What’s in Today’s Article?

• Background (Context, About the Working Group of RBI)
• About Guarantee (Meaning, Components, Purpose, etc.)
• Major Recommendations of the Working Group

Background:

• On January 16, a working group constituted by the Reserve Bank of India (RBI) made certain recommendations to address issues relating to guarantees extended by State governments.
• The working group, constituted in July 2022, comprised of members from the Ministry of Finance, Comptroller and Auditor General of India, and some State governments.
• The working group prescribed a uniform reporting framework for the guarantees extended (by State governments) and a uniform guarantee ceiling.
• As per the RBI, the implementation is “expected to facilitate better fiscal management by State governments.”

What Constitutes a ‘Guarantee’?

• 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.
• 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”.
• The contract involves three parties: the principal debtor, creditor, and surety.
  • The entity to whom the guarantee is given is the ‘creditor’,
  • Defaulting entity on whose behalf the guarantee is given is called the ‘principal debtor’ and
  • The entity giving the guarantee (State governments in this context) is called the ‘surety’.
• 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.

What is the Purpose of a ‘Guarantee’?

• Primarily, guarantees are resorted to in three scenarios at the State level:
  • First, where a sovereign guarantee is a precondition for concessional loans from bilateral or multilateral agencies (to public sector enterprises);
  • Second, to improve viability of projects or activities with the potential to provide significant social and economic benefits;
  • Third, to enable public sector enterprises to raise resources at lower interest charges or on more favorable terms.
• State governments are often required to sanction, and issue guarantees, on behalf of State-owned enterprises, cooperative institutions, urban local bodies and/or other State-governed entities, to respective lenders.
• The latter could be commercial banks or other financial institutions. In return, the entities are required to pay a guarantee commission or fee to the governments.
• The RBI working group’s report notes that one of the reasons why the instrument has been widely used maybe that an upfront cash payment is usually not required in case of guarantees.

Major Recommendations Made by the RBI’s Working Group w.r.t. Guarantees:

• Definition of Guarantee:
  • The Working Group has suggested that the term ‘guarantee’ should be used in a broader sense and include all instruments.
  • Further, it must make any distinction between conditional or unconditional, or financial or performance guarantees in order to assess the fiscal risk.
  • These are contingent liabilities that may crystallise later— in other words, present a potential risk in the future.
• Guidelines for According Guarantees:
  • The Working Group has recommended that government guarantees should not be used to obtain finance through State-owned entities.
  • Additionally, they should not be allowed to create direct liability/de-facto liability on the State.
  • It further recommends adherence to Government of India guidelines stipulating that guarantee be given only for the principal amount and normal interest component of the underlying loan.
  • Furthermore, they must not be extended for external commercial borrowings, must not be extended for more than 80% of the project loan.
  • Also, they must not be provided to private sector companies and institutions.
  • Finally, appropriate preconditions such as period of guarantee must be specified.
• Risk Determination, Fees, Ceiling:
  • The Group suggested that States assign appropriate risk weights before extending guarantees. The categorisation could be high, medium or low risk.
  • These must also consider past record of defaults. They must also disclose the methodology of assigning.
  • The report argues that should a guarantee be required to be invoked; it could lead to significant fiscal stress on the state government.
  • To manage the potential stress, it proposes a ceiling at 5% of Revenue Receipts or 0.5% of Gross State Domestic Product (GSDP) — whichever is less.
• Disclosures & Honoring Commitments:
  • The Working Group has recommended that the RBI may consider advising banks/NBFCs to disclose the credit extended to State-owned entities, backed by State-government guarantees.
  • It has also sought a proper database capturing all extended guarantees, suggesting that a unit may be set up at the State level to track the same – alongside its compilation and consolidation.
  • W.r.t. honoring commitments, the report recognises that delays may affect the sanctity of issued guarantees. Thus, it can result in reputational risk as well as legal risk for the State government.
  • The report seeks that States must be wary before extending any fresh finance to entities that have failed in honoring commitments before.