Indian banking regulator has banned the use of letters of undertaking (LoUs), an instrument which was used by companies of the billionaire diamond merchant and his uncle who were allegedly involved in a huge loan scam.

The decision could have repercussions for import-export in the country, especially in gems, jewellery and gold sectors, for which Indian companies pay their suppliers at a cheaper exchange rate for Indian rupee vis-à-vis foreign currency.

In a notification issued to all banks on Tuesday, the Reserve Bank of India said it has decided to discontinue with immediate effect the practice of issuance of LoUs and letters of comforts (LoCs) for trade credits by banks for imports into India.

It, however, said letters of credit and bank guarantees for trade credits for imports into India may continue to be issued subject to compliance with certain provisions.

For such trade credits, banks should avoid giving unsecured guarantees in large amounts and for medium and long-term periods and they should avoid undue concentration of such unsecured guarantee commitments to particular groups of customers or trades.

The RBI order comes in the backdrop of companies linked to diamond merchant Nirav Modi and his uncle Mehul Choksi obtaining LoUs which were used to get loans close to $2 billion dollars from overseas branches of Indian banks, with the help of conniving employees of a branch of India's second largest bank Punjab National Bank in Mumbai.

Both Nirav Modi and Choksi have fled India. The Central Bureau of Investigation, Enforcement Directorate and Serious Fraud Investigation Office are investigating the fraud.

Indian industry insiders said the ban on LoUs and LoCs is likely to affect trade finance and the Indian rupee as importers, especially in gem and jewellery sector, will struggle to finance their import business.

As importers cannot delay payments, they will be compelled to buy dollars from the open market, which will not only push up the cost of imports but also put the Indian currency under pressure vis-à-vis US Dollar and Euro.