RBI’s guidelines on State ‘guarantees’ on borrowings | Explained

The Reserve Bank of India's working group recommends uniform reporting and guidelines for state government guarantees to improve fiscal management.

The story so far: On January 16, a working group constituted by the Reserve Bank of India (RBI) made certain recommendations to address issues relating to guarantees extended by State governments. The working group, constituted in July 2022, comprised of members from the Ministry of Finance, Comptroller and Auditor General of India, and some State governments. Among other things, the Working Group prescribed a uniform reporting framework for the guarantees extended (by State governments) and a uniform guarantee ceiling, besides expanding the definition of what constitutes a ‘guarantee.’ As per the apex banking regulator, the implementation is “expected to facilitate better fiscal management by State governments.”  

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).  

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.

The RBI working group’s report notes that one of the reasons why the instrument has been widely used maybe that an upfront cash payment is usually not required in case of guarantees. While guarantees are innocuous in good times, it may lead to significant fiscal risks and burden the State at other times, it notes. This may eventually result in unanticipated cash outflows and increased debt. Also, the report notes that as the guarantee can be triggered by certain events, the quantum and timing of potential costs/cash outflows are often difficult to estimate. 

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.