How will LOU Ban affect the Import Export trade?
This can probably be deemed as the second most radical step by the central bank after the demonetization move in 2016. As an ad hoc policy measure, the Reserve Bank of India has barred all the commercial banks from issuing Letters of Undertaking (LoUs) to the borrowers. Apart from that, the issuance of the Letters of Comfort has also been banned with immediate effect.
The decision that really shaken the whole nation, has come in the wake of the recent extortion and misappropriation of funds by some notorious companies through various overseas branches of Indian banks on the basis of a few doubtful Letters of Undertaking.
Moreover, it will have a sweeping effect on the exporters who have been through online GST registration process in India and have applied for a refund of IGST that they have paid on the purchase of inputs for manufacturing. Owing to the gross delay in the refund process, the only way they could operate seamlessly was by signing Letters of Undertaking with the revenue authorities as to move their merchandise on a zero-rated basis.
To get to the crux of this issue, one must understand the concept of LoU and Letters of Comfort (LoC) and their adverse impact on the banking system.
What are Letters of Undertaking?
Letters of Undertaking or LoUs are the testimonials that a bank issues as an agreement wherein a bank permits a borrower to raise finance from a foreign branch of an Indian bank as a short-term loan. This loan is used to make payment to the customer’s offshore suppliers in foreign exchange.
What is a Letter Of Comfort?
A letter of comfort is very much similar to the LoU. It is an informal document that provides a guarantee that a financial obligation will ultimately be met by the borrower. In this case, the bank certifies the credibility of the borrower and assumes the obligation in case the borrower fails to meet it.
How do they affect the banking system?
As they provide virtual guarantees and do not involve trust receipts, LoUs & LoCs are less genuine modes of payments and can be easily misused by the borrowers. This can have a catastrophic impact on the Indian banking system.
How is Letter of Credit more viable than LoUs & LoCs?
A Letter of Credit or LC is a written pledge by a bank on borrower’s behalf that obligation will be duly met under specified conditions thereof. In case of an LC, the consignments are controlled by the issuing bank, and the bank does not release them until the payment has been done by the buyer. Thus, it is much feasible and safer mode of transaction than the LoUs and LoCs and its reliability has been approved by RBI.
What effect will the ban have on the import-export trade?
As LoUs & LoCs assist importers in accessing cheaper and easy credit, they would result in an increase in imports, which would adversely impact the balance of trade. The ban on LoUs & LoCs has seriously weighed down large importers. However, in the long run, it will discourage imports and will boost exports.
All in all, this drastic step by the central bank will eventually provide much incentive to the budding exporters in India. On the basis of some basic credentials such as the unique Import Exports code and LC, they can raise funds from banks in much easier and reliable way.
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