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States letter of comfort offers little guarantee

C. Shivkumar

MOST securities issued by the State government undertakings are on a structured obligation basis. This is because, barring exceptions, most of the State Public Sector Undertakings are loss making entities with revenues unable to meet even their expenditu re requirements.

Consequently, borrowings would have to be backed by some form of a credit enhancement mechanism, which is essentially the guarantees issued by the respective State government. But unfortunately most or all of these guarantors themselves are deep in a fis cal crisis, with large and unsustainable fiscal deficits.

Such deficits are close range any where between 4 to 7 per cent of their respective state domestic products. Clearly, such numbers indicate that the guarantors themselves have very little debt-carrying capacity, and therefore even lesser ability to suppo rt contingent liabilities.

Consequently, for such guarantees to become acceptable to creditors, the option is to create some form of a sinking fund for meeting repayments. But few states have such redemption funds in place for meeting the contingent liabilities. This is converting guarantees into funded liabilities instead of unfunded liabilities.

In fact, institutions like the Housing and Urban Development Corporation, which is the largest financier of non-energy infrastructure projects in the country, have now begun insisting on budgetary provisions.

This would mean that the State governments would have to earmark a portion of their receipts for meeting the redemption obligations. The advantage of this kind of a sinking fund creation is that the guarantees become credible.

But what is currently being done is fixing limits on guarantees, linking to the revenue raising capacity of the states. But these ceilings are also meaningless.

This is because some of the States have resorted to issuing letters of comfort. While letters of comfort are internationally recognised as guarantees, there are many legal complications.

In order of sequence, a letter of comfort, does not assure of primary charge on either the borrower's revenues or guarantor's redemption funds. At best, it offers only a residual charge on either revenues or sinking funds in the event of a default in mee ting debt servicing obligations. Effectively, such letters are therefore meaningless and cannot be treated as a repayment security guarantee.

Another system that is being offered is reduction in stamp duties for improvement of liquidity. But five states have already gone ahead with such reductions since 1996. The reduction of these duties were offered to improve the yields and trading volumes. But with volumes not increasing in the markets, reduction in such stamp duties have only negatively impacted the revenues to the respective state governments.

The message is clear. Liquidity is a function of investment security. Consequently the best alternative to such guarantees/ letters of comfort would therefore be issuance of bonds on the basis of a revenue obligation basis.

Revenue obligation would mean that a portion of the borrowers or the guarantor's earnings would be earmarked for redemption. But there are constitutional and statutory implications for making revenue obligations. Under Article 266, of the Constitution, a ll tax collections, including Central transfers to the States are to be credited only to the consolidated funds of the respective states.

However, certain cesses are outside the ambit of this statute and are part of the public account - sales tax cesses, electricity cesses, water cesses, road cesses, etc. Consequently one of the best credit enhancement mechanisms would be to convert all th e cess collections in the respective states into a single debt/guarantee redemption fund.

The advantage of this mechanism is that the credit worthiness of the States would no longer become questionable. Credit worthiness assessments would be independent of the fiscal situation in the state, but would be linked to the accumulation in this fund . This cess finally acts as a de facto barrier against unbridled borrowings.