Guidelines on State Guarantees on Borrowings

• 06 Feb 2024

For Prelims: RBI’s Guidelines on State Guarantees on Borrowings, Reserve Bank of India (RBI), Indian Contracts Act, 1872.

For Mains: RBI’s Guidelines on State Guarantees on Borrowings.

Source: TH

Why in News?

Recently, a Working Group constituted by the Reserve Bank of India (RBI) has made certain recommendations to address issues relating to Guarantees extended by State governments.

• The Working Group constituted during the 32^nd Conference of the State Finance Secretaries held in July 2022.

What Constitutes a Guarantee?

• About:
  • A ‘guarantee’ is a legal obligation for a State to make payments and protect an investor/lender from the risk of default by a borrower.
  • A guarantee, as per the Indian Contracts Act, 1872, is a contract to “perform the promise, or discharge the liability, of a third person in case of his default. It involves three parties: the principal Debtor, Creditor, and Surety.
    • Creditor: The entity to whom the guarantee is given. This is the party to whom the payment is due, and they are protected by the guarantee.
    • Principal Debtor: The entity on whose behalf the guarantee is given. This is the party that owes a debt or has a liability.
    • Surety: The entity providing the guarantee (State governments in this context), that promises to perform the promise or discharge the liability of the principal debtor in case of default.
      • The surety undertakes a legal obligation to perform the promise or discharge the liability of the principal debtor if they default.
  • A guarantee must not be confused with an ‘Indemnity’ contract that protects the lender from loss caused to them by the conduct of the promisor (or the principal debtor).
• Illustration:
  • 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. C’s action constitutes a guarantee.
• Purpose of a Guarantee:
  • At the state level, guarantees are commonly used in three situations.
    • Seeking Concessional Loan: When seeking concessional loans from bilateral or multilateral agencies for public sector enterprises, a sovereign guarantee is often required.
    • To Enhance the Viability of Projects: Guarantees are employed to enhance the viability of projects that promise significant social and economic benefits.
    • To Secure Resources at Lower Interest: Public sector enterprises may use guarantees to secure resources at lower interest rates or more favourable terms.
• Risk With the Guarantees:
  • The use of guarantees, while convenient in good times, poses fiscal risks.
  • According to the report by the working group, one of the reasons why the instrument has been widely used is that an upfront cash payment is usually not required in case of guarantees.
  • This practice can lead to unforeseen cash outflows and increased debt for the state, especially as guarantee triggers and associated costs are often challenging to estimate.
  • State governments are often obligated to grant guarantees on behalf of various entities like state-owned enterprises, cooperative institutions, and urban local bodies to secure loans from commercial banks or financial institutions.
    • In return, these entities pay a guarantee commission or fee to the state government.

What are the Key Recommendations of the RBI Working Group Regarding Guarantee?

• Definition of Guarantee:
  • The term Guarantee should be used in a broader sense and 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.
  • Further, it must make any distinction between conditional or unconditional, or financial or performance guarantees in order to assess the fiscal risk.
    • These are conditional liabilities that may present a potential risk in the future.
• Guarantees only for the Principal Loan:
  • The government guarantees should not be used to obtain finance through State-owned entities, which substitute budgetary resources of the State Government.
    • Additionally, they should not be allowed to create direct liability/de-facto liability on the State.
  • There should be adherence to Government of India guidelines that stipulate that guarantees be given only for the principal amount and normal interest component of the underlying loan.
  • Guarantees must not be extended for External Commercial Borrowings, must not be extended for more than 80% of the project loan (depending on the conditions imposed by the lender) and must not be provided to private sector companies and institutions.
  • Appropriate preconditions such as the period of guarantee, levy of (guarantee) fee to cover risk, government representation on the management board of the borrowing entity, and right to audit, etc, must be specified.
• Risk Determination, Fee and Ceiling:
  • The Group recommends that States assess the risk associated with guarantees by categorising them as high, medium, or low risk, taking into account the entity's past default history.
    • The methodology used for assigning these risk weights should be transparent and disclosed.
    • Based on the risk assessment minimum guarantee fee must be set at a minimum of 2.5% per annum.
  • The report emphasises that invoking a guarantee could impose considerable fiscal strain on the state government.
    • To mitigate potential stress, the Group proposes imposing a ceiling on guarantees, limiting them to 5% of Revenue Receipts or 0.5% of Gross State Domestic Product (GSDP), whichever is lower.
• Disclosures & Honouring Commitments:
  • The Group recommends that the RBI should suggest banks/NBFCs to disclose the credit given to State-owned entities with State-government guarantees.
  • The report emphasises the need for a comprehensive database to track extended guarantees, proposing the creation of a unit at the State level for this purpose.
  • Acknowledging potential risks, the report highlights that delays in honoring guarantees could harm the State government's reputation and pose legal risks.
  • It advises States to be cautious when providing finance to entities with a history of not meeting commitments.
  • Additionally, the report emphasizes the importance of promptly honoring guarantees to maintain credibility with lenders and investors.

What are the Different Guarantees Given by the Government?

• Guarantees given to RBIs, other banks and Financial Institutions (like IFCI, LIC, UTI etc) for repayment of principal and payment of interest, cash credit facility, financing seasonal agricultural operations, and for providing working capital in respect of companies, corporations, cooperative societies and cooperative banks.
• Guarantees given in pursuance of agreements entered into by the Government of India with International Financial Institutions towards repayment of principal, payment of interest etc.
• Counter-Guarantees to Banks in consideration of the Banks having issued Letters of Authority to Foreign Suppliers for Supplies/Services made/rendered by them on credit basis, in favour of the Companies/Corporations.
• Guarantees given to Railways/State Electricity Boards for due and punctual payment of dues/freight charges by Companies/Corporations. (Nil for past few years)
• Performance guarantees given for fulfilment of contracts/projects awarded to Indian companies or Foreign companies in foreign countries. (Nil for past few years)