The orldBanknk World ~~~~~~~~NOVEMBER : 00 ~~~~~~~~~~~~~~~~~~~~~~~~1 9 9 8 NUMBER 9 IN ASSOCIATION WITH THE FINANCE, PRIVATE SECTOR, AND INFRASTRUCTURE NETWORK ECO N O M I C PO L I CY Contingent liabitities-a threat to fiscat stability Many govemments have faced serious fiscal instability as a result of their con- tingent liabilities. But conventional fiscal analysis fails to address contingent fiscal risks. What should be done? Contingent government liabilities are asso- the probability of a contingency occurring ciated with major hidden fiscal risks. Thus and the magnitude of the required public fiscal adjustment that targets deficit and outlay are exogenous (such as a natural dis- Any study of a debt reduction does not necessarily prevent aster) or endogenous (such as implications fiscal instability. Banking problems, for of market institutions and government pro- country's Fiscal example, have often unexpectedly drawn grams for moral hazard in markets). on public resources. Explicit liabilities are specific government position is Fiscal risks and uncertainties are increas- obligations defined by law or contract. The ing for four main reasons. Private capital government is legally mandated to settle incomplete if it flows are increasing and becoming more such an obligation when it becomes due. volatile. States are moving from financing Implicit liabilities represent a moral obliga- skips ove r services to guaranteeing outcomes. Moral tion or expected burden for the govern- hazard in markets is on the rise. And poli- ment not in the legal sense, but based on obligations made cymakers are engaging in fiscal oppor- public expectations and political pressures. tunism. Transition and emerging market by the government economies face particularly large fiscal risks Beyond the budget and debt because they depend on foreign financing Direct explicit liabilities are the main sub- outside the budget and have opaque ownership structures, lim- ject of conventional fiscal analysis. These ited information disclosure, and weak reg- liabilities include sovereign debt, expen- ulatory and enforcement systems. These ditures guided by budget law in the current shortcomings escalate financial and cor- fiscal year, and expenditures over the long porate failures that in turn put pressure term for legally mandated items. on governments to offer bailouts. Direct implicit liabilities often arise as a Thus any study of a country's fiscal posi- presumed consequence of public expendi- tion is incomplete if it skips over obligations ture policies over the long term. Given their made by the government outside the bud- implicit nature, these obligations are not cap- get. Fiscal risks are of four types: direct or tured in government balance sheets-yet they contingent, each of which is explicit or are usually high for demographically driven implicit (table 1). expenditures. For example, in a public pay as you go scheme, future pensions are a direct A simple framework implicit liability, the size of which reflects Direct liabilities are predictable obligations that the expected generosity of and eligibility for will arise in any event. Contingent liabilities are benefits and future demographic and eco- obligations triggered by a discrete but uncer- nomic developments. In industrial countries tain event. Relative to government policies, estimated net public pension liabilities for FROM THE DEVELOPMENT ECONOMICS VICE PRESIDENCY AND POVERTY REDUCTION AND ECONOMIC MANAGEMENT NETWORK Table 1 Possible sources of fiscal risk for central governments Direct liabilities Contingent liabilities Explicit liabilities * Foreign and domestic sovereign debt a Guarantees for borrowing and obligations of . Budget expenditures-both in the current fiscal subnational governments and public or private year and those legally binding over the long entities term (civil servant salaries and pensions) * Umbrella guarantees for various loans (mortgage loans, student loans, agriculture loans, small business loans) * Guarantees for trade and exchange rate risks . Guarantees for private investments * State insurance schemes (deposit insurance, private pension funds, crop insurance, flood insurance, war-risk insurance) Implicit liabilities * Future public pensions if not required by law * Defaults of subnational governments and . Social security schemes if not required by law public or private entities on nonguaranteed . Future health care financing if not required by law debt and otier obligations . Future recurrent cost of public investments * Liability clean-up in entities being privatized * Bank failures (support beyond state insurance) * Failures of nonguaranteed pension funds or other social security funds * Default of central bank on its obligations (foreign exchange contracts, currency defense) * Collapses due to sudden capital outflows a Environmental recovery, disaster relief, military financing Note: These liabilities refer to fiscal authorities, not the central bank. 1995-2050 range from 5 percent of 1994 GDP Contingent implicit liabilities are not offi- (United Kingdom) to 114 percent (France). cially recognized until a failure occurs. The Contingent explicit liabilities legally oblige triggering event, the amount at risk, and government to make a payment if a specific the required government outlay are uncer- event occurs. (For details on risks specific to tain. In most countries the financial system infrastructure, see PREMnote 10, "Private is the most serious contingent implicit gov- infrastructure, public risk.") Because their fis- ernment liability. Markets expect govern- cal cost is invisible until they are triggered, ment support far beyond its legal obligation contingent explicit liabilities represent a hid- if financial stability is at risk (figure 1). Fiscal den subsidy, blur fiscal analysis, and can drain authorities are often also compelled to cover future government finances. Nevertheless, the uncovered losses and obligations of the government guarantees and financing central bank, subnational governments, state- through government-guaranteed institutions owned or large private enterprises, budgetary are more politically attractive than budget and extrabudgetary agencies, and other insti- support even if they are more expensive later. tutions of political significance. Contingent government obligations can cre- Contingent liabilities grow with weaknesses ate immediate moral hazard in markets, par- in the financial sector, macroeconomic poli- ticularly if the government guarantees all cies, regulatory and supervisory systems, and rather than part of the underlying assets, and information disclosure. With private capital all rather than selected political or commer- flows, for instance, such weaknesses elevate cial risks. State insurance schemes often cover risks of asset bubbles and overborrowing. uninsurable risks of infrequent losses that are enormous in magnitude. Thus, rather than The value of certainty financingthemselvesfromfees, suchschemes Contingent support programs have uncer- redistribute wealth and rely on government tain public financing requirements. Reserve financing. funds reduce the potential harm when con- Figure i Contingent government liabilities are especially high for bank bailouts Thailand China Malaysia, Czech Republic - Korea, Rep. of - Japan .a-'-~ ~ ~ - i gs Lower-bound estimate Egypt . . _ * Difference between Brazil upper- and lower-bound Mexico estimates Chile Poland U Argentina Hungary _ 0 10 20 30 40 50 60 Percentage of GDP Source: Standard and Poor's. tingerit liabilities are called but create other between off-budget activities and policy pri- The first step problems. Thus governments should design orities, and increase the efficiency of direct programs that have less volatile financing and contingent forms of government sup- toward fiscal requirements and lower exposure to risk. port. Disclosure of full fiscal information Governments that are risk adverse, have lim- enables markets to analyze and measure fis- stability is for ited capacity to manage risk, and cannot cal risks and so indirectly assist the govern- borrow easily, should abstain from contin- ment in risk assessment. The International policymakers to gent support programs altogether. Monetary Fund (IMF) and World Bank can contribute to fiscal stability by enforcing identify, classify, Understanding, incentives, and broader fiscal disclosure (for example, fol- capacity lowing the IMF's Fiscal Transparency Code) and understand The first step toward fiscal stability is for pol- and helping countries systematically address icymakers to identify, classify, and understand fiscal risks outside the budget and debt. the full range the full range of fiscal risks (see table 1). Understanding the consequences of these Reducing fiscal risks of fiscal risks risks will encourage policymakers to avoid Fiscal analysis must factor in the cost ofimplicit those that are bound to surface in a politi- subsidies provided by contingent support callymeaningfultimeframe.Forrisks beyond programs. For instance, arrears and other that timeframe, fiscally sound behavior may obligations of state-guaranteed and -owned depend on coercion. Policymakers are more institutions may claim public resources in the likely to make fiscally sound decisions if media, future, or the government may have taken the public, investors, credit rating agencies, advantage of some institutions to finance and and multilateral institutions understand the implement its policies outside the budget sys- government's fiscal risks and if they punish tem. Thus a string of years with a balanced the government for exposing the state to budget and low public debt neither suggests excessive risks and for concealing those risks. that the government has been fiscally pru- Coercion to pursue fiscal discipline beyond dent nor ensures future fiscal stability. the budget and debt can be multifaceted. To identify potential fiscal pressures, con- The ministry of finance and supreme audit tingent fiscal risks should be analyzed in institution may have the authority to publish order of significance, based on existing gov- the size and attributes of contingent and ernment programs and promises. Analysis other fiscal risks, control the relationship that focuses on determinants of risks and Table 2 Systemic measures to promote broad understanding of fiscal risks public, and markets are listed in table 2. Fiscalpolicy Publicfinance institutions Steps to control fiscal risks on a program- * Consider fuU fiscal performance . Internalize and disclose the full fiscal by-program basis are listed in table 3. beyond the budget and debt picture, including fiscal risks * Identify, classify, and analyze * Monitor, regulate, and disclose risks in Agenda for the future all fiscal risks in a single portfolio the public and private sectors G * Determine government's optmal risk exposure and reserve policy cations of contingent government liabilities, according to its risk preference and the World Bank and IMF should take sev- risk management capacity eral steps. Analysis should be broadened of fiscal sustainability and of policies and insti- ways of controlling government risk expo- tutions to address contingent fiscal risks. sure makes it possible to compare the costs Countries should be required to disclose of alternative government programs. information on their exposure to all types Budget institutions should require gov- of fiscal risk. And countries should be aided ernment to treat noncash programs involv- in reforming their analytical, policy, and insti- ing contingent fiscal risks like any other tutional public finance frameworks to treat spending item, and to make the potential contingent government support programs fiscal cost of off-budget programs visible in as attentively as any spending program. advance. Accrual-based budget and account- ing systems support fiscal discipline but Further reading are notentirelysufficientornecessary. More Easterly, William. 1998. "When Is Fiscal crucial are rules on disclosure of fiscal risks, Adjustment an Illusion?" World Bank, on dealing with state guarantees and insur- Washington, D.C. ance programs, and on the behavior of gov- Mody, Ashoka, and C.M. Lewis. 1997. "The ernment-guaranteed and public agencies Management of Contingent Liabilities: A and subnational governments. RiskManagementFrameworkfor National Systemic measures to promote under- Governments." In Timothy Irwin and oth- standing of fiscal risks by policymakers, the ers, eds., Dealing with Public Risk in Private InftrastuctureuWashington, D.C.: World Bank. Polackova, Hana. 1998. "Government Con- Table 3 Measures to control risk in individual programs tingent Liabilities: AHidden Risk to Fiscal Fiscal policy Public finance institutions Stability." Policy Research Working Paper Before accepting 1989. World Bank, Washington, D.C. e Assess the fit with policies * Evaluate risks, estimate the potential * Consider financial risks fiscal cost, and set additional reserve This note was written by Hana Polackova (Public * Announce program hmits to minimize requirement SectorManagement Specalist, Europe and Centra moral hazard * Design to minimize government risk sicoranagement Sealis opesandjCentral Asia, anzd Coordinato; Quality of FiscalAdju>stment VMhen accepted Thematic Group). * Stick to set limits . Budget, account, and disclose the risk Ifyou are interested in similar topics, consider * Monitor risk factors and reserve £ adequacy joining the Quality ofFiscalAdjustment Thematic Mhen executed Group, which focuses on the analysis, manage- * Execute within set limits * Compare and report the actual fiscal cost ment, andfiscal implications of contingent gov- * If implicit, assess the fit with policy relative to estimates, evaluate ernment liabilities. (Contact Hana Polackova, priorities and desired market performance, and punish failures x30182, or click on Thematic Groups on behaviors PREMnet.) This note series is intended to summarize good practice and key policy findings o03 PREM-related topics. PREMnotes are distributed widely to Bank staff and are also available on the PREM website (http://prem). If you are interested in writing a PREMnote, email your idea to Asieh Kehyari. For additional copies of this PREMnote Poay, PeAfaMa n please contact the PREM Advisory Service at 87736. Prepared for WN'orld Bank staff