What are the guidelines set by the RBI regarding state guarantees?

Context: A working group appointed by the Reserve Bank of India has made recommendations to address concerns about guarantees from State governments. One suggestion is to use a standardised reporting framework and broaden the definition of guarantees.

What defines a guarantee?

• A guarantee is a form of protection for lenders or investors against the possibility of a borrower not being able to repay their debt.
• It is a liability for the State government who commits to taking responsibility for the borrower’s default.
• However, guarantees can also create financial challenges and increase the debt of State governments.
• State governments issue guarantees on behalf of different entities to secure loans, and these entities pay fees to the State government for providing the guarantees.

Key features:

• The creditor is the entity that receives a guarantee, the principal debtor is the entity on whose behalf the guarantee is given and who defaults, and the surety is the entity providing the guarantee, often state governments.
• An example of a guarantee is when someone fails to make a payment for goods or services and another entity pledges to pay for their default.
• However, guarantees can pose fiscal risks and burden the state during challenging times, leading to unexpected cash outflows and increased debt.
• State governments often issue guarantees on behalf of state-owned enterprises or other state-governed entities to various lenders, and in return for these guarantees, the entities receiving them must pay guarantee fees to the state governments.

Working groups have made recommendations:

• A working group proposes that states should assign appropriate risk weights before giving guarantees, taking into account the past record of defaults.
• They also suggest implementing a ceiling on the issuance of guarantees to prevent financial stress on state governments.
• The group recommends that banks and non-banking financial companies disclose the credit extended to state-owned entities with state government guarantees.
• They also advocate for the creation of a comprehensive database to improve monitoring and transparency.

Limitations on guarantees provided:

• Various proposals and regulations recommended by the Working Group are connected with measures related to the delivery of guarantees.
• These are supplemented by a recommendation that use of government guarantees, as an alternative to borrowings through State-owned entities, should not be allowed if it amounts to actually transferring the budgetary resources from the history and evolving reform initiatives.
• Moreover, a guarantee should not lead to liability of the State both direct and indirect meaning that the State will be responsible for all money which is guaranteed.
• Another point highlighted by the report is that adherence to the guidelines of Government India, which specifies appropriate coverage for guarantee only such as principal and normal interest component correctly attached with underlying loan should be respected.
• In addition to this, earmarking is inadvisable for external commercial borrowings as the State not should provide guarantees for loans taken from foreign recognized source.
• Further, it is also suggested that guarantees should not cover over 80% of the project loan since one wants to limit the State’s liability to a certain proportional amount of money in comparison with the whole project lending.
• In the end, assuring therefore, should not be provided to private firms or organisations as a way of ensuring that no guarantees are given by governments towards private entities but only public or state-owned enterprises.

Conclusion:

These recommendations are intended to promote responsible and cautious use of government guarantees, avoiding any misuse or excessive reliance that could potentially strain the State’s financial capabilities.

Source: The hindu

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