the challenge of dealing with contingent liabilities hana polackova brixi the world bank
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The Challenge of Dealing with Contingent Liabilities
Hana Polackova Brixi
The World Bank
Why to worry about contingent liabilities?
Governments face increasing risks and uncertainties
Trends toward greater fiscal vulnerability: increasing volatility of international capital flows transformation of the state from financing services
to guaranteeing private sector provision Fiscal opportunism under deficit targets:
tendency to conceal fiscal activities Moral hazard in the markets:
expectations of possible government help
Experiences with fiscal instability triggered by contingent liabilities
Banking sector (A-L): Venezuela, Hungary, Cote d’Ivoire, Indonesia, South Korea, Thailand, ...
Local government liabilities: Argentina, Brazil State guarantees: Mexico (infrastructure projects),
Korea (bank-enterprise loans), the United States (mortgage loans), Colombia (commodity prices)
Central bank liabilities: Thailand and Malaysia (exchange rate guarantees)
Hidden deficits: Czech Republic, Pakistan, ...
Contingent liabilities cause “hidden deficits”
Hidden deficit averaged over the sample periods Source: Kharas and Mishra (2000)
Developing and Transition Countries
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
Cze
ch R
ep
ub
lic
Chile
Jorda
n
Ind
one
sia
Brazil
Cyp
rus
Philip
pin
es
Russia
Arge
ntin
a
Ma
laysia
Th
ailan
d
Kore
a
Uru
gu
ay
Ma
uritiu
s
Tu
nisia
Sri L
an
ka
Israel
Ven
ezu
ela
Bah
rain
S A
frica
Pakista
n
Hun
ga
ry
Tu
rkey
Me
xico
Ind
ia
Pola
nd
Developed Countries
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
Austria
Fin
lan
d
Norw
ay
Austra
lia
Spa
in
US
A
Sw
ed
en
Contingent liabilities relate to currency crises
Correlation (Conventional Def., No of Crises) = 0.15 Correlation (Actuarial Deficit, No of Crises) = 0.55
No. of Currency Crises versus Avg. Conventional Budget Deficit
0
1
2
3
4
5
6
-5 0 5 10 15
Average Conventional Budget Deficit
No
. O
f C
urr
en
cy C
rise
s
No. of Currency Crises versus Average Actuarial Budget Deficit
0
1
2
3
4
5
6
-5 0 5 10 15
Average Actuarial Budget Deficit
No
. O
f C
urr
en
cy C
rise
s
Fiscal risks are large and costly when:
Market institutions and information disclosure are weak - investors do not know the risks and the disciplining effect of financial markets is weak
Moral hazard (history of bail-outs) and volatility in the markets
Government has limited access to debt markets
Future financing pressures on central government: Fiscal Risk Matrix
Obligations Direct(predictable)
Contingent(if a particular event occurs)
Explicitrecognized bygovernment law orcontract
Implicitgovernment moralobligation, publicexpectation, interestgroup pressure
Direct and Explicit
Sovereign borrowing (foreign and domestic loans contracted and securities issued by central government) - amounts and risk structure (currency, maturity, floating rate, link to assets)
Budgetary expenditures
Expenditures legally binding in the long term (civil service salaries, civil service pensions)
xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx
Direct and Implicit
Future public pensions if not required by law (implicit pension debt)
Social security schemes if not required by law
Future health care financing
Future recurrent cost of public investment projects
xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx
Contingent and Explicit
State guarantees for borrowing and obligations of subnational governments and public/private entities
Umbrella guarantees for various loans (mortgage loans, student loans, agriculture loans, small business loans)
State guarantees on private investments, trade, exchange rate
State insurance schemes (deposit insurance, minimum returns from private pension funds, crop insurance, flood insurance, war-risk insurance)
xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx
Contingent and Implicit Default of a subnational government and public/
private entity on non-guaranteed debt/obligations Bank failure (support beyond state insurance) Clean-up of liabilities in entities being privatized Failure of non-guaranteed pension/social security
funds Default of central bank on its obligations (foreign
exchange contracts, currency defense, BOP) Collapses due to sudden capital outflows Environmental recovery, disaster relief, war/military,
...
xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx
Financial Flows Guarantees
Ministry of Finance
National Property Fund (NPF)
Bonds Issued
Ceska Inkasni (CI)
Purchase of bad loans
CSOB
Refinancing
Konsolidacni Banka (KOB)
Borrowings and bonds issuedF
inan
cial
M
arke
tC
orpo
rate
Se
ctor
Spe
cial
In
stit
uti
ons
Banks, enterprises, hospitals and other entities qualified for support
Czech National Bank
Ceska Financni (CF)
Bad assetsPayment for bad assets
Refinancing Credit
Gov
ernm
ent
Redistribution credit
Corporate & environment
liabilities
Example: The Czech Republic
Fiscal risks grew from poor institutions
Little scrutiny was required for contingent liabilities (inadequate limits, procedures, approval processes and reporting requirements, thus an easy escape from the budget constraints)
The fiscal framework was short-term and did not require to discuss contingent liabilities
No risk awareness and no risk-sharing No reserve requirement and alternative ways of
“hidden” borrowing
Recent country advances
Australia, Czech R. and New Zealand: Transparency
Statement of contingent liabilities show face values and discuss risks
Hungary and South Africa: Medium-term outlook Official medium-term fiscal projections and MTEF reflect
expected outlays on contingent liabilities
United States: Budgeting for credit guarantees Budget and the reported deficit reflect on present value of
the expected cost of newly issued credit guarantees
Canada and the Netherlands: Joint sector ceilings
Expenditures and guarantees are subject to a single budget ceiling for each sector (sectors are cash-neutral)
Present value of expected fiscal cost is transferred from the sectoral budget allocation to a central reserve fund
Sweden and Colombia: Risk management Debt office is responsible for risk analysis of proposed
contingent liabilities and for the risk management of both contingent and direct liabilities outstanding
Debt office collects fees from guarantee beneficiaries to build reserves
Beyond transparency
For contingent government liabilities consider expected fiscal effects and integrate with
the medium-term fiscal outlook consider effectiveness in the context of policy
priorities and budget allocations consider efficiency (as a form of government
support and source of government risk exposure)
Some questions to ask:
Before assuming an obligation What form of government involvement? (deregulation,
subsidy, contingent support, benefits and risks of alternative forms)
How to design the program to cover only justifiable risks and to minimize moral hazard? (fit with policy priorities)
How to price the contingent liability? What would be the marginal risk added to the overall
government risk exposure? (ALM approach, possible future fiscal effects)
When obligation is held
How to disclose, budget, and account for the potential fiscal cost? (implicit subsidy)
How to monitor the program risk factors? (moral hazard) How to manage the risk? (portfolio approach, reserve
requirement, hedging possibilities, purchase of reinsurance)
How to manage reserves to ensure reserve adequacy and avoid misuse?
After obligation falls due
How to execute the obligation to minimize its fiscal cost and moral hazard implications?
When to accept an implicit obligation? (the fit with policy priorities, moral hazard impact)
How to build accountability for dealing with contingent liabilities? (the role of performance management and independent audit)
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