LoU ban to limit financial flexibility of Indian importers.

The Reserve Bank of India’s (RBI) decision to ban letters of undertaking (LoUs) and letters of comfort (LoCs) as trade finance instruments is likely to limit the overall financial flexibility of Indian importers, at least in the near term says India Ratings and Research (Ind-Ra). The curb on the mobilisation of foreign currency working capital funds is likely to translate into liquidity pressure and higher funding costs for small (annual revenue below Rs 250 crore) and medium-sized corporates (annual revenue between Rs 250 crore and Rs 750 crore). Meanwhile, the impact on large sized (revenue above Rs 750 crore) players is likely to be low.

Ind-Ra expects aggregate interest coverage of 46 mid and small size importers by import value of the top 160 importers that avail buyer’s credit likely to contract by 0.75x-1.00x (from 3.85x). How ever, the aggregate interest coverage of 160 importers is likely to contract by about 0.41x. Historically, importers have heavily relied on buyer’s credit to meet net working capital requirements, as it enables them to arbitrage the spread between the London Inter-Bank Offered Rate (LIBOR) and marginal cost of funds based lending rate (MCLR). The spread was about 600bp in February 2018. Furthermore, the working capital financing of the majority of importers is structured in a manner w here their outstanding letters of credit (LCs) (used for the import of goods) are converted into buyer’s credit, giving them extended credit at a low cost.

Ind-Ra opines that funding costs for 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. Sectors where the majority of the player are small and medium-sized players, such as gems and jewellery, are likely to be more affected by the ban compared with sectors where the majority of the players are large and well-entrenched. Palm oil and electronic component importers, players in the gems and jewellery sector and others are likely to be highly affected by the ban.