The economics of loan guarantees
The Centre’s credit guarantee scheme pushes down the interest rates on savings as also PSBs’ interest income
Now, guarantees have been going out of fashion in line with FRBM, and states are being told to lower these when supporting state PSUs.The concept of credit guarantee by the government, on loans given by commercial banks, is as close as it can get for a link to be established between the sovereign and private borrower. As borrowers tend to be small—SMEs or tourist guides or MFIs—it is a unique way of supporting flow of funds. This has been actively followed by the government as part of Covid relief, and opens the doors for more such inclusions as these are blanket guarantees.
How does the economics of this look? The government spends nothing on such loans as it is a contingent liability. The Centre offered Rs 3 lakh crore last year and another Rs 2.6 lakh crore this year (total Rs 5.6 lakh crore). As of FY20, the latest for which data is available, total outstanding guarantees of the Centre were Rs 4.7 lakh crore, with incremental guarantees being Rs 20,000 crore. This was before Covid. Now the amount will be more than double. Outstanding debt as of FY22 would be Rs 136 lakh crore, which means that these new guarantees will be around 4% of total. But this will be a fiscally neutral position and will have an impact only if there are defaults and the government has to step in.Now, guarantees have been going out of fashion in line with FRBM, and states are being told to lower these when supporting state PSUs. This is why we had the UDAY scheme for discoms where states were asked to transfer such debt on to their books rather than shield through this curtain. The pandemic has led to a U-turn when it comes to off-balance-sheet items. The Centre had, in the FY22 Budget, sought to get more transparent with FCI transfers by including the amount in the Budget. But, these unusual circumstances have justified such an action. The government, however, needs to put in place a rule on guarantees so that they don’t become a habit.
The other important thing about guarantees is that there is a cost involved on the commercial side. The government has fixed the ceiling interest rate on all these loans, which can range from 7.95% to 9.25% (SMEs). This is below the market rate that can be 4-5% higher for MSMEs. This is good for the borrower, but what about the bank? If Rs 5.6 lakh crore is being disbursed at a rate of 5% lower than normal rate, the loss of income for banks would be around Rs 28,000 crore. This is one of the reasons why banks continue to pay lower interest rates on deposits as there are too many compulsions imposed as part of the government’s social/welfare policy.
Ideally, this should have been done as an interest rate subvention, which is the case with farm loans. But, here, it appears the government saves Rs 28,000 crore on the revenue account, which gets reflected in lower interest income for banks for a period of at least three years until the amount is repaid. This is a big burden to PSBs which are just about getting up.
What about repayments? Most of these loans have/are being given for three years (plus moratorium), which means that the quality of the asset will be standard until such time they come for final repayment. It will be interesting to see how the mechanism works because, with an average NPA ratio of 10% in this segment in the past, there could be progressive claims from the government on interest and principal payment. The fact is that if a tourist operator or an MSME is unable to operate, there is no wherewithal to support repayment schedules.
The missing link is the appetite for funds and the willingness to lend. Banks will still cherrypick customers, while borrowers won’t overleverage merely because there are cheaper funds with a guarantee. The economy has to turn first before this becomes attractive. Loan guarantees, on their own, may not be able to provide momentum for this growth.
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