The latest fraud in the banking system linked to foreign-trade financing has come at a time when the economy was showing signs of picking up. In a bid to ensure discipline, the RBI on March 14 decided to ban the use of Letters of Undertaking (LoU) and Letters of Comfort (LoC) as instruments of trade finance.

Let us understand what LoUs and LoCs are. An LoU is a guarantee assuring timely debt servicing by the borrower, issued by an Indian bank in favour of a foreign bank extending the buyer’s credit. On the other hand, an LoC is an assurance of debt servicing extended by the Indian branch of the bank in favour of a foreign branch of the same bank providing the buyer’s credit.

Historically, importers have heavily relied on buyer’s credit to meet their net working capital requirements. The arrangement enables importers to reduce the cost of borrowing by linking it to London Interbank Offer Rate. Furthermore, the working-capital financing of the majority of importers is structured in such a manner where their outstanding Letters of Credit (LCs) are converted into buyer’s credit.

In such transactions, the foreign bank/branch of an Indian bank would typically provide funding assistance in the form of a buyer’s credit to the importer — which would be facilitated by an LoU/LoC issued by the domestic bank/branch. From the point of view of the foreign bank/branch, such a transaction will be treated as an inter-bank exposure towards the bank/branch issuing the LoU/LoC.

As on March 31, 2017, the total outstanding buyer’s credit of the top 160 importers was over ₹330 billion. Out of that, ₹312 billion of the credit was availed by large-sized importers, followed by small- and medium-sized importers (₹19 billion).

Impact on corporates

The impact of this ban on corporates will be asymmetric. Within the 160 top importers who also avail buyer’s credit, it is noteworthy that the level of dependence on buyer’s credit is inversely related to the annual turnover of the importer, ie, buyer’s credit comprises a larger portion of the total debt for small- and medium-sized imports (revenue less than ₹2.5 billion and between ₹2.5 billion and ₹7.5billion, respectively).

The curb is likely to translate into sudden liquidity pressure and higher funding costs for small- and medium-sized importers. Of the total sample of 160 importers, the aggregate interest coverage of mid- and small-size importers is likely to contract by 0.75-1.00x (from 3.85x). However, the aggregate interest coverage of all the importers is likely to contract by about 0.41x (from 4.03x).

On the other hand, larger players with strong credit profiles and well-entrenched market positions are likely to be able to continue to avail buyer’s credit by securing their facilities using alternatives such as standby LCs and guarantees.

Players with relatively weaker profiles are unlikely to be able to secure funding via such alternatives. Inability to mobilise financing may lead to lower-than-anticipated revenue growth, subdued profitability margins and/or liquidity pressures.

Additionally, projects where a substantial portion of plant and machinery is required to be imported may witness an increase in finance cost in initial years, thereby exacerbating the pressure on project returns. Low interest-servicing requirements under foreign-currency instruments enable better matching of operating cash flows and debt-servicing commitments, especially in initial project stages.

From the banks’ perceptive, the dip in access to buyer’s credit is likely to result in shrinkage of the loan-books of the foreign branches. Some part of the contraction in the foreign currency book at a consolidated level may be mitigated by a corresponding expansion in the rupee loan book.

Furthermore, some of the off-balance sheet exposure of Indian branches is likely to be converted into fund-based exposures.

Impact on India

India being a net importer, the critical question is, will this impact foreign trade? Our understanding suggests that foreign trade is unlikely to be affected, barring short-term disruptions. The reason being a large part of this deficit is contributed by the top eight imported commodities. Sectors largely comprising large-sized importers, such as petroleum, are unlikely to be significantly affected by the restrictions on the use of LoUs.

On the other hand, players from relatively fragmented sectors that are largely dominated by a large number of small- and medium-sized players — including electronic components, gems and jewellery — are likely to be substantially affected.

Soumyajit Niyogi and Arindam Som are Associate Director and Analyst, respectively, at India Ratings & Research.

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