The poor state of state government finances is well reflected in the repeated defaults by state governments on government guaranteed bonds. According to figures put out by the Indian Banks Association, the figure has now touched Rs 700 crore within the financial year of 2002 alone. While no panic buttons have been pressed, there is talk of some measures being taken to address the problem. Of this, restructuring of loans to special purpose vehicles as well as retiring of some high cost debt is being considered. While this is welcome, it needs to be said that this would only be a temporary solution. It should be remembered that a guarantee is a credit enhancement facility which gives an assurance to the lender that the state would meet its obligations in the event the purpose for which funds have been lent do not generate the required cash flow. If states continue to ignore all prudential norms while extending guarantees and also do not generate revenues to sustain the payment obligations falling upon them, they would continue to default in the future. It needs to said that under Article 293(1) of the Constitution of India, a state can give guarantees upon the security of the Consolidated Fund of the State. This is an implicit ceiling in order to maintain the creditworthiness of the state. It also allows the state to fix a limit up to which the guarantees can be given. Some states, such as Gujarat, have imposed a ceiling through a legislation on government guarantees as far back as 1963. Similarly, in Karnataka, the total outstanding government guarantees as on April 1 any year should not exceed 80 per cent of the states revenue receipt of the second preceding year, as in the books of the Accountant General in Karnataka.
Now, why cant other states take such similar measures This would at least set some internal discipline within the state. There are other extreme cases as that of Orissa, whereby despite its Reforms Act which requires guarantees to be cleared by the Legislature, the states guarantee was downgraded during the late nineties. In a private sector project where debt repayment obligations are built into the cash flow analysis, corporates do offer their balance sheet as security to lenders in the event the required cash flows are not generated. However, all efforts are made by the company to ensure that lenders dont use the recourse to the balance sheet. On the other hand, state government guarantees go towards meeting the requirements of projects or bonds which are part commercial in nature, usually with a very long gestation gap. When cash flows are not directly linked to the purpose for which the guarantee is given, the state always runs the risk of defaulting on its obligations if it uses the tool of guarantees recklessly. This is what needs to be stopped and this where the Centre as well the Reserve Bank of India have a crucial role to play. Failing this, we run the risk of not only stopping developmental activities but also of transferring fiscal sickness to our lending institutions.