Introduction

A working group constituted by the Reserve Bank of India (RBI) has presented key recommendations to address challenges related to guarantees extended by State governments.

Understanding ‘Guarantee’

A ‘guarantee’ involves a legal obligation for a State to make payments on behalf of a borrower, safeguarding investors/lenders from default risks.
As defined by the Indian Contracts Act (1872), it is a contract involving three parties: the principal debtor, creditor, and surety (State government).
The ‘guarantee’ acts as a safety net, ensuring payment in case of default by the borrower.

Sovereign Guarantee: Facilitates concessional loans from bilateral or multilateral agencies to public sector enterprises.
Project Viability: Enhances project viability for activities with significant social and economic benefits.
Resource Mobilization: Enables public sector enterprises to secure resources at favorable terms, contributing to lower interest charges.

Cash Outflows and Debt: While guarantees may not require upfront cash payments, they pose fiscal risks, leading to unanticipated cash outflows and increased debt during challenging times.
Complex Estimation: Estimating the quantum and timing of potential costs/cash outflows is challenging due to triggers associated with guarantees.

Broadened Definition: The term ‘guarantee’ should encompass all instruments creating obligations for the guarantor (State) to make future payments on behalf of the borrower.
Guidelines for Accordance: Government guarantees should not substitute budgetary resources and should adhere to Government of India guidelines.
Preconditions: Specify preconditions, including the period of guarantee, guarantee fee, government representation on the management board, and audit rights.

Risk Weight Assignment: States should assign risk weights (high, medium, low) before extending guarantees, considering past defaults.
Ceiling on Guarantees: A desirable ceiling for incremental guarantees during a year, limiting stress on state governments.
Guarantee Fee Structure: Reflective of borrower’s project riskiness and activities, with a base fee of at least 2.5% per annum.

Credit Disclosure: Banks/NBFCs should disclose credit extended to State-owned entities backed by State guarantees for improved credibility.
Database Establishment: Set up a state-level unit to track and consolidate all guarantees, ensuring proper data compilation.
Timely Honouring: States must honor guarantees without delay, recognizing the reputational and legal risks associated with defaults.

The RBI working group’s recommendations aim to fortify fiscal management by introducing standardized practices, enhancing risk assessment, and ensuring transparent disclosures.
These measures, if implemented, can contribute to better fiscal discipline and mitigate potential risks associated with state government guarantees.