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RBI panel calls for ceiling on guarantees to contingent liabilities

The committee the Reserve Bank of India has constituted to study state government guarantees has, in its report, recommended a ceiling on guarantees to contingent liabilities, which should be operationally relevant through legislation.

The committee was formed after a meeting of state finance secretaries in November 1997. The committee consisted of finance secretaries from Gujarat, Jammu and Kashmir, Karnataka, Maharashtra, Meghalaya, Punjab and Uttar Pradesh.

The broad issues the committee addressed included prescribed limit on guarantees, ensuring greater selectivity in calling for and providing guarantees, honouring guarantees, disclosure and transparency in reporting guarantees, including letters of comfort, structured payment arrangements, escrow and direct debit mechanisms, standardisation of documentation and institution of contingency fund for guarantees.

On the parameters of guarantees, the committee has said that the state government should have sufficient flexibility to choose the most appropriate parameter. The first approach suggested is to link guarantees to a dynamic variable like net state domestic product, total outstanding debt and a third of outstanding guarantees should not exceed 50 per cent of NSDP.

The second approach is that each state government could work out the flexible cash available with it each year after deducting the obligatory expenditure. Depending on the maturity pattern and nature of loan guaranteed and using the same equation of debt to guarantee as according to the first approach, the likely outflows could be worked out and related to coverage available against the flexible cash flows. A coverage of 1:10 should be maintained over the period of loan/guarantee.

The third approach is to link the guarantees and debt to the consolidated fund itself and that guarantees and debt do not exceed twice the receipts in the consolidated fund. The fourth approach would be to ensure that the incremental guarantee to incremental net market borrowings is kept constant or brought down.

The committee feels that the proposal for prescribing a ceiling on guarantee can be practical only if there is more selectivity in the calling for and proving guarantees. Each state may lay down the procedures to be followed in case of projects or units where state guarantee is involved.

They could identify a nodal officer in the finance department, who could co-ordinate the proposals involving guarantees it will also be in the interest of banks and financial institutions to involve the finance departments in any financial arrangement involving the provision of guarantee by state governments.

Some degree of risk sharing between the lenders/investors, borrowers and state government is desirable in the interest of ensuring efficient utilisation of funds and financial discipline. Instead of state governments providing guarantee for 100 per cent of the loan/bond, guarantee could be restricted to 75 per cent to start with and adjusted suitably depending upon the project with the concurrence of the investor/lender, the committee says.

States may give immediate attention to finalisation of the audited accounts of state public sector enterprises in order to minimise the cases where guarantees are required.

The committee said that state governments should ensure that all guarantees for loans and bonds are immediately honoured whenever there is default. RBI could be authorised to earmark or pre-empt a portion of the new loans towards the arrears in payment of interest and principal on loans and bonds.

Alternatively, special bonds could be issued to banks and financial institutions in lieu of the accumulated arrears of payment due from state governments under invoked guarantees. Each bond issued could be limited to the specific amount of guarantees invoked by the bank/financial institution concerned, based on market related interest rate so that such bonds could be also traded in the secondary market.

Both these measures should be viewed as exceptional one-time measures so as to avoid moral hazard. As there is an implicit liability arising out of a letter of comfort and there is a need to contain contingent liabilities devolving upon it.

State government may eschew the practice of providing letters of comforts and where letter of comfort from state government is required, credit enhancement may be provided through explicit guarantees within the overall limit fixed for the purpose. As regards letters of comfort provided in past, full details may be disclosed in the budget documents and may be included in reckoning the ceiling on guarantees.

Comprehensive information on guarantees as also letters of comfort wherever issued should be disclosed by the state governments in the budget at a glance on as contemporaneous a basis as possible.

The committee has recommended that the proposal for ceiling on guarantees using whichever parameter the state government feels is appropriate for it, should be brought to the legislature before the next year's budget formulation exercise say, by September, so that the ceiling can be debated and legislated upon.

Mechanisms providing for automatic debit of state government accounts run the risk of there being insufficient funds relative to such pre-emption and minimum obligatory payments such as salaries, pensions, amortisation and interest payments. Reservations have also been expressed to such arrangements on other grounds as well.

Debit amounting to expenditure has to be authorised by state legislature in its budget and such automatic debits being uncertain cannot be specifically authorised. Recourse to automatic debit mechanisms should therefore be subjected to great circumspection.

Structured payment arrangements provide mechanisms for assured payment by state governments even where there is no guarantee whereas under guarantees issued by the state governments there is no such mechanism. Such arrangements should be discouraged as the financing decision is then not based on the intrinsic viability of the project but the availability of such assured payment arrangement.

Simultaneous with prescribing a ceiling on guarantees and ensuring selectivity in issuing guarantees, such structured payments should be included in the guarantees reported and subject to the limits fixed by the states.

State governments should encourage the state electricity boards to build up a risk fund to handle the contingent liability on account of exchange risk under escrow account arrangements provided to IPPS.

Along with disclosure of guarantees, states should also disclose the revalued liabilities of the state electricity boards under IPPS or similar arrangements for other utilities. Standardisation of guarantee documents though desirable would be difficult. Each state government could, however, evolve its own standard documentation for guarantees.

The guarantee fee should be so structured that the receipts from such fees will take care of the devolvement. Guarantee fees should be invariably charged, appropriately calculated and properly accounted for. The charging of guarantee fee should be rationalised and each state should set up a contingency fund or make some provision for discharging the development under guarantees. The fees collected should be credited to the fund set up for the purpose.

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