What are the RBI’s guidelines on State ‘guarantees’?
- A working group constituted by the RBI recently proposed significant recommendations on state government guarantees.
- Objective: To address issues relating to guarantees extended by State governments.
- RBI anticipates that the proposed reforms will enhance fiscal management for state governments.
Definition and Purpose of Guarantees
- 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.
- It should not be confused with an ‘indemnity’ contract that protects the lender from loss caused to them by the conduct of the promisor (or the principal debtor).
- Primarily, Guarantees are resorted to in three scenarios at the State level
- Where a sovereign guarantee is a precondition for concessional loans from bilateral or multilateral agencies (to public sector enterprises)
- To improve viability of projects or activities with the potential to provide significant social and economic benefits
- To enable public sector enterprises to raise resources at lower interest charges or on more favourable terms.
Working Group Recommendations
- Broader Definition
- Suggests using a broader definition of guarantees, encompassing all instruments creating obligations for future payments by the guarantor (State).
- It must make any distinction between conditional or unconditional, or financial or performance guarantees in order to assess the fiscal risk.
- Guidelines for Issuance
- Recommends guarantees should not be used to obtain finance through State-owned entities, which substitute budgetary resources of the State Government.
- Additionally, they should not be allowed to create direct liability/de-facto liability on the State.
- Recommends adherence to GoI guidelines, emphasizing guarantees for the principal amount and normal interest components only.
- Furthermore, they must not be extended
- For external commercial borrowings
- For more than 80% of the project loan (depending on the conditions imposed by the lender)
- For private sector companies and institutions.
- Proposes appropriate preconditions, including guarantee fee, government representation, and audit rights.
- Risk Weight Assignment
- Recommends the states to assign appropriate risk weights (high, medium, low) considering past defaults.
- Urges conservative risk weight assignment, setting the lowest slab at 100%.
- Ceiling on Guarantees
- Advocates a desirable ceiling on issuance of guarantees to manage potential fiscal stress.
- Proposes a ceiling at 5% of Revenue Receipts or 0.5% of GSDP - whichever is less, for incremental guarantees issued during a year.
- Further, the guarantee fee should be reflective of project riskiness; suggests a minimum base fee of 2.5% per annum.
- Data Disclosure
- Recommends RBI advising banks/NBFCs to disclose credit extended to state-owned entities backed by government guarantees.
- Availability of data, both from issuer and the lender, may improve the credibility of the data reported by the State government.
- Suggests set up of a unit at the State level to track the same – alongside its compilation and consolidation.
- Guarantee Honouring
- Highlights the significance of promptly honouring guarantees to maintain credibility and avoid reputational and legal risks.
- Encourages states to exercise caution in extending fresh finance to entities with a history of commitment failures.