The World Bank
November
PREMnotes
1998
number 9
Economic Policy
Contingent liabilities—a threat
to fiscal stability
Many governments 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- policies, the probability of a contingency
ciated with major hidden fiscal risks. Thus occurring and the magnitude of the
fiscal adjustment that targets deficit and required public outlay are exogenous (such Any study of a
debt reduction does not necessarily prevent as a natural disaster) or endogenous (such
fiscal instability. Banking problems, for as implications of market institutions and country’s fiscal
example, have often unexpectedly drawn government programs for moral hazard
on public resources. in markets). position is
Fiscal risks and uncertainties are increas- Explicit liabilities are specific government
ing for four main reasons. Private capital obligations defined by law or contract. The incomplete if it
flows are increasing and becoming more government is legally mandated to settle
volatile. States are moving from financing such an obligation when it becomes due. skips over
services to guaranteeing outcomes. Moral Implicit liabilities represent a moral obliga-
hazard in markets is on the rise. And poli- tion or expected burden for the govern- obligations made
cymakers are engaging in fiscal oppor- ment not in the legal sense, but based on
tunism. Transition and emerging market public expectations and political pressures. by the government
economies face particularly large fiscal risks
because they depend on foreign financing Beyond the budget and debt outside the budget
and have opaque ownership structures, lim- Direct explicit liabilities are the main sub-
ited information disclosure, and weak reg- ject of conventional fiscal analysis. These
ulatory and enforcement systems. These liabilities include sovereign debt, expen-
shortcomings escalate financial and cor- ditures guided by budget law in the current
porate failures that in turn put pressure fiscal year, and expenditures over the long
on governments to offer bailouts. term for legally mandated items.
Thus any study of a country’s fiscal posi- Direct implicit liabilities often arise as
tion is incomplete if it skips over obligations a presumed consequence of public expen-
made by the government outside the bud- diture policies over the long term. Given
get. Fiscal risks are of four types: direct or their implicit nature, these obligations are
contingent, each of which is explicit or not captured in government balance
implicit (table 1). sheets—yet they are usually high for demo-
graphically driven expenditures. For exam-
A simple framework ple, in a public pay as you go scheme,
Direct liabilities are predictable obligations future pensions are a direct implicit lia-
that will arise in any event. Contingent lia- bility, the size of which reflects the
bilities are obligations triggered by a discrete expected generosity of and eligibility for
but uncertain event. Relative to government benefits and future demographic and eco-
f ro m the developm ent economics vice p res iden cy a nd pover t y re d u ct i o n a nd e co no mi c ma na ge me nt n e t w o r k
Table 1 Possible sources of fiscal risk for central governments
Direct liabilities Contingent liabilities
Explicit liabilities • Foreign and domestic sovereign debt • 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 (development banks)
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 other 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
• Environmental recovery, disaster relief, military
financing
Note: These liabilities refer to fiscal authorities, not the central bank.
nomic developments. In industrial coun- themselves from fees, such schemes redis-
tries estimated net public pension liabili- tribute wealth and rely on government
ties for 1995–2050 range from 5 percent financing.
of 1994 GDP (United Kingdom) to 114 Contingent implicit liabilities are not
percent (France). officially recognized until a failure occurs.
Contingent explicit liabilities legally The triggering event, the amount at risk,
oblige government to make a payment if a and the required government outlay are
specific event occurs. (For details on risks uncertain. In most countries the financial
specific to infrastructure, see PREMnote system is the most serious contingent
10.) Because their fiscal cost is invisible until implicit government liability. Markets
they are triggered, contingent explicit lia- expect government support far beyond
bilities represent a hidden subsidy, blur fiscal its legal obligation if financial stability is
analysis, and can drain future government at risk (figure 1). Fiscal authorities are often
finances. Nevertheless, government guar- also compelled to cover the uncovered
antees and financing through government- losses and obligations of the central bank,
guaranteed institutions are more politically subnational governments, state-owned or
attractive than budget support even if they large private enterprises, budgetary and
are more expensive later. Contingent gov- extrabudgetary agencies, and other insti-
ernment obligations can create immediate tutions of political significance.
moral hazard in markets, particularly if the Contingent liabilities grow with weak-
government guarantees all rather than part nesses in the financial sector, macroeco-
of the underlying assets, and all rather than nomic policies, regulatory and supervisory
selected political or commercial risks. State systems, and information disclosure. With
insurance schemes often cover uninsurable private capital flows, for instance, such weak-
risks of infrequent losses that are enormous nesses elevate risks of asset bubbles and over-
in magnitude. Thus, rather than financing borrowing.
Figure 1 Contingent government liabilities are especially high for bank bailouts
Thailand
China
Malaysia
Czech Republic
Korea, Rep. of
Japan
Lower-bound estimate
Egypt
Difference between
Brazil upper- and lower-bound
Mexico estimates The first step
Chile
Poland
toward fiscal
Argentina
stability is for
Hungary
0 10 20 30 40 50 60
policymakers to
Percentage of GDP
Source: Standard and Poor’s.
identify, classify,
Coercion to pursue fiscal discipline beyond
The value of certainty the budget and debt can be multifaceted. and understand
Contingent support programs have uncer- The ministry of finance and supreme audit
tain public financing requirements. Reserve institution may have the authority to publish the full range
funds reduce the potential harm when con- the size and attributes of contingent and
tingent liabilities are called but create other other fiscal risks, control the relationship of fiscal risks
problems. Thus governments should design between off-budget activities and policy pri-
programs that have less volatile financing orities, and increase the efficiency of direct
requirements and lower exposure to risk. and contingent forms of government sup-
Governments that are risk adverse, have lim- port. Disclosure of full fiscal information
ited capacity to manage risk, and cannot enables markets to analyze and measure fis-
borrow easily should abstain from contin- cal risks and so indirectly assist the govern-
gent support programs altogether. ment in risk assessment. The International
Monetary Fund (IMF) and World Bank can
Understanding, incentives, and contribute to fiscal stability by enforcing
capacity broader fiscal disclosure (for example, fol-
The first step toward fiscal stability is for lowing the IMF’s Fiscal Transparency Code)
policymakers to identify, classify, and under- and helping countries systematically address
stand the full range of fiscal risks (see table fiscal risks outside the budget and debt.
1). Understanding the consequences of
these risks will encourage policymakers to Reducing fiscal risks
avoid those that are bound to surface in a Fiscal analysis must factor in the cost of
politically meaningful timeframe. For risks implicit subsidies provided by contingent
beyond that timeframe, fiscally sound behav- support programs. For instance, arrears and
ior may depend on coercion. Policymakers other obligations of state-guaranteed and -
are more likely to make fiscally sound deci- owned institutions may claim public
sions if media, the public, investors, credit resources in the future. Moreover, the gov-
rating agencies, and multilateral institu- ernment may have taken advantage of some
tions understand the government’s fiscal institutions to finance and implement its
risks and if they punish the government for policies outside the budget system. Thus a
exposing the state to excessive risks and for string of years with a balanced budget and
concealing those risks. low public debt neither suggests that the
Table 2 Systemic measures to promote broad understanding of fiscal risks
on dealing with state guarantees and insur-
Fiscal policy Public finance institutions ance programs, and on the behavior of gov-
• Consider full fiscal performance • Internalize and disclose the full fiscal ernment-guaranteed and public agencies
beyond the budget and debt picture, including fiscal risks and subnational governments.
• Identify, classify, and analyze • Monitor, regulate, and disclose risks in Systemic measures to promote under-
all fiscal risks in a single portfolio the public and private sectors
standing of fiscal risks by policymakers, the
• Determine government’s optimal
risk exposure and reserve policy public, and markets are listed in table 2.
according to its risk preference and Steps to control fiscal risks on a program-
risk management capacity by-program basis are listed in table 3.
government has been fiscally prudent nor Agenda for the future
ensures future fiscal stability. Given the increasingly serious fiscal impli-
To identify potential fiscal pressures, con- cations of contingent government liabilities,
tingent fiscal risks should be analyzed in the World Bank and IMF should take sev-
order of significance, based on existing gov- eral steps. Analysis should be broadened of
ernment programs and promises. Analysis fiscal sustainability and of policies and insti-
that focuses on determinants of risks and tutions to address contingent fiscal risks.
ways of controlling government risk expo- Countries should be required to disclose
sure makes it possible to compare the costs information on their exposure to all types
of alternative government programs. of fiscal risk. And countries should be aided
Budget institutions should require gov- in reforming their analytical, policy, and insti-
ernment to treat noncash programs involv- tutional public finance frameworks to treat
ing contingent fiscal risks like any other contingent government support programs
spending item, and to make the potential as attentively as any spending program.
fiscal cost of off-budget programs visible in
advance. Accrual-based budget and account- Further reading
ing systems support fiscal discipline but Easterly, William. 1998. “When Is Fiscal
are not entirely sufficient or necessary. More Adjustment an Illusion?” World Bank,
crucial are rules on disclosure of fiscal risks, Washington, D.C.
Mody, Ashoka, and C.M. Lewis. 1997. “The
Table 3 Measures to control risk in individual programs Management of Contingent Liabilities: A
Risk Management Framework for National
Fiscal policy Public finance institutions
Governments.” In Timothy Irwin and oth-
Before accepting ers, eds., Dealing with Public Risk in Private
• Assess the fit with policies • Evaluate risks, estimate the potential
Infrastructure. Washington, D.C.: World Bank.
• Consider financial risks fiscal cost, and set additional reserve
• Announce program limits to minimize requirement Polackova, Hana. 1998. “Government
moral hazard • Design to minimize government risk Contingent Liabilities: A Hidden Risk
to Fiscal Stability.” Policy Research
When accepted
• Stick to set limits • Budget, account, and disclose the risk Working Paper 1989. World Bank,
• Monitor risk factors and reserve Washington, D.C.
adequacy
When executed This note was prepared by Hana Polackova (Public
• Execute within set limits • Compare and report the actual fiscal cost Sector Management Specialist, Europe and Central
• If implicit, assess the fit with policy relative to estimates, evaluate Asia, and Coordinator, Quality of Fiscal Adjustment
priorities and desired market performance, and punish failures Thematic Group). Please contact her (x30182) if
behaviors
This note series is intended to summarize good practice and key policy findings on
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
please contact the PREM Advisory Service at 87736.
Prepared for World Bank staff
you want to participate in the Quality of Fiscal
Adjustment Thematic Group, which focuses on
the analysis, management, and fiscal implications
of contingent government liabilities.