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 ä Trends toward greater fiscal vulnerability: ä increasing volatility of international capital flows ä transformation of the state from financing services to guaranteeing private sector provision ä Fiscal opportunism under deficit targets: ä tendency to conceal fiscal activities ä Moral hazard in the markets: ä expectations of possible government help

Experiences with fiscal instability triggered by contingent liabilities ä Banking sector (A-L): Venezuela, Hungary, Cote d’Ivoire, Indonesia, South Korea, Thailand,... ä Local government liabilities: Argentina, Brazil ä State guarantees: Mexico (infrastructure projects), Korea (bank-enterprise loans), the United States (mortgage loans), Colombia (commodity prices) ä Central bank liabilities: Thailand and Malaysia (exchange rate guarantees) ä 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 Czech RepublicChileJordanIndonesiaBrazilCyprusPhilippinesRussiaArgentinaMalaysiaThailandKoreaUruguayMauritiusTunisiaSri LankaIsraelVenezuelaBahrainS AfricaPakistanHungaryTurkeyMexicoIndiaPoland Developed Countries AustriaFinlandNorwayAustraliaSpainUSASweden

Contingent liabilities relate to currency crises

Fiscal risks are large and costly when: ä Market institutions and information disclosure are weak - investors do not know the risks and the disciplining effect of financial markets is weak ä Moral hazard (history of bail-outs) and volatility in the markets ä Government has limited access to debt markets

Future financing pressures on central government: Fiscal Risk Matrix

Direct and Explicit ä Sovereign borrowing (foreign and domestic loans contracted and securities issued by central government) - amounts and risk structure (currency, maturity, floating rate, link to assets) ä Budgetary expenditures ä Expenditures legally binding in the long term (civil service salaries, civil service pensions)

Direct and Implicit ä Future public pensions if not required by law (implicit pension debt) ä Social security schemes if not required by law ä Future health care financing ä Future recurrent cost of public investment projects

Contingent and Explicit ä State guarantees for borrowing and obligations of subnational governments and public/private entities ä Umbrella guarantees for various loans (mortgage loans, student loans, agriculture loans, small business loans) ä State guarantees on private investments, trade, exchange rate ä State insurance schemes (deposit insurance, minimum returns from private pension funds, crop insurance, flood insurance, war-risk insurance)

Contingent and Implicit ä Default of a subnational government and public/ private entity on non-guaranteed debt/obligations ä Bank failure (support beyond state insurance) ä Clean-up of liabilities in entities being privatized ä Failure of non-guaranteed pension/social security funds ä Default of central bank on its obligations (foreign exchange contracts, currency defense, BOP) ä Collapses due to sudden capital outflows ä Environmental recovery, disaster relief, war/military,...

Financial FlowsGuarantees Ministry of Finance National Property Fund (NPF) Bonds Issued Ceska Inkasni (CI) Purchase of bad loans CSOB Refinancing Konsolidacni Banka (KOB) Borrowings and bonds issued Financial Market Corporate Sector Special Institutions Banks, enterprises, hospitals and other entities qualified for support Czech National Bank Ceska Financni (CF) Bad assets Payment for bad assets Refinancing Credit Government Redistribution credit Corporate & environment liabilities Example: The Czech Republic

Fiscal risks grew from poor institutions ä Little scrutiny was required for contingent liabilities (inadequate limits, procedures, approval processes and reporting requirements, thus an easy escape from the budget constraints) ä The fiscal framework was short-term and did not require to discuss contingent liabilities ä No risk awareness and no risk-sharing ä No reserve requirement and alternative ways of “hidden” borrowing

Recent country advances Australia, Czech R. and New Zealand: Transparency ä Statement of contingent liabilities show face values and discuss risks Hungary and South Africa: Medium-term outlook ä Official medium-term fiscal projections and MTEF reflect expected outlays on contingent liabilities United States: Budgeting for credit guarantees ä Budget and the reported deficit reflect on present value of the expected cost of newly issued credit guarantees

ä Canada and the Netherlands: Joint sector ceilings ä Expenditures and guarantees are subject to a single budget ceiling for each sector (sectors are cash-neutral) ä Present value of expected fiscal cost is transferred from the sectoral budget allocation to a central reserve fund Sweden and Colombia: Risk management ä Debt office is responsible for risk analysis of proposed contingent liabilities and for the risk management of both contingent and direct liabilities outstanding ä Debt office collects fees from guarantee beneficiaries to build reserves

Beyond transparency For contingent government liabilities ä consider expected fiscal effects and integrate with the medium-term fiscal outlook ä consider effectiveness in the context of policy priorities and budget allocations ä consider efficiency (as a form of government support and source of government risk exposure)

Some questions to ask: Before assuming an obligation ä What form of government involvement? (deregulation, subsidy, contingent support, benefits and risks of alternative forms) ä How to design the program to cover only justifiable risks and to minimize moral hazard? (fit with policy priorities) ä How to price the contingent liability? ä 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)