But for this, government departments should aggressively adopt them as an instrument to mitigate risk and provide long-term value to projects.
The signs so far are encouraging.
The Prime Minister Narendra Modi-led government deserves plaudits for the launch of India’s first-ever surety bond, unveiled by the Union Minister for Road Transport and Highways, Nitin Gadkari, last month.
Government institutions took exceptional interest in surety bonds, working closely with insurance companies to iron out issues plaguing the instrument.
Right from Finance Minister Nirmala Sitharaman’s announcement that surety bonds could be a substitute for bank guarantees, to the interest shown by the roads ministry and the National Highways Authority of India, the entire exercise is commendable and a testament to India’s pro-business agenda. With the announcements and unveiling out of the way, however, it’s now down to the nitty-gritties.
To begin with, government departments can spell out clear timelines for their agencies to adopt surety bonds. Proper initiatives will turn this into perhaps one of the most critical reforms in the Indian economy, enabling open capital access to millions of small and medium-sized enterprises.
The move will not only boost the MSME ecosystem, but will also nudge insurance companies to launch customized products for the sector. Around 70% of India’s infrastructure work is carried out by family-owned small to medium-sized companies, which run pillar to post in arranging collateral for bank guarantees. These guarantees typically range between 3% and 10% of the project value.
Banks, however, demand anything between 30% and 100% of the guarantee value in the form of collaterals. This can be in cash or fixed assets, thereby limiting entrepreneurs’ appetites to scale up their businesses.
Moreover, since these projects are long term, this capital in the form of bank guarantees is for an extended period–making it a painful exercise for small entrepreneurs needing money. The government seeks bank guarantees to ensure that contractors have skin in the game and do not abandon their projects midway.
Surety bonds intend to solve this problem by looking at the previous track record of contractors, their internal management and accounting records, their credit history, net worth, and profitability. All of this indicates their ability to complete future projects.
Surety bonds act as a tripartite instrument between the contractor, government, and insurance company. The contractor pays a premium to the insurance company, which will compensate the government if a contractor defaults or runs away before completing a project in the stipulated time.
A surety bond is not uncommon and works beautifully in developed economies such as the US. A recent study in the US by the consultancy firm EY suggested several benefits of surety bonds in managing risk and providing long-term value in construction projects.
The study found that default by contractors on non-surety bond projects was 85% higher than on projects protected by surety bonds. In addition, it found that projects without surety bonds are more likely to default than those with surety bonds, perhaps by as much as ten times. Of all the contractors/developers that EY spoke with, 75% said surety bonds reduce contractor pricing due to increased confidence in the general contractor to complete the project and increased ability to pay the subcontractors.
Moreover, if contractors opt for surety bonds, they have higher chances of completing the project on or ahead of schedule. Even amid financial difficulty, they are more likely to prioritize completing surety bond projects.
While all of these are more likely to be valid in the Indian context, there is no denying that with the broader adoption of surety bonds, these small businesses will compete for jobs with other large companies and prove crucial in the country achieving its $5 trillion economy landmark.
Yet, the success of surety bonds will rely solely on the availability and acceptability of such products, and that has to be a joint effort on the part of the policymakers, regulators, and insurance companies.
A timeline for the widespread adoption of surety bonds by all government agencies will be a boon. It is also essential that IRDAI strengthens the guidelines with a nuanced focus on priority sectors for Indian infrastructure’s growth.
The insurance regulator needs to ensure that pricing for surety bonds is lesser than the current margin of money charged by banks. If the pricing is at par or more than the current margin level, then the surety bonds will not work.
As India embarks on this new path of surety bonds, the tremendous potential of this tool to realize the nation’s ambitious infrastructure target will soon become evident. The devil, as they say, however, lies in the details. And it is the detail of this instrument that the government needs to plan and iron out for a seamless and effective transition.
The authors are co-founders of Zetwerk Manufacturing.