UPSC Exam Preparation: Topic of the Day – Letter of Undertaking (LoU)

A LoU is an assurance given by one bank to another to meet a liability on behalf of a customer. They are used in international banking transactions. A LoU is issued for overseas import remittances and involves four parties — an issuing bank, a receiving bank, an importer and a beneficiary entity overseas.

• According to norms, the term of an LoU is 180 days, and can be rolled over once for six months.
• Since LoUs are a form of lending, they are typically backed by security.
• LoUs are conveyed from bank to bank through Society for Worldwide Interbank Financial Telecommunication (SWIFT) instructions
• Because of its attractive pricing, it is also known as buyers’ credit in banking parlance.
• It is estimated that overall, bank finance for imports into India is around $140 billion, of which over 60% is funded through such buyers’ credit.

RBI has issued its decision to discontinue the issuance of LOU/ Letter of Credit (LoC) for trade credits. It has clamped down and issued directives saying that existing Letters of Undertaking would be honoured.

Impact of RBI’s Decision:

• A number of SMEs are extremely dependent on LoUs for raising funding at a reasonable cost. These SMEs are involved in exports and are tier-1 suppliers to large corporates.
• The gems and jewellery sector, the pain would be prolonged because LoUs were the main source of funding.
• Even exporters who use imported material to make goods for exports would be affected adversely.
  • Indian traders aren’t having a good time fighting global restrictions (protectionist policies in developed markets/ trade wars), problems in the domestic market (demand, labour), and currency imbalances across markets. Banning of LoUs will hit exporters hard since they use these instruments heavily to buy raw materials that are used to make export materials.

However, according to exporters’ body Federation of Indian Export Organizations (FIEO), the discontinuation of Letter of Undertaking (LoU) and Letter of Comfort (LoC) by the RBI will not have much impact on trade as such instruments are being used by just about 5 per cent of importers.

Way forward:

• The RBI’s stance is valid, owing to the PNB fraud that came into light and caused discomfort with knee-jerk reactions in the economy.
• In the very same vein, its omnibus ban of LoUs will impact the $85 billion buyers’ credit market that was mostly conducted in accordance with the law of the land.
• The RBI could tightened the norms for LoUs and introduced safeguards based on the latest learnings. It is still not too late to do that.
• The RBI must strengthen and tighten existing regulations rather than completely discontinue a legitimate product