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

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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,

...

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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)