Context:
Recently, a working group (WG) constituted by the Reserve Bank of India (RBI) made certain recommendations to address issues relating to guarantees extended by State governments.
About State Guarantee
- A Legal Obligation for States: A ‘state guarantee’ is a legal obligation for a State to make payments and protect an investor/lender from the risk of default by a borrower.
- For Example: If A delivers certain goods or services to B and B does not make the agreed-upon payment, B is defaulting and at the risk of being sued for the debt. C steps in and promises that s/he would pay for B. A agrees to the forbear request. This constitutes a guarantee.
- A Contract of Promise: As per the Indian Contracts Act (1872), it is a contract to “perform the promise, or discharge the liability, of a third person in case of his default.”
- Involved Parties: The contract involves three parties- the principal debtor, creditor, and surety.
- Creditor: The entity to whom the guarantee is given.
- Debtor: The defaulting entity on whose behalf the guarantee is given.
- Surety: The entity giving the guarantee (State governments in this context).
- Indemnity Contract: It is a contract that protects the lender from loss caused to them by the conduct of the promisor (or the principal debtor).
- Purpose: Primarily, guarantees are resorted to in three scenarios at the State level:
- A Precondition: Where a sovereign guarantee is a precondition for concessional loans from bilateral or multilateral agencies (to public sector enterprises)
- For Improvement: To improve viability of projects or activities with the potential to provide significant social and economic benefits
- For Favourable Terms: To enable a public sector enterprise to raise resources at lower interest charges or on more favourable terms.
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RBI Working Group Recommendation On State Guarantee
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On the Definition of State Guarantee:
- Wider Scope: The ‘State guarantee’ should include all instruments, if they create an obligation on the guarantor (State) to make a payment on behalf of the borrower at a future date.
- Ensuring Fiscal Responsibility: The government guarantees should not be used to obtain finance through State-owned entities and also should not be allowed to create direct liability/de-facto liability on the State.
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On Guidelines:
- Follow the Guidelines: Need to adhere with the Government of India guidelines that stipulate that guarantees be given only for the principal amount and normal interest component of the underlying loan.
- Limited Provision: The Guarantee must not be extended for external commercial borrowings, for more than 80% of the project loan (depending on the conditions imposed by the lender) and for private sector companies and institutions.
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On Appropriate Preconditions:
- Specified: The period of guarantee, levy of fee to cover risk, govt representation on the management board of the borrowing entity, and right to audit, etc., must be specified.
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On Risk Determination:
- Assessment: Similar to the prior mandate recommendation of 2002, the WG suggested that States assign appropriate risk weights (indicator of the holding the lender should ideally have to adjust the associated risk) before extending guarantees.
- Consideration: The categorisation could be high, medium or low risk, must also consider the past record of defaults. They must also disclose the methodology of assigning.
- States conservatively keep the lowest slab at 100%.
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On Fees & Ceiling:
- Fees: On the basis of the risk assessment, also taking into account the tenure, the base fee or minimum guarantee fee must be set at a minimum of 2.5% per annum.
- Additional risk premium may be considered based on the risk assessment.
- Ceiling: To manage the potential stress, for incremental guarantees issued during a year, WG proposes a ceiling at 5% of Revenue Receipts or 0.5% of GSDP– whichever is less.
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On Disclosures:
- Disclosure for Improvement: RBI may consider advising banks/NBFCs to disclose the credit extended to State-owned entities, backed by State-government guarantees.
- A proper Database: For all extended guarantees.
- Availability of data, both from issuer and the lender may improve the credibility of the data reported by the State government.
- A Tracking Unit: A unit may be set up at the State level to track the same alongside its compilation and consolidation.
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On Honouring Guaranteed Obligations:
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- Careful Decisions: States must be wary before extending any fresh finance to entities that have failed in honouring commitments before.
- Also, fresh guarantees issued by the State Government may not be readily accepted by the lenders/investors.
Concerns Raised by the RBI Working Group
- Fiscal Burden: The Guidelines has been widely used as may be an upfront cash payment is usually not required. While guarantees are safe in good times, it may lead to significant fiscal risks and burden the State at other times.
- The guarantee can be triggered by certain events, the quantum and timing of potential costs/cash outflows are often difficult to estimate.
- The implementation of given recommendations are “expected to facilitate better fiscal management by State governments.”
Also Read: Government Guarantees On A Rising Trend In 12 States
News Source: The Hindu
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January 29, 2024