Context:

  • Recently a working group constituted by the Reserve Bank of India (RBI) made certain recommendations to address issues which are related to guarantees extended by State governments.
  • The Working Group prescribed a uniform reporting framework for the guarantees extended apart from expanding the definition of what constitutes a ‘’

What constitutes a ‘guarantee’?

  • A ‘guarantee’ is contingent liability of a State which is processed by an accessory contract that protects the lender/investor from the risk of borrower defaulting.
  • They promise to be responsible for the debt, default or miscarriage of the latter.
  • The entity to whom the guarantee is given is the ‘creditor’, the defaulting entity on whose behalf the guarantee is given is called the ‘principal debtor’ and the entity which is giving the guarantee (State governments) is called the ‘surety’.
  • The RBI working group’s report notes that while guarantees are innocuous in good times but it may lead to significant fiscal risks and burden the State at other times.
  • This may result in unanticipated cash outflows and also increased debt.
  • State governments are often required to sanction, and issue guarantees, on behalf of State­owned enterprises, cooperative institutions, urban local bodies and other State­governed entities.
  • In return for the guarantee, the entities are required to pay a guarantee fee to the governments.

Suggestions by the Working Group:

  • The Working Group has suggested that the term ‘guarantee’ should be used in a broader sense and should include all instruments, if they create obligation on the guarantor (State) to make a payment on behalf of the borrower at a future date.
  • They also suggested that the guarantee must not make any distinction between conditional or unconditional, or financial or performance guarantees in order to assess the fiscal risk.
  • The Working Group has suggested that government guarantees should not be used to obtain finance through State­owned entities, which substitute budgetary resources of the State Government.
  • Apart from that, they should not be allowed to create direct liability/de­facto liability on the State.
  • The group further recommends adherence to the Government of India guidelines that stipulate that guarantees be given only for the principal amount and normal interest component of the underlying loan.
  • The guarantees must not be extended for external commercial borrowings, must not be extended for more than 80% of the project loan and must not be provided to private sector companies/ institutions.
  • The Working Group has recommended that the apex banking regulator may consider advising banks/NBFCs to disclose the credit extended to State­owned entities which are backed by State­government guarantees.