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Economy
Mahesh

28/01/24 10:11 AM IST

RBI’s guidelines on State ‘guarantees’ on borrowings

In News
  • Recently, working group constituted by the Reserve Bank of India (RBI) made certain recommendations to address issues relating to guarantees extended by State governments.
Guarantee
  • 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.
  • Per the Indian Contracts Act (1872), it is a contract to “perform the promise, or discharge the liability, of a third person in case of his default.”
  • The contract involves three parties: the principal debtor, creditor, and surety.
  • 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 B. A agrees to the forbear request. This constitutes a guarantee.
  • A guarantee must 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).
Purpose of a guarantee
  • Primarily, guarantees are resorted to in three scenarios at the State level:
  • First, where a sovereign guarantee is a precondition for concessional loans from bilateral or multilateral agencies (to public sector enterprises);
  • Second, to improve viability of projects or activities with the potential to provide significant social and economic benefits; and
  • Lastly, to enable public sector enterprises to raise resources at lower interest charges or on more favourable terms.
  • 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 commission or fee to the governments.
Definition of Guarantee
  • 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 make any distinction between conditional or unconditional, or financial or performance guarantees in order to assess the fiscal risk.
  • These are contingent liabilities that may crystallise later— in other words, present a potential risk in the future.
Guidelines
  • 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 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 (depending on the conditions imposed by the lender) and they must not be provided to private sector companies and institutions.
  • Finally, appropriate preconditions, such as period of guarantee, levy of (guarantee) fee to cover risk, government representation on the management board of the borrowing entity, and right to audit, among other things, must be specified.
Source- The Hindu

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