The Hindu Business Line : States can leverage sovereign guarantee

ALL the World Bank's loans to Indian entities other than the Government of India carry a sovereign guarantee. It is, in fact, the very basis of the Bank's lending - no credit exposure to the borrowing entity, unless it is the Federal Government itself.

The Bank's risk is reduced to country risk and none as far as the assisted project is concerned, which could succeed or fail. Irrespective of that, the Bank will get repaid by the sovereign - unless, of course, the country runs short of forex reserves to make the repayment.

In India, the practice has been for the Government of India to channel World Bank loans to various State Governments. This on-lending is in rupees at interest linked to domestic rates. In turn, State Governments (or the borrowing entities) are protected from exchange risk, i.e., if the rupee depreciates, the loss is borne by the Government of India.

Changes in this mode of financing State-level projects are in the works. The proposal, in short, is that the borrowing entities must themselves bear the currency risk, meaning if the rupee falls and the rupee value of the forex liability to the World Bank increases, the additionality is to the borrower's account.

In return, the borrower will enjoy the generally lower rate of interest on hard currencies, e.g., the dollar, euro and yen. However, sovereign guarantees will continue. (The World Bank, unfortunately for the Government of India, will not compromise on that)!

But times have changed. For one, the domestic debt market has grown enormously, enabling State Government-owned enterprises to raise thousands of crores of rupees for their infrastructure projects. This was not the case a decade or so back when projects had to depend entirely on institutional finance.

Thus, there are multiple choices. Apart from bonds or straight loans, avenues such as securitisation can fund projects at low rates of interest.

Does it make sense for State Governments or their entities to take on exchange risk? The few instances that come to mind offer little comfort. One recalls a shipping company owned by a State Government losing huge amounts of money because of a wrong call on dollar - yen.

Obviously, they lack the expertise to navigate the volatility that now characterises exchange and interest rate markets.

The solution seems to lie in leveraging the sovereign guarantee that the Government of India offers anyway to the World Bank. If it does the same thing for domestic borrowing, State Government entities can fund their projects at extremely competitive rates of interest.

The key question is whether the Government of India is willing to do this. It seems absurd that in a given situation, it will guarantee foreign lenders but not domestic ones. After all, the borrower, project and risks are identical. So there is absolutely no difference whether the lender is the World Bank or (for example) a consortium of local institutions.

Indeed, guaranteeing rupee funding is free of exchange risk, hence could be deemed that much safer.

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