Chapter – 12 Foreign Trade and Banking


Introduction and Genesis

• Exchange control system was initially introduced in India in 1939 under the Defence of India Regulations to conserve foreign exchange. Such savings were mainly to buy defence equipment and other war materials.

• Since it was felt then that such control over reserves was necessary throughout,with only change in its intensity.

• As such first FERA was enacted in 1947, which came into force on 25th March 1947.

• With many changes brought into the system after independence, and many amendments done during Five Year Plans, it was felt to further make FERA comprehensive and as such new form of FERA encompassing the amendments made from time to time was brought in 1973.

• Government of India and Reserve bank of India were made through this Act to control and regulate foreign exchange dealings in India.

• With the enactment of FERA all transactions having direct or indirect dealings in foreign exchange required the general or special consent of Reserve Bank of India.

• The main objective at that point of time was to ensure proper control over foreign exchange transactions and secondly to avoid misuse of foreign exchange of the country.

• The FERA, 1973 contained very strict rules of forex dealing which most industrial houses found it containing draconian provisions which act retardants to the foreign exchange business growth.

• With the reforms coming up after 1991, and lot of liberalization and deregulation being promoted, the FERA became obsolete in terms of its impact on regulating foreign exchange business in India and the Act became outdated.

• During late nineties, say 1997 onwards developments that took place through reforms in the field of foreign exchange include:

(i) Increase in foreign exchange reserves,

(ii) Growth in foreign trade

(iii) Rationalization of tariffs,

(iv) Current account convertibility,

(v) Liberalization of Indian Investment Abroad,

(vi) Relaxation and Increase in external borrowing by Indian corporate,

(vii) Participation of foreign institutional investors in Indian stock markets, etc.

• With all the above reasons in mind and also the feeling that there is no need to strictly hold on to the legislation to control foreign exchange business and balance of payments transactions, gave way to the foreign exchange management.

Foreign Exchange Management Act


• Bill on FEMA passed in Lok Sabha on 2nd December, 1999.

• Rajya passed the FEMA Bill on 8th December, 1999,

• Bill got the assent of the President of India on 29th December, 1999.

• Gazette Notification from the Ministry of Finance, Department of Economic Affairs came on May 1, 2000. The Act came into force from June 1, 2000. The same day the Foreign Exchange Regulation Act (FERA) was repealed, i.e. on 1.6.2000.

Objective of enacting FEMA

• Some of clauses and regulations under FERA were considered harsh and anti-business, particularly foreign trade. The industrial sector raised these concerns frequently before Central Government and desired the Government to review the FERA.

• Keeping in line with the policy of liberalization and globalization, Government modified FERA in the form of FEMA (Foreign Exchange Management Act) in 1999.

• FEMA is applicable to whole of India, and all offices abroad but controlled by resident Indian.

• Another objective is to facilitate external trade and payment system and promote systematic development of forex market in India.

Important Features of FEMA

• FEMA has in all 49 sections that deal with various aspects of foreign exchange business.

• Section 46 and 47 provide powers to Government of India and Reserve Bank of India to make rules and regulations the way forex business is to be managed in the country.

• Another important feature of the Act is that it divides Forex business in to two major parts, viz.

Capital Account Transactions
Current Account Transactions

Terminology and Definition of words as given in FEMA

• Currency: As per section 2 (h) of FEMA, 1999, word “currency” means and includes all currency notes, postal orders, money orders, drafts, cheques, Travellers cheques, letters of credit, bills of exchange, promissory notes, credit cards including debit cards, ATM cards or any other instrument which will create a financial liability.

• Authorized Person: He is a person who is authorized dealer, money changer or off-shore banking unit or any other person authorized by RBI from time to time to deal in foreign exchange or in foreign securities. (section 10 (1) of FEMA, 1999.

• Person of Indian Origin (PIO) : PIO means a citizen of any country other than Bangladesh or Pakistan if:

He at any time held Indian Passport, OR
He or either of his parents or any of his grand-parents was a citizen of India by virtue of the Constitution of India or Citizenship Act of 1955 (57 of 1955, OR
The person is a spouse of an Indian citizen.
• Foreign Currency: means any currency other than Indian currency.

• Capital Account Transactions: Section 2 (e) of FEMA, 1999 explains the capital account transactions as “transaction that alters the assets or liabilities, including contingent liabilities, outside India of person (s) resident in India or assets or liabilities in India of person (s) resident outside India i.e. abroad would all amount to Capital Account Transaction. RBI has the power under the Act to impose any restrictions on drawal of foreign exchange for the purpose of capital account transaction.

• Current Account Transaction: Section 20 of FEMA, 1999 explains current account transaction as one which is not a capital account transaction. It includes the following:

(a) all payments due in connection with foreign trade, other current business services, short term banking and credit services

(b) Interest payments due on loans and net income on investment,

(c) Expenses connected with travel, education, medical care etc.

(d) Maintenance expenses of dependents residing abroad.

In this regard Government of India has been empowered under the FEMA, 1999 to make rules and regulation to restrict drawal of foreign exchange for the purpose of any current account transaction. As such Government of India has made certain rules called Foreign Exchange Management (current Account Transaction) Rules, 2000. These rules prohibit certain transactions involving foreign exchange and prescribe the limit upto which foreign exchange can be remitted. These limits can be revised by Central Government / RBI from time to time.

Nostro Account: It means our account with you. In this case a bank in India maintains an account with bank abroad. Say, an ICICI bank having an account in Hongkong bank in London. This account shall be in pound sterling.

Vostro Account: It means your account with us. This is reverse of Nostro account. In this case a bank in London opens an account with an ICICI bank in India. Such account shall be in rupee. Bank in India would call such accounts as “Vostro” account.

LORO Account: It means their account with you. Here a bank in India if wants to refer to any account abroad (opened by a Indian Bank), it refers to such account as Loro Account. For instance, if an ICICI Bank has an account with Hong kong Bank in London. Now if State bank of India corresponds with Hongkong Bank in London it can refer ICICI bank’s account as Loro Account.

Mirror Account: Mirror account is also called a Shadow Account. For instance, an account of a foreign bank maintained in India with a bank in India, is called Mirror Account. Here all types of entries – both in foreign exchange as well as in Indian rupee are recorded.


• Between the countries there are different natures of transactions for which they have to make payments to each other. Such transactions may relate to countries imports or countries exports.

• Transaction statement showing the level of imports and exports is called Balance of Trade of that country.

• The statement of all debits and credits on account of payments to be made to different countries is called ‘balance of payment’. These payments may relate to capital goods exchange, tourists, other expenditures like interest payable etc.

• Balance of Payments is classified into two parts, viz.

Balance of payments on current account, and
Balance of payment on capital account.
• Balance of payment on current account relates to imports and exports whereas balance of payment on capital account relates to countries international financial position.

Imbalance in Trade:

India’s trade deficit with its top trading partner China continued to mount, touching a whopping $ 31.42 billion as the bilateral trade declined by 1.5 per cent in 2013, registering a downward trend for the second consecutive year.

India’s trade deficit increased by $ 2.5 billion compared to 2012, bringing into sharp focus the failure of Indian exports to make headway into China despite repeated promises by Beijing to address India’s concerns.

Currency Swap:

A currency swap is a contract which commits two counter parties to an exchange, over an agreed period, two streams of payments in different currencies, each calculated using a different interest rate, and an exchange, at the end of the period, of the corresponding principal amounts, at an exchange rate agreed at the start of the contract.

Currency swaps involve an exchange of cash flows in two different currencies. It is generally used to raise funds in a market where the corporate has a comparative advantage and to achieve a portfolio in a different currency of his choice, at a cost lower than if he accessed the market of the second currency directly.


Import Letter of Credit

Most of the payment systems in India like cash payment, cheque, draft payments, etc. are all those mode of payments where parties to contract to buying and selling are known or seen face to face. However there could be situation (s) wherein the parties to business deal of buying and selling are not known to each other nor have ever seen each other like one party is in India and other is in USA. Also the nature of doing business with unknown persons is risky. Merchants in international trade are domiciled in different countries having conflicting issues. Whereas seller (exporter) wants to ensure receiving payments of goods sold, on the other hand buyer wants to ensure receipt of goods ordered within the terms and conditions agreed.

As such another mode of transacting this type business has been developed and that is to deal through their respective banks. This mode of payment and executing transaction is called Commercial Letter of Credit or Documentary Credit.

• Technically speaking Letter of Credit has been defined under Article 2 of Uniform Customs & Practices as “Documentary Credit” and “Standby Letter of Credit”.

• UCP also states that any arrangement whereby a issuing bank on behalf of his customer (applicant) or on its own, make a payment to or to his order to third party (beneficiary) or accept and pay bills of exchange drawn by beneficiary against agreed documents and agreed terms and conditions is Letter of Credit. This is also called DOCUMENTARY CREDIT.

• It also means under UCP authorizing another bank to make agreed sum of money or authorizes another bank to negotiate against stipulated document (s).

• In international business, a typical situation is that merchants to transaction are residing indifferent place or countries. Each has his own interests which at times may be conflicting to seal the deal.

• In simple words Letter of Credit means a letter issued by importer’s bank favouring exporter, where in bank (importer’s bank) undertakes to make payment against fulfillment of agreed terms and conditions, documents, specified period and specified sum of money.

• A letter of credit is normally issued at the request of bank’s customer, who happens to be buyer of goods (called applicant) for payment of sum of money mentioned therein to exporter of goods.

• A letter of credit can only be amended by the issuing bank and none else.

Definition of Various Players to Letter of Credit

Applicant: He is a person who requests his bank to open a letter of credit in favour of other party (beneficiary / exporter). He is also called by the name buyer, or importer.

Issuing Bank: The buyer’s bank which opens LC and creates documentary credit. It also undertakes to make payment. It is the bank which operates letter of credit. It is sometimes called as importer’s bank also.

Beneficiary:(a) He is seller or exporter of goods. (b) He is one in whose favour letter of credit has been opened. (c) He is entitled to receive the benefits under letter of credit or documentary credit.

Advising Bank: It is the bank which acts as a correspondent (agent) to the issuing bank and is located in exporter or sellers country. Advising Bank in turn advises the establishment of credit to the beneficiary so as to ensure genuineness of the credit. Sometimes bankers use the word ‘Notifying Bank’ for advising bank. Advising Bank is not liable to pay under the documentary credit or letter of credit.

Confirming Bank: Advising Bank that confirms the credit on behalf of the issuing bank. By adding confirmation, it undertakes the responsibility of payment under the letter of credit arrangement.

Paying Bank: Bank which is authorized to make payment under letter of credit established by the issuing bank is called paying bank. For making payment, issuing bank has to confirm payment.

Negotiating Bank: It is a bank in the sellers / exporters country whose name is specified or nominated to negotiate the documents / bills drawn by seller. If letter of credit mentions the name of any bank to negotiate the documents, then such bank is called “negotiating bank”. Sometimes negotiating bank can be paying bank, and as such is also called “paying bank”.

Reimbursing Bank: It is the bank that has been authorized by the issuing bank to honour the reimbursement claims in relation to settlement of negotiation /acceptance / or payment lodged with negotiating bank. It is normally the bank with which the issuing bank maintains account from which the payment is to be made.


In practice, there are two major types of letters of credit forms. These are based on four parameters:

A. Based on degrees of security

B. Based on payment methods

C. Special types of Credit

D. Credit with Advance Payment

First two types are discussed below:

According to degree of security

There are three forms of documentary credit or letter of credit.

(a) Revocable Letter of Credit

(b) Irrevocable Letter of Credit

(c) Irrevocable Confirmed Credit

Revocable Letter of Credit:

This type of letter of credit provides maximum flexibility to the issuing bank or buyer for any amendment or cancellation without notice to the beneficiary up to the moment of payment by the bank at which the issuing bank has made credit available. This form of letter of credit runs the risk for beneficiary since it can be cancelled or amended without information. Hence this form is less common.

When a letter of credit does not mention the form LC then it is considered irrevocable.

Irrevocable Letter of Credit

• This type of credit is considered beneficial for the seller since the contents of the credit cannot be modified, cancelled or revoked by any one party without the consent of the other. No party to the agreement has the right to change the terms and conditions credit.

• The seller remains dependent on the undertaking of foreign Issuing Bank. The Issuing Bank irrevocably commits itself to honour the exporter’s documents prescribed in the Documentary Credit and are in order.

Irrevocable Conformed Credit

• When an advising bank advises credit to the beneficiary and also confirms the credit, then it is called conformed credit provided the credit arrangement is irrevocable.

• It gives beneficiary a double assurance of payment, since it represents the undertaking of the Issuing Bank and the confirmation of the Confirming Bank. Confirmation is usually given by a bank in the exporter’s country.

• In confirmed irrevocable credit, the political and transfer risks are eliminated.

Credit With or Without Recourse

• Bills drawn under the credit (Letter of Credit) by the beneficiary, he is liable to make payment if the drawee fails to do so. In other words, he is relieved of his liability only when drawee makes payment. Such LC are called “LC With Recourse”. Where beneficiary excludes his name from the liability by adding the word “Without Recourse”, then such letter of credit is called “LC Without Recourse”.


Based on the payment modes, the documentary credit is divided into three methods:

1. Sight Credit

2. Acceptance Credit

3. Deferred Payment Credit

Sight Credit: In this method the beneficiary receives the payment of credit when he presents the documents and those documents are properly examined.

Acceptance Credit: In this method importer gets time to make payment. Depending upon the credit terms, exporter draws a document or time draft either on Issuing Bank, or Conforming Bank or another bank. Period of payment could be 60 days or more or less as agreed upon between the parties.

Deferred Payment: The main difference between the Acceptance Credit and Deferred Credit is the lack of an accepted draft/document. Deferred payment is possible under both confirmed as well as unconfirmed credits.


(a) Revolving Credit

(b) Back to back Credits

(c) Standby Credit

(d) Transferable Credit

Revolving Credit

Revolving credit means that the sanctioned limit when gets exhausted and the bills are paid, the same credit can be reused again from the original level by the beneficiary. The same credit is revolved many times without entering into new contract and documentation. Two basic conditions must be fulfilled. One terms and conditions of LC must be abided by and secondly, amount can revolve in terms of money and time.

Back-to-Back Credit

The beneficiary in whose name the LC has been issued earlier, uses the same to obtain another LC in favour of supplier

For instance, suppose a company XYZ in Delhi gets a project in Bhutan, for which they have got a Letter of Credit opened in their favour (XYZ). However in order to complete the project, XYZ company wants some machines from China for which they ask their bank to open an LC in favour of Chinese firm based on the strength of LC opened by Bhutan firm in favour of XYZ. Such LC when opened on the strength of earlier LC of Bhutan is called Back-to-Back Letter of Credit.


There are two types of credit with advance payment terms. These are:

Red Clause Credit
Green Clause Credit
Red Clause Credit:

It contains a clause for providing for payment of advance (like working capital) for purchase of inputs like raw material, packaging material etc.

Green Clause Credit:

In addition to the credit given in Red Clause above, here in Green Clause, credit is also given for insurance and warehousing at the port where goods are stored pending shipment.


Important points to be considered are

• While opening the Letter of Credit, Issuing bank should ensure the creditworthiness and capacity of the importer or buyer or applicant.

• Does the applicant has experience in line of business?

• Purpose of Import should be recorded: it may be personal use, for business or for onward sale.

• Marketability of goods and landed cost.

• Payment terms

• Mode of Import

• Letter of Credit number, name of bank on Bills of lading, Airways bill or Invoice Bills of Exchange.

• It is important to note that in case goods supplied are unacceptable to oversea buyer due to inferior quality etc., the Issuing bank is bound to pay the negotiating bank.

• When a Letter of Credit clearly mentions that payment shall be made by bank at sight, or on demand or on presentation, then such LC’s are called Sight Credit Lc’s.

• Similarly, when LC make a reference for full value of shipment of goods but with a clause that dispatch of goods may be done in batches or in particular quantity at a time, then such Letters of Credit are called “Deferred Credit or Deferred LCs”.

• When LC mentions that drafts may be drawn after a particular period or usance which require acceptance or payment as the case may be by the drawee at the close of usance period, then such LC is called Usance Credit.

• Note that LC is just like bank guarantee. Just like bank guarantee, the liability to pay money under LC on behalf of the beneficiary is primary and cannot be avoided if everything is in order.

• Under the “restricted letter of credit” negotiation of documents is limited to a specific bank mentioned in the document of LC.

• Unless mentioned specifically about the form of LC, all LCs where no form is mentioned, are irrevocable.

Benefits of Letters of Credit:

Letter of credit provides many benefits to both purchaser (buyer, applicant) and seller (beneficiary, exporter). These benefits are:

To Buyer/Applicant:

• Major benefit to the buyer or purchaser is that he can avail credit from his bank till the documents reach his bank. Normally this facility is not available from seller.

• Buyer or purchaser need not pay any money to seller in advance as it is being done by the Bank. This is the time when he can use this money for productive purposes.

• Since most of the LC documents have an agreement that goods have to be of quality specified. For which he needs independent certificate from independent body in this regard. In case of default, bank does not pay the money to the seller. Thus purchaser is assured of the quality goods.

• Since most of the bills are usance in nature, the buyer/purchaser gets additional credit.

To Seller

• Seller gets assured of payment.

• Seller can get payment by negotiating the bills immediately after shipment of goods.

• Import regulations of buyer’s country are no issue for the seller.


Important features of Domestic Letters of Credit are:

• Like in the case of import LCs, domestic LC can also be opened for domestic purchaser.

• In domestic LCs the bank of purchaser agrees to pay money to seller subject to submission of documents and completion of terms and conditions of LC.

• Domestic LCs are normally of two types:

Sight LCs, which means payment is made at sight.
Usance LCs, which means payment is made at maturity of bills.
• The procedure of opening domestic LC is that applicant purchaser applies for opening an LC in favour of Seller (beneficiary).

• Bank after verification of financial background of the purchaser applicant and ensuring business need, opens an LC and advises the seller (beneficiary). After dispatching the goods, the seller submits the documents through the nominated bank in the LC and seller than gets his payment through the bank.

• Bank is required to open LCs only for genuine trade transactions.Benefits to Buyer and Seller

• Both gets confidence. Buyer for receiving the goods and seller for receiving the payment.• Further advantage to the buyer is that he pays only when goods are received as per the terms of the LC.Benefit to Bank

• It earns commission on opening of such LCs-whether import or domestic. LCs.


Important features of Guarantee,Bank Guarantee and Indemnity are given below.

• General meaning of guarantee is a contract to perform the promise or discharge the liabilities of third person in case of his default.

• For a contract of guarantee to be lawful, it must have certain pre-requisites like:

Free consent of parties to contract.
Legally competent person to contract
Contract to be backed by consideration.
Contract should not be void.
• Contract of Guarantee is covered by Indian Contract Act and defined in section 126.

• There are three parties to Guarantee, namely, surety, principal debtor, and creditor.

• Guarantee can be either oral or written.

• When Guarantee is taken, a contract is established between creditor (banker) and borrower (principal debtor); creditor and surety; surety and principal debtor.

• Continuing guarantee is one which extends to series of transactions; which is revoked on the reconstitution of partnership firm; and where surety is liable for the ultimate balance in the account except where limit is imposed on liability.


Indemnity means under section 124 of Indian Contract Act, 1972 to perform the promise or discharge the liability of a third person in case of his default.

• In case of indemnity, there are two contracts.

• In contract of Indemnity, the promise is entitled to recover from the promisor, under section 125 of Indian Contract Act, 1872, all damages in which the promise to indemnify applies besides getting all costs and sums that promise have paid under a compromise.


Important features of Bank Guarantee are:

• Definition of Bank Guarantee: In its simplest form Bank Guarantee means an assurance by one party to the other to pay the money in case of the default by the third party. For instance, if Z wants to obtain a contract from Y but Y is not sure about Z’s credentials, then Y asks Z to give a bank guarantee for ensuring the completion of the work of Y in time. When Z’s bank gives such guarantee in favour of Y, then it is called Bank Guarantee. submits the documents through the nominated bank in the LC and seller then gets his payment through the bank

• In other words it means a guarantee given by a bank to a third person, to pay him certain sum on behalf of the bank’s customer, in the event the customer fails to fulfill any contractual or legal obligation towards third person.

• There are three parties to the bank Guarantee. The person giving the guaranty is called “Surety”, whereas the person in respect of whose default the guarantee is given is called “principal debtor”. The third person to whom the guarantee is given is called the “creditor”.

• Need for issuing financial guarantee arises because:

Government departments insist on an Earnest Money Deposit (EMD) or in lieu Bank Guarantee.
Customer does not have cash to that extent and hence as of Bank Guarantee.
It binds the customer to perform and fulfill his/her contractual obligations for the performance of a job assigned to him/her by the government department.
• Important terms of agreement of guarantee are:

(i) Security,

(ii) Maturity Date,

(iii) and purpose of the guarantee.

• While issuing guarantees on behalf of the customer, bank should ensure following important safeguards:

Bank should satisfy itself before issuing financial guarantee that customer would be able to reimburse the bank in case guarantee is invoked by third party.
In case of performance guarantee, bank should exercise due caution and have sufficient knowledge and experience about customer, his capacity and means to perform his promise under contract.
Avoid issuing guarantee as far as possible to customers who are not having dealings with the bank, i.e. credit facility from bank, deposits with bank etc.
• When the payment is invoked under the bank guarantee, bank has following major obligations to fulfill:

Payment should be made to the beneficiary without delay and demur since delay erodes the value of the bank guarantee as well as affecting negatively the image of the bank.
When the beneficiary invokes the bank guarantee and a letter invoking the guarantee is sent to the bank in terms of bank guarantee, bank is under obligation to make payment after verifying the facts.

Classification of Bank Guarantees

• Though there is no legal classification of bank guarantees, yet in practice three important types of bank guarantees are recognized. These are:

Financial Guarantee
Performance Guarantee
Deferred Payment Guarantee, and
Statutory Guarantee.
Financial Guarantee

• Financial guarantee is issued in lieu of cash deposit by customer as Earnest Money Deposit as security.

• Need for “Financial Guarantee” also arises:

In lieu of cash credit facility to a customer.
To make Customer under pressure to complete the agreed obligations.
It makes the third party assured that their work will be completed in time.
Performance Guarantee

• These are guarantee issued in respect of performance of a task contracted.

• Performance guarantee is issued by bank on behalf of its customer in favour of third party assuring him that customer will perform as per contractual obligations stipulated in the contract, failing which bank will compensate third party up to an amount specified in guarantee.

Deferred Payment Guarantee

• Deferred Payment Guarantee (DPG) means an unconditional and irrevocable bank guarantee to seller/exporter where the payment is deferred / postponed and paid in instalments on due date.

Statutory Guarantee

• Statutory Guarantees are those guarantees that are issued by banks in favour of courts, IT departments or other statutory authorities like customs and Central Excise, under Ports Act, Sales Tax, Provident Fund departments etc.

What is Forex?

The market in which currencies are traded is called ‘forex’.There is no central marketplace for currency exchange; trade is conducted over the counter. The forex market is open 24 hours a day, five days a week and currencies are traded worldwide among the major financial centres of London, New York, Tokyo, Zürich, Frankfurt, Hong Kong, Singapore, Paris and Sydney.

The forex is the largest market in the world in terms of the total cash value traded, and any person, firm or country may participate in this market.