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 not step in

9
Disclosing CLs Good Practices

• Disclosure statements should include
• Classification by major category
• Fiscal significance of governments 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 Governments
  balance sheet and
• Governments 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