Letters of credit (L/Cs) are apparently being used by Indian importers in arbitrage plays that take advantage of circumstances whereby documentary credits are available at much lower interest rates than other types of credit. This enables importers to employ money raised on cheap buyer's credits available from local banks in a range of investments.

According to one of India's leading business papers however, such practices are pushing the value of the rupee up against the US dollar and becoming so widespread that they are limiting the availability of foreign exchange.

Conventional L/C

According to the Economic Times, a typical arbitrage play would start with the importer instructing its bank to open a conventionally framed L/C specifying that the bank will pay the required amount to the overseas seller's bank on a specified date, normally three to six months later, on fulfilment of certain conditions.

In order to pay the overseas supplier, the bank makes the foreign exchange payment by borrowing from an overseas bank prepared to extend a credit line to it.

Interest rate differentials

The importer meanwhile does not pay its bank. It charges the importer interest on the L/C that works out at around 3-3.5 per cent. These rates are about three times less than the rates at which importers could otherwise borrow rupee funds.

According to the English language daily, importers are also asking local banks to defer L/Cs, thus postponing their payment to the local bank and providing them with the opportunity to benefit from interest rate differentials for a few more months.

Exchange advantage

Some importers are also taking advantage of the falling US dollar according to the Economic Times. It says that importers are taking the view that by the time payment eventually has to be made, the dollar will have sunk lower.

The paper says that the delays in payments have caused the rupee to gain against the US dollar in the foreign exchange market. The delays have essentially softened US dollar demand it says.

Intervention calls

Banks meanwhile are reluctant to refuse credit to clients for fear of losing their business and thus, credit lines from overseas banks are stretched to the limit in some cases according to a banker quoted by the Economic Times.

It says the Reserve Bank of India (RBI) should intervene. According to a senior banker quoted by the paper, "RBI is aware of the problem... it has even informally hinted that banks may hike charges to make such arbitrage[s] unattractive."

This article represents the views of the author and not necessarily those of the ICC or any of the other partners in DC-PRO.