Now that the hon’ble minister of road transport and highways, Mr. Nitin Gadkari, launched the first-ever surety bond insurance in India, the question that comes to every principal/contractor’s mind is “how much would surety bonds in India cost?” “Are they going to save the cash strapped businesses or are just a new formality introduced by government?” Let us delve deeper into these questions.
What was the need to introduce surety bonds?
The need to introduce surety bonds is closely related to their costing. Let us understand the same.
What was happening prior to surety bonds?
In order to find contractors who meet the requirements to work on a project, the government typically releases bids. After being chosen, a contractor starts working on the project.
The contractors employ bank guarantees to avoid a situation in which they are unable to meet deadlines, pay their vendors and subcontractors, or repay the government’s advance. In the event that the contractor is unable to fulfil its obligations, the bank disburses funds to the government or vendors.
What was problem with this ?
A bank guarantee requires significant collateral. This held collateral or margin money can be as high as 100% of the guarantee amount. It acts an indirect cost for the contractor as the money held is not available for use. Also this amount blocks line of credit. This makes it difficult to avail other important loans such as loans for machinery, working capital etc.
The compound effect of high collateral & blocking of line of credit creates a liquidity crunch. If a company faces liquidity issues but has no assets left to collateralise due to a bank guarantee’s strict requirements, its liquidity troubles delays awarded projects or even keep these projects incomplete.
How worse has the problem BECOME ?
Over the past ten years, there have been numerous problems in India’s infrastructure sector.
Loans made to infrastructure businesses went bankrupt due to liquidity problems such as fund unavailability & cost overruns.
Cost overruns totaled Rs 4 lakh crore, according to the Ministry of Statistics and Programme Implementation. In a report from April 2022, the ministry noted that 359 projects had cost overruns and that 640 of the 1,559 projects it was monitoring were experiencing time delays.
The industry has undoubtedly been having difficulties. After several painful years of handling infrastructure-related non-performing assets, banks also have been quite careful about issuing bank guarantees.
Surety bonds cost in India : The Saviour
Surety bonds though new to India, have been in existence for a long time. So much so that in countries like the United States, they are mandated by law for public works projects. This stands as testimony to their success.
The most important contributing factor to their success is their cost. Both direct & indirect cost when compared with Bank Guarantees.
First, Surety Bonds need no to minimal collateral. This frees up a huge amount for use by the contractor as he wills. As large as 100% of the guarantee amount.
Secondly, Surety Bonds do not block one’s line of credit & the contractor is free to avail loans for costly & crucial things like machinery, labour cost etc.
Now for direct cost, Surety Bond direct cost for same period of time is 5-10% lower than that of Bank Guarantees. Moreover, a surety bond is much lighter on a contractor’s pocket since it’s period is customized to the duration of the project and paid on pro-rata basis. You pay only for the duration for which you avail the surety bond insurance. This is unlike Bank Guarantees that have to be renewed periodically and paid quarterly or annually. This means that, as an example, if a contractor uses a bank guarantee for a period of 3 months and 10 days, they would end up paying for 2 quarters while for Surety Bonds the contractor pays for the exact period of 3 months & 10 days on a pro-rata basis.
Due to these cost advantages of Surety Bonds, they were sought after by government to bail out the infrastructure sector. The Indian Government thus announced acceptance of surety bonds in the financial year 2023 (FY23) budget & actively worked with partners like us for surety bond insurance to see light of the day.
View videos where Surety Se7en experts explain Surety bonds here.
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