To facilitate better fiscal management by State governments, an RBI working group has recommended that they should be subject to a reasonable cap on issuance of guarantees.

Further, States have been cautioned against using guarantees to obtain finance through State-owned entities, which substitute budgetary resources of the State government. 

States should also ensure that all guarantees in respect of loans and bonds, when there is a default, are honoured without delay, per the Group.

The Working Group on ‘State Government Guarantees,’ comprising members drawn from the Ministry of Finance, Government of India; Comptroller and Auditor General of India; and some State Governments, emphasised that guarantee is a potential future liability that is contingent on the occurring of an unforeseen future event.

“If these liabilities get crystallised without having adequate buffer, it may lead to increase in expenditure, deficit, and debt levels for the State government. If the guarantee invoked is not honoured, it may cause reputational damages and legal costs to the Guarantor,” per the Group’s report.

Therefore, it is important to assess, monitor and be prudent while issuing guarantees, especially when such guarantees are issued by a State government.

The group expressed concern at the increasing bank finance to government-owned entities backed by government guarantee, especially where the bank finance appeared to substitute budgetary resources of State governments.

Government guarantees should not be allowed for creating direct liability /de-facto liability on the State, it added.

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Ceiling on Guarantees

The group recommended a ceiling for incremental guarantees issued during a year at five per cent of revenue receipts or 0.5 per cent of GSDP (gross state domestic product), whichever is less.

As of March-end 2021, outstanding guarantees issued by the States stood at ₹7.40-lakh crore, or 3.7 per cent of their combined SGDP. The group noted that guarantee fee charged should reflect the riskiness of the borrowers / projects / activities.

Hence, a minimum of 0.25 per cent per annum may be considered as the base or minimum guarantee fee. An additional risk premium, based on risk assessment by the State Government, may be charged to each risk category of issuances.

The guarantee fee should also be linked to the tenor of the underlying loan, said the group.

States should continue with their contributions towards building up the Guarantee Redemption Fund/ GRF to a desirable level of five per cent of their total outstanding guarantees over a period of five years from the date of constitution of the fund, the report said.

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The corpus may be maintained on a rolling basis thereafter. The objective of the GRF is to provide a cushion for servicing contingent liabilities arising from the invocation of guarantees issued by the State Governments in respect of bonds and other borrowings by state level undertakings or other bodies.

Though the participation from the states in GRF is voluntary, 19 states have already established GRF. The GRF corpus managed by the RBI stood at ₹10,839 crore as on March 31, 2023.

The group said State governments need to classify the projects/ activities as high risk, medium risk and low risk and assign appropriate risk weights before extending guarantee for them, the Group said. Such risk categorisation should also take into consideration past record of defaults.

It suggested that the states should conservatively keep the lowest slab of risk weight at 100 per cent. Additionally, they should disclose their methodology for assigning risk weight.

States should not make any distinction made between conditional/ unconditional, financial/ performance guarantees as far as assessment of fiscal risk is concerned as all of these are in the nature of contingent liability that might get crystallised on a future date.