Fiscal Transparency and Public Contingent Liabilities

Sudarshan GooptuLead EconomistPoverty Reduction and Economic Management Sector UnitEast Asia and Pacific RegionWorld Bank

Presentation at World Bank Workshop on “Fiscal Transparency and Data Management”, Washington, DC.December 4-7, 2006.

Lessons from Cross-Country Experiences

Contingent Liabilities

DefinitionObligations for the government that materialize if a particular event occurs⌧e.g. financial guarantees on borrowings by sub-national

entities.The risks involved in on-lending are very much like risks involved with government guarantees

Contingent claimsMoral Hazard: The willingness to take risks on the part of the borrower can be excessiveThe risks involved must be controlledGuarantees are often off-budget

Why worry about Contingent Liabilities?

Governments face increasing risks and uncertainties• Trends toward greater fiscal vulnerability:

increasing volatility of international capital flowstransformation of the state from financing public

service delivery to guaranteeing private sector provision• Fiscal opportunism under deficit targets:

conceal state support and its fiscal cost• Moral hazard in the markets:

markets expect government support in cases of failure

Fiscal risks in emerging-market economies are particularly large and costly

• Market institutions are weak• Inadequate information disclosure - investors do not

fully understand the risks• Disciplining effect of financial markets is weak• Governments have history of bail-outs• Moral hazard and possible failures in the markets are

large• Government has limited access to borrowing

“Fiscal Risk Matrix”to identify future financing pressures on Central

Government

L ia b ilitie s D irect(p red ic tab le )

C o n tin g en t(if a p a rticu la rev en t o ccu rs)

E x p lic itR eco g n ized b yg o v ern m en t lawo r co n trac tIm p lic itG o v ern m en tm o ra l o b lig a tio n ,p u b licex p ec ta tio n ,in te res t g ro u pp ressu re

Cataloguing the various types of fiscal risks is not an end in itself, but a means of enabling governments to manage the risks they take.

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)

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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 sub-national governments and public/private entitiesUmbrella guarantees for various loans (mortgage loans, student loans, agriculture loans, small business loans)State guarantees on private investments, trade, exchange rateState insurance schemes (deposit insurance, minimum returns from private pension funds, crop insurance, flood insurance, war-risk insurance)

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Contingent and Implicit

Default of a sub-national government and public/ private entity on non-guaranteed debt/obligationsBank failure (support beyond state insurance)Clean-up of liabilities in entities being privatizedFailure of non-guaranteed pension/social security fundsDefault of central bank on its obligations (foreign exchange contracts, currency defense, BOP)Collapses due to sudden capital outflowsEnvironmental recovery, disaster relief, war/military, ...

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Australia’s State of Victoria

Canada’s Ontario ProvinceIndia’s State TripuraUnited Kingdom’s England and Wales - publish a list of the sources of their risk exposure- discuss the nature, sensitivities and possible financial implications

of the risks - provide face value and/or estimates of future possible fiscal cost.

At the central government level, good practice is pursued particularly by Australia, Canada, Czech Republic, Netherlands, New Zealand, South Africa, United Kingdom, and the United States.The IMF’s Manual on Fiscal Transparency sets a good model.

International experience of effective risk disclosure

Some Examples of fiscal risk Some Examples of fiscal risk matrices in East Asian Countriesmatrices in East Asian Countries……

Fiscal Risk Matrix for the Philippines

Bail out of failed banksPossible default of the central

bank Support to public enterprises

for covering losses or assuming non-guaranteed obligations

Future cost overruns or recurrent costs of public investment projects

ImplicitA moral obligation of the govt. due to public or interest group pressures

Govt. guarantees for GOCC loans

Govt. guarantees given to the operators of the BOT projects

Umbrella guarantees for loans given to the priority sectors

Guarantees on benefits of the social security system

Sovereign debtExpenditures approved in

the BudgetFuture legally-binding

expenditures (pensions and provident funds)

ExplicitGovt. liability by law or contact

Contingent (obligation if a particular event occurs)

Direct (obligation in any event

Liabilities

INDONESIASources of Fiscal Risk Exposure

Guarantees to protect depositors in and creditors to the bankingsystemSovereign guarantees on insured credits to private infrastructure providers, for instance, in the provision of Toll Roads and withIPPs in the Power sectorObligations of minimum pension payments, and Guarantee schemes to the private sector (some of which were instituted since the crisis to restore the flow of credit)Off-balance sheet obligations of public sector corporations, which ultimately are the obligations of the Government

THAILANDSources of Fiscal Risk Exposure

Guaranteed debt of state-owned enterprisesObligations of FIDF and future recapitalization needs in the banking sector Financing needs under programs of price support and price control (SOEs, EBFs)Losses, non-guaranteed obligations, arrears and deferred maintenance of SOEsPossibly negative net worth of BOTFuture possible commitments and obligations of sub-national government

THAILANDOther Sources of Fiscal Risks

Example: State Railway of Thailandoperating losses (4 billion expected in 2000)reported liabilities (35 billion in 1999)deferred maintenance (20 billion remaining track rehabilitation)arrears (fuel cost to PTT)total obligations to be covered are over 60 billion baht (on top of future losses)

Therefore, the guaranteed debt is not all.

Contingent Liabilities in the Chinese Context

The use of specialized Municipal Corporations (MCs) or Urban Development Investment Corporations (UDICs) is common practice to finance infrastructure in China.These quasi-government entities are playing a primary role in the infrastructure-led growth of Chinese cities. The market borrowings of these entities may often carry the implied guarantee of the sponsoring government (local or national), even when the authorities make an explicit declaration that it will not honor the debt of the UDIC.The market perceives that the Government will step in and not let the UDIC default.

EXAMPLE

Other Sources of Fiscal Risks Exposure in China

Banking Sector (Implicit liabilities, e.g. NPLs)Pension Liabilities (Implicit liabilities)Foreign public and publicly guaranteed debt (Explicit liabilities)Private participation in Infrastructure Projects (implicit liabilities, sometimes explicit at sub-national level.)

Source: Krumm, Kathie and Christine Wong, Government Fiscal Risk Exposure in China. Chapter 10 in “Government at Risk” by Hana Brixi and Allen Schick (eds.), World Bank, Washington DC. 2002.

Lessons from International Experiences

Need a Centralized Unit in Government for:-- Identification and measurement of CLs-- Policy formulation for issue of CLs-- Determination of guarantee fees-- Designing of CL instruments-- Monitoring risk exposures

Some countries have established a Contingent Liability Redemption Fund (an on-budget item)DO NOT provide any automatic guaranteesPrescribe limits on Sovereign guarantee issuance

Lessons from International Experiences (contd.)

Establish sound risk sharing arrangements among government, operators, insurance companiesPromote sound corporate governanceImprove the supervision and regulation of SOEsMaintain macro-economic stabilityEstablish/strengthen appropriate legal, regulatory and institutional set-upSet up an independent Public Debt Management OfficeStrengthen capability in Government for Contingent Liability Management

Institutions to Enhance Fiscal Transparency

Formulate single strategy for all State agencies dealing with contingent external liabilitiesEnsure strong coordination between public debt management and monetary policyStandardize across all State agencies:

Methods for the valuation of contingent risksRules for the use of financial engineering toolsMonitoring and evaluation procedures

Transparency strengthens creditworthiness

a database of local government direct and contingent obligations

adequate institutional capacity, including the capacity to gather relevant information and understand risk exposures

for internal disclosure, an adequate enforcement mechanism, including supportive legal environment (for instance, with respect to local government reporting on their direct and contingent obligations to the central government)

for public disclosure, local governments should agree (or the central government may need to issue rules) on what information the make public

Prerequisites for disclosure and adequate risk awareness at the local level

Beyond transparency

For contingent government liabilitiesconsider expected fiscal effects and integrate with the medium-term fiscal outlookconsider effectiveness in the context of policy priorities and budget allocationsconsider efficiency (as a form of government support and source of government risk exposure)

Some questions to ask:

Before assuming an obligationWhat 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)What is the most likely and maximum likely future fiscal cost? ……………. DMOWhat would be the marginal risk added to the overall government risk exposure? (ALM approach, possible future fiscal effects) ………………DMO

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) ……. DMO

• How to manage reserves to ensure reserve adequacy and avoid misuse? …….. DMO

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)

In Conclusion

In the context of fiscal transparency, turn focus from “level” of contingent liabilities to “risks” associated with them.These “Risks” may entail fiscal, financial and politicalcosts, among others. Contingent liabilities may not be preferable but are a reality that all Governments have had to face.Issue CLs to improve efficiency of service delivery not just financial cost minimization objectives.Try to understand the sources of risks but also incentives guarnatees/credit enhancements may create to those who get them and precedence it may cause.