Reserve Bank of India scraps LoUs in PNB scam fallout

Dubious corporates in nexus with corrupt bankers can no longer abuse Letters of Undertaking (LoUs) as the Reserve Bank of India (RBI) has scrapped this import credit instrument that is unique to India and was fraudulently misused by diamantaire Nirav Modi and his uncle Mehul Choksi to defraud the Punjab National Bank.

The apex bank Tuesday discontinued the issuance of LoUs and Letters of Comfort (LoC) by banks for trade credits to facilitate imports to India. The move comes into effect immediately, RBI said in a statement.

While the extreme measure will put a stop to fraudulent use of LoUs, some bankers feel it may negatively impact the rupee as demand for dollar rises. "There may be a scramble to buy dollars as an avenue of trade finance is shutting. The rupee may be hit in the short run. But such a check is needed. A fraud can be easily committed through an LoU," a senior banker said.

The PNB fraud, now pegged at Rs 13,645 crore, has obviously kept RBI worried. The central bank's other big worry is the huge liability that Indian banks are sitting on. Indian banks have $26.6 billion of trade credit issued in the form of LoCs and LoUs which will come up for repayment in the next six months to one year, according to government data on external debt.

Long before the RBI clampdown, the LoU market was jammed with banks offering no quotes for these instruments. The fraud at PNB has forced banks to freeze the issual of new Letter of Credits to companies until they reconcile with the existing liabilities.

"The market for these LoUs were already dead ever since the scam broke out. There was a doubt in everyone's mind, especially since PNB is yet to honour its commitments on the LoUs," said a public sector banker who works in the forex branch.

An LoU was a code No 799 on the swift messaging system and was used only by Indian banks to facilitate faster trade finance. LoU is used only by Indian banks and it is not issued by any foreign banks. Unlike a letter of credit or a bank guarantee, an LoU is just a message on the swift messaging system without the bank having access to import documents.

LoUs were the major instruments used by Modi and Choksi to siphon out money from PNB to finance their diamond, pearl and other precious stone purchases. The diamond and other precious stones are imported into the country for polishing and converting into finished jewelry. India is the world's biggest cutting and polishing centre, with Surat in Gujarat being the hub. About 90% of the diamonds that come into the country are exported to various overseas markets in Europe and west Asia.

According to a rating agency CARE report, "The recent development is expected to impact the export-import in value terms. Diamonds together accounted for 5.8% of the diamond and jewellery trade in value terms in 2015-16. The shutdown of the two companies would have an impact of 5-6% on the diamond and jewelry foreign trade in value terms over the next year that is in 2018-19."