Contingent Liabilities and Debt Management Strategy

1. Contingent Liabilities and Debt Management Strategy 6th UNCTAD Debt Management Conference Geneva November 19-21, 2007 Udaibir S. Das Division Chief Sovereign Asset and Liability Management Division Monetary and Capital Markets Department IMF

2. Contingent Liabilities Significance Disclosure: Good practices Management and Debt Strategy Conclusions

3. Definition and Motivation Key aspects • Timing and amount of obligations contingent on the occurrence of some uncertain future • Event outside the control of the government • Explicit or implicit

4. Significance • Poses significant balance sheet risk • Governments increasingly assuming financial risks for society • Opportunistic use of CLs (guarantees) • Creative financing • Not just fiscal, but several often ignored negative spillovers • Often leads to large “hidden deficits” • fiscal balances and debt build up

5. Significance of contingent liabilities? Annual “Hidden” Deficits (percent of GDP)

6. Significance of contingent liabilities • Moral hazard • Transfer of risk to the government give rise to moral hazard • Particularly strong with implicit CLs • Expectations that government would intervene in the event of a crisis Past bailouts: Average cost 12.8% of GDP (40 sample episodes).

7. Contingent liabilities: New Challenges • Changing macroeconomic, financial and capital market landscape • Role of sub-nationals, and private sector debt • Capital market more discerning • Strengthening of debt management capacity • Transparency and disclosure

8. Disclosing CLs: Good Practices • Compiled and disclosed in budget documentation, fiscal reports and financial statements Exceptions: • Implicit CLs, to minimize moral hazard • Sensitive information • Implicit CLs should be made explicit if: • Strong prima facie evidence of a guarantee • A framework to avoid open-ended guarantees • Government is explicit when it will notstep in

9. Disclosing CLs: Good Practices • Disclosure statements should include: • Classification by major category • Fiscal significance of government’s CLs • Information on the past calls on the government • Information about reserve assets set aside against specific contingencies • A good practice to collate information on all fiscal risks into a single Statement

10. Managing CLs: Framework • CLs should be issued under the guidance of a well-articulated policy framework: • Justification • Design • Approval and Integration with Budget • Management and Analysis • A good example:“Guidelines for Issuing and Managing Indemnities, Guarantees, Warranties and Letters of Comfort”.

11. Managing CLs: Justification and Design When CLs are acceptable and preferable to other forms of support: • Market failure or administrative advantages • Risks borne by those best placed to manage them • Risk taken by government should be clearly identifiable • Risk sharing with private sector • Limiting scope and duration of CL

12. Managing CLs: Approval • Issuance of CLs (guarantees) integrated into the budget process and taken by parliament • Explicit CLs are similar to conventional debt • Budget for the cost of CLs, even if budget is cash-based • Legislature can set quantitative ceilings on CLs • Disclose CLs and risks in supporting budget documents to give parliament information • Sub national agencies? • Country Examples

13. Managing CLs: Budgeting • Fee reflecting the market cost of the guarantee should be charged ex-ante to the recipient • Prevents disguised expenditures • Recipient bears cost of the guarantee • State subsidy? • Margin over and above expected costs as a buffer for worse case scenario • Country Examples

14. Managing CLs: Budgeting • If subsidize, then market cost of guarantee charged against the budget • Acknowledges and internalizes cost of the decision • Ensures other expenditures are reduced • Removes bias in favor of guarantees • Guarantees often not the most efficient way to provide subsidies

15. Managing CLs: Contingency Funds • Resources should be set aside to meet future costs • Actual reserve funds: invest resources in managing these assets • Notional reserve funds: charges reduce gross debt if other spending is crowded out • Other financial tools to meet future costs (natural disasters): • Insurance and reinsurance • Calamity Funds/Contracting contingency credits • Allowing contingency margin in current budget

16. Managing CLs: Integration with DM • Risk management of entire stock of government debt, including contingent, should be centralized • Compilation and reporting of an inventory of CLs • If some debts are administered by specialized entities these should be reported to the DMO • Analysis and management of risk from contingent and non-contingent debts should be integrated

17. Managing CLs: Integration with DM • Limited role for debt managers in decisions to issue CLs .… • …. strong case for a bigger role • Price CLs • Separates the decision to issue guarantees from their pricing • Unbiased assessment of costs and risks • Specialized skills may be needed in project evaluation (PPPs) • Guidelines on contingent debts and principles for pricing

18. Managing CLs: Integration with DM • Expanding the management of public debt by integrating CL makes sense: • A latent form of public debt with a positive probability of becoming conventional debt; • Represents a potential claim on the Government’s balance sheet; and • Government’s overall fiscal/financial risks better assessed and managed

19. Managing CLs: Integration with DM Conventional debt portfolio “Potential” total public debt portfolio Explicit contingent debt portfolio Implicit contingent debt portfolio

20. Managing CLs: Integration with DM • But, some informational preconditions are needed: • Size (expected cost) of contingent liabilities • Financial risks associated with these contingent liabilities • “Easier” to quantify expected cost and risk associated with explicit than implicit ones

21. Conclusions • Increasingly important due to the implied vulnerabilities • Need to be properly identified and disclosed • Well managed, through: • Clear framework of CL instruments • Integration in the budget process • Integration with management of conventional debt

22. Four Issues Under Study • Systems for monitoring sub national and private sector debt and estimating its contingent nature • Use of financial derivatives to mitigate financial risks likely to arise from contingent debt • Role of debt audits and transparency • Managing CLs and its effects on CaR framework and debt strategies