GET Note: Contingent Liability Risks from SOEs "Recently Asked Questions" Series June 2009 53456 Contingent Liability Risks from State-Owned Enterprises What are the key principles to emphasize in addressing contingent liabilities of poorly performing state-owned enterprises (SOEs) and parastatals? INTRODUCTION Countries across all continents face the challenge of managing contingent liabilities arising from multiple sources, including state-owned enterprises, parastatals, off-budget financing arrangements, civil servant entitlement schemes etc. The current financial crisis has made countries even more vulnerable to the severe impact of contingent liabilities on government finances, creating an urgent need to institutionalize systems to control and mitigate fiscal risks arising from these contingent liabilities. This note captures the technical advice provided by the PSP GET in response to a just-in-time request by Bank staff working with government officials in a Middle- Eastern country to manage contingent liability risks arising from state-owned enterprises (SOEs). What are the key principles The financial crisis in this case posed two distinct challenges. One, a large number of off-budget and that should be emphasized contingent liabilities have emerged--mainly from in response to government SOEs--creating considerable unforeseen costs for the concerns about contingent government. Second, there is a need to reassure financial markets that the country takes public fiscal liabilities emerging from and corporate governance seriously. The financial poorly performing state- crisis is creating considerable impetus for reform in the area of public financial management and opening owned enterprises (SOEs)? doors for more far reaching governance reforms. SUMMARY OF ADVICE: In essence, reform strategies should bring SOEs into more transparent arrangements and to control, or otherwise limit, the financial exposure that such entities can undertake. For some entities, this may involve fully integrating them into the budget, while for others placing them within a broader holding company or otherwise ensuring that their holdings are audited regularly would be the solution. GET Notes ­ Recently Asked Questions Series intends to capture the knowledge and advice from individual engagements of the World Bank's Global Expert Team on Public Sector Performance (PSP GET). The views expressed in the notes are those of the authors and do not necessarily reflect those of the World Bank. For more information about the PSP GET, contact the GET team leaders Bill Dorotinsky (wdorotinsky@worldbank.org) and Nick Manning (nmanning@worldbank.org) or go to http://knowledge.worldbank.org/public-sector-performance-get . JUNE 2009 The World Bank First, get a clear picture of the magnitude of the problem the government is confronting. This would involve conducting an inventory of state enterprises and parastatals, their assets and liabilities, and flagging assets and liabilities whose value is unknown and or highly speculative. Particular attention should be put on the banking and real estate sectors, which for many countries enjoys markedly less oversight and weaker regulatory environment than other sectors. Next, a classification of the risks faced should be undertaken, including establishing the boundaries or parameters of fiscal risk in the form of low and high-end estimates. Based on the risk identification and classification, a range of strategies that acknowledge the political economy issues should be devised--and employed on a case-by-case basis--to mitigate against these risks. GUIDING PRINCIPLES: PRINCIPLE 1: Know the nature and scope of the problem GUIDING PRINCIPLES: Conduct an inventory of all SOEs. Unfortunately, some countries do not Know the magnitude of the have a clear picture of how many problem; SOEs exist, as each ministry is able create them at will (sometimes they Put in place viable length are used as an extra-budgetary fund to governance principles for State- owned Enterprises; `park' budget resources) or they can be created by sub-national Create transparent arrangements governments (where they might take for loan guarantees; on domestic and external debt without oversight). Incorporate fiscal risk assessment in policy discussions and budgeting processes. Quickly review a given country's capacity for debt management, identifying how the office is structured and managed, staff training and capacity needs, performance targets and other elements. PRINCIPLE 2: Put in place viable arms' length governance principles for State-owned Enterprises Getting the governance arrangements right for public commercial and non- commercial business operations is essential. The state should place at arms' length its enterprise interests and attempt to limit public exposure (for the value of its equity in the business). JUNE 2009 Put in place clear and consistent accounting standards for the SOEs, consistent with IPSAS/IFAC international standards, and requirements for regular financial reporting, auditing of year-end financial statements, and transparency through public annual reports. To improve transparency, the balance sheets of SOEs could be added as an informational annex to the budget. Ensure clear arrangements for oversight of SOE finances. One example is to have a unit in the treasury responsible for SOE oversight, which includes monthly monitoring of all SOE balance sheets, and with a mandate to intervene before financial trouble arises to avoid hitting the central government balance sheet. Clear identification of quasi-fiscal activity (non-commercial activity) required by government. That is, incorporate in the annual budget quasi- fiscal activity transfers for SOEs, including general subsidies and new requested guarantees by SOEs. Hence, making these decisions subject to transparency and explicit risk assessment. PRINCIPLE 3: Create transparent arrangements for loan guarantees Show all loan guarantees in an annex to the budget documentation. Information should at a minimum specify: i) name of beneficiary; ii) lending institution; iii) amounts to be paid per year, including the final principal payment; and iv) the purpose of the guarantee. Collect information on loan guarantees for X number of previous years to estimate risks, construct a frequency distribution of default rates and analyze the assembled information for default rates in different sectors, liquidity exposure by year, repeater borrowers and other relevant categories. Value the loan guarantees (where it is possible) using a variety of methodologies available, for example, by creating an upper and lower band via a simulation. Include ­ eventually ­ a contingency in the budget for payment of guarantees. Initially, the contingency may be based on rough estimates but over time, as data on default risks becomes more comprehensive, a more precise estimate can be developed. JUNE 2009 PRINCIPLE 4: Incorporate fiscal risk assessment into policy discussions and budgeting processes Other contingent liabilities may not appear to be quite as risky as loan guarantees, however, the financial crisis may be an opportune moment for governments to perform an overall assessment of fiscal risk, including the structure of entitlements. Establish tracking mechanisms to provide comprehensive and timely data to inform budgeting and policy formulation. An entity, such as a public debt management office, should be given the responsibility for tracking key indicators related to the guarantees. Once established, in the context of annual budgeting, the legislature/executive could set ex ante limits on the amount of guarantees that can be issued, depending on the fiscal situation and resource estimates. In one country, each new guarantee had to be approved by parliament, and the total transparency substantially reduced requests for new guarantees. Be transparent about recording contingent liabilities. Some contingent liabilities are easy to value, while others are not. At the very least liabilities should be recorded and made transparent. Where they are of a contractually known nature, such as a guaranteed loan, they should be recorded in all their glory. In early pre-budget statements or policy documents, some government discussion of the problem, and the policies being put in place to manage it, will do much to give confidence to markets. FURTHER READING MATERIALS AND REFERENCES: Cebotari, Aliona, Contingent Liabilities: Issues and Practice (October 2008). IMF Working Papers, Vol. , pp. 1-60, 2008. Flanagan, Mark J., Resolving a Large Contingent Fiscal Liability: Eastern Europe Experience (July 2008). IMF Working Papers, Vol. , pp. 1-40, 2008. Polackova, Hana and Allen Schick. Government at Risk: Contingent Liabilities and Fiscal Risk (2002). World Bank, Oxford University Press. Polackova, Hana, Contingent Government Liabilities: A Hidden Risk for Fiscal Stability (October 1998). World Bank Policy Research Working Paper No. 1989. World Bank, PREM Note: Contingent Liabilities ­ a threat to fiscal stability (November 1998). JUNE 2009 SELECTED EXPERTS ON THE TOPIC: Jim Brumby, Lead Public Sector Specialist, PRMPS (jbrumby@worldbank.org). Bill Dorotinsky, Lead Public Sector Specialist, ECSPE (wdorotinsky@worldbank.org). Salvatore Schiavo-Campo, Consultant (sschiavocampo@worldbank.org) Robert Beschel, Lead Public Sector Specialist, MNSED, (rbeschel@worldbank.org) JUNE 2009