India’s central bank bans credit guarantees linked to alleged fraud

India’s central bank has sparked fears of a trade finance squeeze by banning a form of credit guarantee widely used by importers and linked to the alleged $2bn fraud reported by Punjab National Bank.

In an announcement late on Tuesday, the Reserve Bank of India said lenders were now barred from providing importers with letters of undertaking. The credit guarantees, issued by domestic branches of Indian banks, have become popular among Indian importers as a means of obtaining dollar-denominated bank loans overseas.

According to PNB, India’s second-largest state-controlled lender, the LoUs were key to one of the biggest frauds in the country’s history. It has alleged that Nirav Modi, a celebrity jeweller, and people and entities close to him, acting in collusion with PNB staff, used fraudulently issued LoUs to obtain credit from overseas branches of Indian banks. Mr Modi’s lawyer has denied the allegations.

These lenders, including State Bank of India, the market leader, and Axis Bank, a private sector bank, were alleged to have then made local currency payments to designated bank accounts in countries from Belgium to Mauritius. The transactions were not recorded in PNB’s central information system.

In a written statement to parliament on Tuesday, the finance ministry said PNB had reported fraudulent LoUs for payment of import bills amounting to Rs129.7bn ($2bn). The bank had estimated the value of the fraudulent transactions at $1.77bn in its previous announcement on February 14.

Analysts warned that the disruption caused by the sudden ban on a widely used instrument threatened to exacerbate a credit squeeze that has been hurting Indian importers, as nervous banks pull back on lending seen as potentially risky.

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“In general trade finance seems to have dried up in recent weeks,” said Saurabh Mukherjea, chief executive of Ambit Capital, a brokerage, adding that the abolition of LoUs would be a new blow to importers. 

“They were big users of LoUs as these reduce the working capital strain on their own balance sheets,” he added, warning that the rupee could come under pressure if large numbers of businesses resort to buying dollars in the market to finance imports.

In its announcement, the RBI said banks could continue to issue letters of credit — under which a bank commits to pay the importer’s overseas supplier, whether or not the importer defaults. The bank then recovers the amount from the importer.

“These other tools are available, but as [letters of undertaking] wind down, there will be a working capital squeeze,” said Sri Karthik Velamakanni, an analyst at Investec, highlighting a risk to jewellery companies as well as those importing electronic goods. “I don’t think life stops, but smaller importers and exporters will feel the pinch.”