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Surety Bonds – the solution to the Corona triggered liquidity crisis?
Posted by Vikash Khandewal on Nov 24, 2020 8:57:27 AM
The Finance Minister Ms Nirmala Sitharaman announced a reduction in the requirement of performance security on construction & infrastructure contracts to 3% from the 5-10% required earlier while a bid security declaration has been permitted as a replacement for the bid security or an earnest money deposit. These announcements, a part of the Atmanirbhar 3 stimulus package announced on November 12 are expected to ease liquidity for contractors by reducing their working capital requirements.
It is evident that the entire construction & the infrastructure industry is in the middle of acute stress which has been accentuated by the pandemic pushing the infrastructure companies into working capital cycles that are probably the longest in the world. Given that the entire guarantee requirements are catered to by bank guarantees which cut across banking lines, consume on productive collateral and suck out liquidity by way of margin money which at times are as high as 100%, the Finance Minister’s announcements would have come as a major source of relief to the entire Industry.
While the initiatives which are currently focused towards enhancing liquidity and easing problems for the construction & infrastructure industry are commendable, they should ideally have been accompanied by measures aimed at reducing risks for the project owner. This becomes even more relevant if one were to consider the cost and time overruns already being experienced in the projects monitored by the Ministry of Statistics and Program Implementation.
The announcements have possibly overlooked the risks associated with the execution of infrastructure projects where even reputed contractors have been known to fail. The guarantees required under an infrastructure project are meant to protect the project owner in the event of default by the contractor. By reducing the performance guarantees from 10% to 3% for public projects, we are in effect reducing the quantum of cover available to the project owners. Given the coronavirus pandemic and its crippling impact on the finances of the contractors, the risk has multiplied manifold.
Competent Contractors -The need for a surety in the Indian economy is now more acute than ever before. A Surety Bond is a risk transfer mechanism where the surety company assures the project owner that the contractor will perform a contract in accordance with the contract documents. A surety or a specialized guarantee company helps bring capabilities to the project by way of a rigorous pre-qualification process on the contractor’s ability to fulfil the obligations of the contract. A study conducted by the Canadian Centre for Economic Analysis has concluded that a non-bonded construction enterprise is 10 times more likely to become insolvent than bonded companies thus illustrating the effectiveness of the surety risk selection process in ensuring that only qualified firms are permitted to undertake public work.
“Essentially, if you have the right contractor, the probability of him defaulting on the contract is minimised”
Infusing Liquidity: Sureties depend on their underwriting expertise to assess the risks associated with the project and hence do not usually require cash collaterals or margins. As such, use of surety guarantees would have also had the desired effect of releasing liquidity to the contractors without any additional risks to the project owner.
Surety Guarantees help protect the interests of the taxpayer, the public & private project owners and the lenders from the potentially devastating consequences of contractor failure and are ideally suited for situations that the Indian economy currently finds itself in.
Topics: Surety Guarantees
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