RBI’s guidelines on State “guarantees”
The Reserve Bank of India (RBI) working group, recently, proposed recommendations to address concerns related to guarantees provided by State governments. The suggestions focus on defining guarantees, determining associated risks, limiting issuance, and enhancing disclosure practices.
GS-03 GS-02 (Fiscal federalism, Government policies and interventions)
Evaluate the recommendations made by the Reserve Bank of India’s working group regarding State government guarantees. Discuss the potential impact of these recommendations on fiscal responsibility, risk management, and financial transparency in the context of Indian states. (250 words)
Understanding the Concept of ‘Guarantee’:
- A ‘guarantee’ constitutes a legal commitment by a State to ensure payments and protect an investor or lender from the potential default risk by a borrower.
- In accordance with the Indian Contracts Act of 1872, it is a contractual agreement to “perform the promise or discharge the liability of a third person in case of his default.”
- This contractual arrangement involves three essential parties: the principal debtor, creditor, and surety.
- (The ‘creditor’ is the entity to whom the guarantee is provided, while the ‘principal debtor’ is the defaulting entity on whose behalf the guarantee is granted.)
- The entity offering the guarantee, typically State governments in this context, is referred to as the ‘surety.’
Purpose and Scenarios of a ‘Guarantee’:
At the State level, guarantees are predominantly utilized in three scenarios:
- Sovereign Guarantee: It is a prerequisite for securing concessional loans from bilateral or multilateral agencies, particularly for public sector enterprises.
- Project Viability Enhancement: Guarantees may be employed to enhance the viability of projects or activities that hold substantial social and economic benefits.
- Resource Mobilization for Public Sector Enterprises: Guarantees enable public sector enterprises to secure resources at more favorable terms, facilitating lower interest charges.
- State governments often authorize and issue guarantees on behalf of State-owned enterprises, cooperative institutions, urban local bodies, or other State-governed entities to respective lenders, which could be commercial banks or financial institutions.
- In return, these entities are obligated to pay a guarantee commission or fee to the governments.
- The report from the RBI working group highlights that one contributing factor to the widespread use of this instrument is the absence of an upfront cash payment requirement in the case of guarantees.
Dimensions of the Article:
- Understanding Guarantees
- Broadening the Definition
- RBI’s Guidelines for According Guarantees
- Enhancing Disclosures
- Guarantees serve as a safety net for lenders, shielding them from potential defaults by borrowers. In the context of State governments, guarantees become crucial when supporting State-owned enterprises, cooperatives, and other entities.
- The working group underscores that while guarantees seem harmless during stable periods, they can pose significant fiscal risks, leading to unforeseen financial burdens on State governments.
Broadening the Definition:
- The working group recommends broadening the definition of ‘guarantee‘ to encompass all instruments creating an obligation on the guarantor (State) to make future payments on behalf of the borrower.
- The proposed definition aims to eliminate distinctions between conditional or unconditional, financial or performance guarantees, ensuring a comprehensive assessment of fiscal risks.
RBI’s Guidelines for According Guarantees:
- The group advises against the misuse of government guarantees to secure finances for State-owned entities, emphasizing that they should not substitute the State’s budgetary resources.
- Adherence to Government of India guidelines is proposed, limiting guarantees to the principal amount and normal interest component, restricting external commercial borrowings, and preventing guarantees to private sector entities.
Risk Determination and Ceilings:
- States are encouraged to assign appropriate risk weights, categorizing guarantees into high, medium, or low risk based on past default records.
- The working group suggests the implementation of a ceiling on the issuance of guarantees, preventing excessive fiscal stress on State governments. The proposed ceiling is set at 5% of Revenue Receipts or 0.5% of GSDP, whichever is less, for incremental guarantees issued during a year.
- The group proposes that the RBI encourages banks/NBFCs to disclose credit extended to State-owned entities backed by State-government guarantees.
- The availability of comprehensive data from both issuers and lenders is deemed essential to improve the credibility of reported data by State governments. The working group emphasizes the creation of a comprehensive database capturing all extended guarantees.
- The recommendations from the RBI working group aim to create a robust framework for managing guarantees extended by State governments, mitigating fiscal risks, and ensuring responsible financial practices.
- The proposed guidelines, if implemented, could contribute to better risk management, transparency, and accountability in the utilization of guarantees by State governments.