foreign Trade Policy (except gold) and up to three years for import of capital goods, subject to prudential guidelines issued by RBI from time to time. The notification shall effectively nullify the said provision of Circular No. 24 dated November 1, 2004, meaning thereby, banks authorised to deal in foreign exchange (AD Category-I banks) shall, now onwards, not be allowed to issue /LoUs/LoCs for trade imports.
However, it is to be noted here that RBI has allowed continuance of issuing of Letters of Credit and Bank Guarantees for Trade Credits for imports into India, subject to compliance with the provisions contained in the Master Circular – Guarantees and Co-acceptances, dated 1st July, 2015.
There are slight similarities between LoUs,LoCs, Letter of Credits and Bank Guarantees, however, they are mechanically different instruments.
For the sake of understanding, meaning of all 4 instruments is given hereunder:
|Letter of Undertaking||Letter of Comfort||Bank Guarantee||Letter of Credit|
|It is a contract to perform the promise, or discharge the liability, of a third person.||It is a written document that provides a comfort or level of assurance by a third party w.r.t. financial soundness of the borrower to repay its debt(s).||It is a guarantee from a lending institution ensuring that the liabilities of the Principal Debtor shall be met by or satisfied by the guarantor in case of default by the Principal Debtor.||It is a document issued by a bank or financial institution at the request of importer whereby, the bank or financial institution assures payment to a seller subject to fulfillment of terms and conditions specified in the document including the product specifications, etc. In other words, Letter of Credit is a promise made by Bank to pay to exporter / seller on behalf of importer / buyer.|
When looked upon with a bird’s eye view, all four instruments look similar to each other. However, there are certain fundamental differences. In the case of Letter of Credit and Bank Guarantee (regarded as instruments of suppliers’ credit), the receiving bank does not honor the amount on mere basis of existence of such instruments, rather, they are under obligation to conduct a due diligence of the client at their own level and only upon their satisfaction do they honor the amount. On the other hand, such due diligence is not conducted in the case of LoUs or LoCs (regarded as instruments of buyers’ credit) and banks honor amount merely relying on the instruments presented by the client. It is also highlighted that LoUs have not been recognized as a banking instrument according to the international code.
RBI didn’t accord any reason behind such discontinuance. It is being speculated that this move is in the wake of alleged blow of around Rs. 14000 Crores by fashion jeweler Nirav Modi and Mehul Choksi (infamously termed as ‘PNB Fraud’). This is yet another example of ‘Reactive Law Making’.
As per the data of RBI, the quantum of Buyers’ Credit till the end of September, 2017 stands at around US$ 7090 million, i.e. approximately INR 46,000 crores. On the other hand, the uantum of Suppliers’ Credit till the end of September, 2017 stands at US$ 1011 million, i.e. approximately INR 6,500 crores. Owing to the discontinuance, the cost of funding is expected to increase by aroun 2%, which will be roughly around INR 900 crores. Such a steep inflation may have an adverse impact on the usage of credit and decrease in trade volumes of the country.
The intentions of RBI cannot be questioned, however, the decision to absolutely eliminate the usage of a material instrument in the international trade cycle of the country can prove to be harmful. Historical examples conclude that absolute prohibition, lead to opening up newer avenues to carry out frauds.
A decent example could be the Four Pests Campaign, also known as the Great Sparrow Campaign, started in the year 1958, where millions of sparrows were exterminated, on account of eating grain seeds. Since sparrows ate large amount of insects, on near their extinction, the population of insects increased, which thereon damaged the crops and defeated the whole purpose of the Campaign. If there are loopholes in any system, the idea should not be to eliminate the instruments/ objects being used to do the damage, but to cover the loopholes with a more robust structure of check, communication and authority flow in the system.
Any immediate regulatory corrective action is widely impressive. However, haste should always be combined by extensive reasoning and a long-term approach. Fraudsters may find different ways to fool the system. Therefore, the need is to make such changes so that there are no regulatory loopholes. Bank guarantees and other similar instruments may as well be used to defraud people, however, every time a banking fail comes into highlight, a straight-away ban on the instrument cannot be the right action. In light of the discussion, RBI may think of revisiting its stand on LoUs an
 Paragraph 2 of A.P. (DIR Series) Circular No. 24 dated November 1, 2004
 Home – Statistics – External Sector – External Debt – Quarterly – External Debt of India, available at < https://dbie.rbi.org.in/DBIE/dbie.rbi?site=statistics>