6-February-2024-Editorial

RBI’S GUIDELINES ON STATE ‘GUARANTEES’ ON BORROWINGS

Recently, the Reserve Bank of India (RBI) constituted a Working Group to address issues related to guarantees extended by State governments.

This initiative aims to manage fiscal risks associated with guarantees, a legal obligation to protect investors/lenders from borrower default.

Guarantees involve three parties: the principal debtor, creditor, and surety (State governments).

The group’s recommendations focus on defining guarantees, ensuring responsible usage, risk assessment, fees, and disclosures to mitigate fiscal strains.

Constituting a Guarantee:

• Definition: A guarantee, as per the Indian Contracts Act, involves a legal obligation for a State to make payments, protecting the creditor from the principal debtor’s default.
• Three Parties Involved: It includes the principal debtor (party owing a debt), creditor (party receiving the guarantee), and surety (State government ensuring payment in case of default).
• Purpose: Guarantees are commonly used for seeking concessional loans, enhancing project viability, and securing resources at better terms for public sector enterprises.

Issues with Guarantees:

• Guarantees pose fiscal risks, leading to unforeseen cash outflows and increased state debt.
• States grant guarantees on behalf of various entities, and the lack of upfront cash payment makes it a widely used but risky instrument.

Key Recommendations:

Definition of Guarantee:

• Guarantees should encompass all instruments creating an obligation on the State to make future payments on behalf of the borrower.
• No distinction should be made based on conditions, ensuring a comprehensive assessment of fiscal risks.

Limits and Conditions:

• Government guarantees should not substitute state budgetary resources.
• Adherence to guidelines: Guarantees only for the principal amount, not exceeding 80% of the project loan, and not for External Commercial Borrowings.
• Preconditions include the guarantee period, levy of fees to cover risk, government representation on the management board, and the right to audit.

Risk Determination, Fee, and Ceiling:

• States should categorize guarantees as high, medium, or low risk based on the entity’s default history.
• Minimum guarantee fee set at 2.5% per annum.
• Imposing a ceiling on guarantees, limited to 5% of Revenue Receipts or 0.5% of Gross State Domestic Product (GSDP), whichever is lower.

Disclosures and Honouring Commitments:

• RBI should suggest banks to disclose credit given to State-owned entities with guarantees.
• Need for a comprehensive database to track guarantees, proposing a dedicated unit at the State level.
• Timely honoring of guarantees is crucial for maintaining credibility, and delays could harm the State government’s reputation.

Types of Guarantees Given by the Government:

• Guarantees for repayment of principal and payment of interest to RBIs, banks, and financial institutions.
• Guarantees related to agreements with international financial institutions.
• Counter-guarantees to banks for credit issued to foreign suppliers.
• Guarantees for railways/state electricity boards for due payments.
• Performance guarantees for contracts/projects awarded to Indian or foreign companies abroad.

Conclusion:

The RBI’s Working Group recommendations aim to ensure responsible and transparent use of guarantees by State governments, addressing fiscal risks and promoting sound financial practices. These guidelines, if implemented effectively, can contribute to fiscal prudence and better risk management in the context of state-level financial commitments.