What constitutes a ‘guarantee’?
A ‘guarantee’ is contingent liability of a State, processed by an accessory contract, that protects the lender/investor from the risk of borrower defaulting.
They promise to be answerable 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 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 the default of B.
This is a guarantee.
The RBI working group’s report notes that while guarantees are innocuous in good times.
It may lead to significant fiscal risks and burden the State at other times.
This may result in unanticipated cash outflows and increased debt.
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 fee to the governments.
Definition of guarantee - according guarantees
The Working Group has suggested that the term ‘guarantee’ should be used in a broader sense and include all instruments, by whatever name they may be called, if they create obligation
on the guarantor (State) to make a payment on behalf of the borrower at a future date.
Further, it 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 recommended that government 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.
It 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.
Furthermore, they 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.
What about risk determination?
The Group suggested that States assign appropriate risk weights (indicative of the holding
the lender should ideally have to adjust the associated risk) before extending guarantees.
The categorisation could be high, medium or low risk.
These must also consider past record of defaults.
Additionally, it deemed a ceiling on issuance of guarantees as “desirable.”
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, for incremental guarantees (additional guarantees) issued during a year, it proposes a ceiling at 5% of Revenue Receipts or 0.5% of GSDP.
What about disclosures?
The Working Group has recommended that the apex banking regulator may consider advising banks/NBFCs to disclose the credit extended to State-owned entities.
Backed by State-government guarantees.
Availability of data, both from issuer and the lender, the report states, may improve the credibility of the data reported by the State government.
It has also sought a proper database capturing all extended guarantees.
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