RBI reduces term of L/Cs opened for diamond imports

Category: International Trade Sub-category: Export Import Procedures
Document type: news


The Reserve Bank of India (RBI) has reduced the term of letters of credit (L/C) opened for import of rough and polished diamonds to 90 days from up to 1 year which will automatically stop the interest rate arbitrage created by some diamond merchants as they open an L/C against a fixed deposit with a local bank.

A reduction in the term of the L/C means reduction in the profit for the trader which is the difference between the return on fixed deposits (FD) and the interest paid to the foreign bank.

This can be explained as follows:

The rough diamond importer opens an L/C against a fixed deposit with a local bank. This L/C acts as a guarantee for the importer as this local bank will make the payment if he fails to pay the supplier.

Once the foreign supplier's bank receives the L/C, it dispatches the goods to the importer's bank and releases the diamonds to the importer after he makes the payment to the seller. Now for paying the overseas supplier, the importer takes a loan from a foreign bank at Libor + 200 basis points against a guarantee from the local bank with which the trader has opened the L/C. This gives the importer a 5.5-6% cheaper loan compared to that by the local bank.

After receiving the rough diamonds, the importer cuts and polishes the diamonds and sells them in the overseas or in the Indian market. The diamond merchant again opens another FD with his local bank which earns interest of around 7-8 % using the funds they gets by selling cut and polished diamonds.

Since they get up to 1 year to pay off the foreign bank, they earn a neat spread of 5.6%. Against the new FD, the diamond merchant opens another L/C and follows the same procedure using cheap funds from banks and thus earns high interest on these funds.

India is the world's largest polishing centre for rough diamonds. The rough diamonds are imported into the country which is cut and polished and re-exported.  In fiscal year 2011, the India's export of diamonds was US$ 28251.92 million, 54.91% higher from that in the previous financial year, whereas the import of diamonds was US$ 11929.91 million, 31.86% higher than that in 2010.