Government at Risk

Governmentat Risk

Hana Polackova BrixiAllen Schick

editors

A COPUBLICATION OFTHE WORLD BANK ANDOXFORD UNIVERSITY PRESS

contingent liabilitiesand fiscal risk

© 2002 The International Bank for Reconstruction and Development /The World Bank1818 H Street, NWWashington, DC 20433

All rights reserved.

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A copublication of the World Bank and Oxford University Press.

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v

Contents

Foreword ixNick Stern, Senior Vice President and Chief Economist,

World BankGobind Nankani, Vice President, World Bank

Acknowledgments xi

Introduction 1Hana Polackova Brixi, World Bank,and Allen Schick, University of Maryland

Part I Learning to Deal withFiscal Risks in Government Portfolios

possible analytical and institutional frameworks

1. Dealing with Government Fiscal Risk: An Overview 21Hana Polackova Brixi, World Bank,and Ashoka Mody, IMF

2. Accounting and Financial Accountability to Capture Risk 59Murray Petrie, The Economics and Strategy Group

3. Budgeting for Fiscal Risk 79Allen Schick, University of Maryland

4. Institutional and Analytical Framework for Measuringand Managing Government’s Contingent Liabilities 99Suresh M. Sundaresan, Columbia University

5. Analytical Techniques Applicable to GovernmentManagement of Fiscal Risk 123Krishna Ramaswamy, the Wharton School

6. Fiscal Sustainability and a Contingency Trust Fund 143Daniel Cohen, Université de Paris,École Normale Supérieure

7. A Framework for Assessing Fiscal Vulnerability 159Richard Hemming, IMF, and Murray Petrie,The Economics and Strategy Group

country examples

8. Evaluating Government Net Worth inColombia and Républica Bolivariana de Venezuela 181William Easterly and David Yuravlivker, World Bank

9. The Challenges of Fiscal Risks in Transition:Czech Republic, Hungary, and Bulgaria 203Hana Polackova Brixi, World Bank, Allen Schick,University of Maryland, and Leila Zlaoui, World Bank

10. Analyzing Government Fiscal Risk Exposure in China 235Kathie L. Krumm, World Bank, and Christine P.Wong,University of Washington

11. Dealing with Contingent Liabilities inIndonesia and Thailand 251Hana Polackova Brixi, World Bank,and Sudarshan Gooptu, World Bank

12. Dealing with Contingent Liabilities in Colombia 269Juan Carlos Echeverry, Verónica Navas, Juan CamiloGutierrez, and Jorge Enrique Cardona,Government of Colombia

Part II Dealing with SpecificSources of Government Fiscal Risk

analytical and managerial tools

13. Pension Guarantees: A Methodology for AssessingFiscal Risk 283George G. Pennacchi, University of Illinois

vi contents

contents vii

14. Measuring and Managing Government ContingentLiabilities in the Banking Sector 311Stijn Claessens, University of Amsterdam,and Daniela Klingebiel, World Bank

15. Government Insurance Programs:Risks and Risk Management 335Ron Feldman, Federal Reserve Bank of Minneapolis

16. Contingent Liabilities of the Central Bank:Analyzing a Possible Fiscal Risk for Government 355Mario Blejer, Central Bank of Argentina,and Liliana Schumacher, IMF

practice

17. Contingent Liabilities in Infrastructure:Lessons from the East Asian Financial Crisis 373Ashoka Mody, IMF

18. Monitoring Fiscal Risks of Subnational Governments:Selected Country Experiences 393Jun Ma, Deutsche Bank

19. Guarantees as Options: An Evaluation of ForeignDebt Restructuring Agreements 419Sweder van Wijnbergen, University of Amsterdamand the Centre for Economic Policy Research,and Nina Budina, World Bank

20. The Fiscal Risk of Floods: Lessons of Argentina 451Alcira Kreimer, World Bank

Conclusion: Toward a Code of Good Practiceon Managing Fiscal Risk 461Allen Schick, University of Maryland

Foreword

In public finance, it no longer suffices for analysts and institutionsto focus solely on budget revenues and expenditures. Recent historydemonstrates that fiscal performance and, in turn, economic develop-ment can be seriously disrupted by the sudden, unexpected costs ofhidden contingent liabilities and other unanticipated fiscal risks.

During the second half of the 1990s, unreported contingent liabili-ties and related fiscal risks contributed to economic crises and disruptedgrowth in a number of developing countries, motivating stepped-upefforts at the World Bank to devise new concepts and tools for analyz-ing and managing public finance. With the aim of improving the analy-sis of fiscal risks and supporting policy advice in this area, the EconomicPolicy Unit of the Bank’s Poverty Reduction and Economic Manage-ment Network established the Quality of Fiscal Adjustment ThematicGroup. This book was produced as part of the effort by this ThematicGroup to promote new thinking about public finance.

We now know that conventional frameworks for fiscal analysis thatconcentrate on direct, explicit liabilities fail to address contingent fiscalrisks. For example, fiscal sustainability analysis that focuses, as is typi-cally the case, on the officially reported budget deficits fails to detectpossible future increases in government debt and payments that mayemerge from both explicit and implicit government guarantees on en-terprise credit, state insurance schemes, exchange rate guarantees, andcommitments to assist failed banks. Similarly, the government budgetprocess and documentation generally fail to scrutinize the substantialclaims on public resources that are associated with contingent liabili-ties, realized and potential.

This book is a notable step forward in filling gaps in our under-standing of fiscal risks and in developing suitable frameworks for man-aging them. Through country cases and advances in conceptual design,the book provides a menu of practical ideas for policymakers andscholars for bringing fiscal risk within the ambit of public finance. Itdemonstrates that government fiscal analysis needs to cover the entire

ix

portfolio of direct and contingent liabilities, as well as assets and therevenue base. This in turn requires the government to identify, classify,and assess its fiscal risks so that it can provide reliable estimates of futurepayments that may ensue from past and pending liabilities. Only by iden-tifying and measuring its exposure can a government bring its risks un-der effective control. This task has been facilitated by the availability ofnew methodologies, such as value-at-risk analysis and options pricing.But despite these advances, governments still face technical challenges indealing with risk. However, the greater challenges are political and infor-mational. Governments must care enough about fiscal and economic per-formance beyond the short term to impose limits on future risk-takingand to invest resources in identifying and controlling fiscal risks.

The essential challenge for governments is to launch a full and forth-right effort to avoid excessive risk-taking and to prudently manage therisks that they do take. Doing so typically requires governments to com-mit themselves to greater transparency and broader fiscal disciplinethan they have had in the past.

The benefits for governments that make the effort are enormous,not only with respect to their future fiscal stability, but also with re-spect to their capacity to achieve broader policy objectives. The ideasand cases presented in this book should prompt governments to under-take this effort.

At the World Bank, the analysis and control of fiscal risks has nowbecome an integral part of its assistance to member countries. Workingclosely with policymakers, the Bank tailors its analytic support andpolicy advice to country-specific circumstances, taking into account thetechnical challenges (few countries have a reasonably complete inven-tory of government contingent liabilities and other fiscal risks), the in-stitutional set-up (fiscal and quasi-fiscal institutions and relationships),and the political sensitivity of the issues (a full accounting of fiscal risksoften shows a government to be in a less favorable financial conditionthan is reported in official statements).

There is no single approach to dealing with contingent liabilities andfiscal risk. As the studies in this book indicate, governments that havesought to control their risk exposure have taken several different ap-proaches. This book points the way ahead by setting out general prin-ciples of sound fiscal management and by providing specific examplesof innovative country practices.

Nicholas H. Stern Gobind T. NankaniSenior Vice President Vice President and Head of Network

Development Economics Poverty Reduction and Economicand Chief Economist Management Network

The World Bank The World Bank

x foreword

Acknowledgments

We would like to express our sincere gratitude to all the distin-guished authors for their valuable contributions to this book. We alsothank our many colleagues and friends who provided helpful adviceand suggestions. We acknowledge in particular the support and feed-back on the papers that we received from the Quality of Fiscal Adjust-ment Thematic Group (QFA TG) of the Economic Policy division ofWorld Bank’s Poverty Reduction and Economic Management (PREM)Network. Assistance from other World Bank staff, staff of other inter-national institutions, government officials, academics, and researchers,who provided valuable feedback on earlier drafts of the chapters, isalso gratefully acknowledged. Finally, we would like to thank the anony-mous reviewers of this book whose challenging comments and sugges-tions have greatly improved this text.

We acknowledge with thanks the financial support we received forthis book and related research and dissemination from the EconomicPolicy division of World Bank’s PREM Network through the QFA TG.Support received from the Public Expenditure Thematic Group of thePublic Sector Division is also gratefully acknowledged.

The views expressed in this book are those of the authors and shouldnot be attributed to any particular institution, including institutionswith which individual authors may be associated, including the WorldBank, International Monetary Fund, the Federal Reserve System, andothers.

xi

1

introduction

Government at Risk:Contingent Liabilities

and Fiscal Risks

Hana Polackova BrixiWorld Bank

Allen SchickUniversity of Maryland

One does not have to search far to see evidence of governments atrisk. In some countries, a long spell of seemingly sound fiscal manage-ment was followed by a fast-moving crash that forced the governmentto spend unbudgeted resources to pay obligations that few knew ex-isted. When economic conditions stabilized, the government was leftwith elevated levels of debt and other obligations. Similarly, in othercountries government debt soared much faster than the official deficitwould have suggested, because the government was compelled to makegood on obligations that had been assumed to be outside the budget-ary framework. Today, in still other countries, the public finances arefacing a difficult future as the off-budget obligations accumulated inthe past come due in the decades immediately ahead. In all these sce-narios, governments at risk have faced or are facing major fiscal chal-lenges as a result of their contingent liabilities, which tend to remainoutside the framework of conventional public finance analysis andinstitutions.

When risks come due in developed countries, they impose costs ongovernment budgets and sometimes temporarily reduce economic out-put. When governments in less-affluent countries take imprudent risks,the effects of such risks may spread quickly across the economy, cause

2 brixi and schick

capital to flow out to safer havens, possibly compel the government tochange economic course, and so retard or even reverse the country’sdevelopment. Moreover, if the mechanisms for information disclosureare weak and market institutions not well developed, the risks assumedby government generate a bias in the behavior of economic agents andmoral hazard in the markets, and thus work against development evenbefore they are realized.

In many countries, the reality or prospect of unbudgeted fiscal riskscoming due has been a wakeup call to extend fiscal management be-yond the budget to all actions and transactions that put the govern-ment in financial jeopardy. Doing so is difficult, however, because itrequires government to enter uncharted fiscal territory, where analyti-cal frameworks are sometimes difficult to apply, accounting standardsare underdeveloped or poorly enforced, and the data are inadequate orhidden from public scrutiny. And, because contingent liabilities oftengrow from fiscal opportunism, when policymakers seek to hide thereal fiscal cost of their decisions and to reduce the reported budgetdeficit, bringing them under control may become first of all a questionof political will.

This book aims to provide motivation and practical guidance togovernments seeking to improve their management of fiscal risks.Among other things, it addresses some of the difficult analytical andinstitutional challenges that face reformers tooling up to manage gov-ernment fiscal risks, and it describes the inadequacies of conventionalpractices as well as recent advances in dealing with fiscal risk. It alsopresents several untested ideas for developing new instruments for regu-lating and valuing fiscal risks. In so doing, the authors recognize thatsome novel schemes are not yet sufficiently developed to warrant im-mediate application by governments. But pushing forward the frontierof public finance today, the book aims to enhance the practice of fiscalanalysis and management in the future.

This volume has grown out of World Bank initiatives to assist coun-tries that are working to understand and manage the fiscal risks facingtheir governments. These initiatives, led by the World Bank Quality ofFiscal Adjustment Thematic Group during 1998–2001, covered over40 interested countries and involved partnerships with many govern-ment agencies, leading universities, research institutions, internationalagencies, and associations of practitioners around the world.

The Magnitude of the Problem

We define fiscal risk as a source of financial stress that could face agovernment in the future. The book focuses particularly on the fiscalrisks that are realized when uncertain events occur—such fiscal risks

introduction 3

are often associated with government contingent liabilities. Recent his-tory has brought with it many examples of contingent liabilities thatchallenge government finances. The explicit and implicit governmentinsurance schemes in the domestic banking sector that emerged fromthe 1997 financial crisis in East Asia added some 50 percent of grossdomestic product (GDP) to the stock of government debt in Indonesia,30 percent in Thailand, and over 20 percent in Japan and Korea. In the1980s, similar schemes generated a fiscal cost of over 40 percent ofGDP in Chile and around 25 percent of GDP in Côte d’Ivoire, Uru-guay, and Républica Bolivariana de Venezuela.1 In the 1990s, Braziland Argentina saw their government debt escalate when the centralgovernment had to bail out commitments made by subnational gov-ernments. Government debt in Malaysia, Mexico, and Pakistan soaredfrom unexpected defaults on government guarantees that had beenissued to promote private participation in infrastructure. Several chap-ters of this book illustrate that contingent liabilities may become themost critical factor in a country’s fiscal performance.

Empirical analysis of past increases in the stock of government debtconfirms that realized government contingent liabilities account for alarge share of those increases. Kharas and Mishra (2001) illustrateacross nearly 50 countries that large increases in the stock of govern-ment debt cannot be explained by the governments’ reported budgetdeficits (see Figure 1). Calling the annual increase in government debtthat is in excess of budget deficit a “hidden deficit,” Kharas and Mishrashow that hidden deficits have stemmed mainly from the cost of real-ized contingent liabilities and realized risks in the government debtportfolio (particularly the currency risk of government foreign debtinstruments). In some developing and transition countries, contingentliabilities have contributed on average to hidden deficits of more than2 percent of GDP annually over a period of more than 10 years. Theanalysis by Kharas and Mishra also indicates that contingent liabilitiestend to be associated with speculative attacks and currency crises.

In the recent past, several factors have worked to increase govern-ments’ exposure to fiscal risk and their tendency to incur hidden defi-cits. The rapidly increasing volumes and volatility of internationalprivate capital flows have accelerated the growth of domestic finan-cial systems but also have made these systems, and thus implicitly thecountries’ fiscal authorities, more vulnerable. This condition was clearlyillustrated during the three years following the 1997 outflow of foreigncapital from East Asia. Privatization and reduction of the explicit fi-nancial role of the state allowed many governments to cut their bud-geted expenditures, but required either explicit or implicit promisesthat the government would come to the rescue should the private sec-tor fail to deliver expected outcomes. Such guarantees and promises,in turn, have increased the uncertainty of future public financing

4 brixi and schick

requirements. Furthermore, these guarantees have boosted moral haz-ard in the markets. Loans and investments with a full guarantee sufferfrom insufficient analysis and supervision by creditors. Moreover, thebeneficiaries of poorly designed state insurance schemes tend to ex-pose themselves to excessive risks. For example, in the United Statesthe generous benefits of the federal flood insurance program have re-sulted in the excessive construction of homes in flood-prone areas (U.S.GAO 1998). This market behavior makes it more likely that later thegovernment will be asked to provide financial support.

The Political Economy of Contingent Liabilitiesand Fiscal Risk

Often fiscal risks, particularly those in the form of contingent liabili-ties, arise from politics and fiscal opportunism rather than economicpolicy. Policymakers tend to build up government contingent liabili-ties to avoid difficult adjustment and painful structural reforms. In

Figure 1. Average Annual “Hidden” Deficits(percent of GDP over different 5- to 20-year periods from 1970s to 1990s)

Note: Graphs represent average annual increases in government debt unexplained by reported deficits.

Source: Kharas and Mishra (2001).

876543210

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introduction 5

this process, credit guarantees replace budgetary subsidies; take-or-pay contracts come in lieu of liberalizing prices and restructuring theenergy, water, and other vital sectors; “letters of comfort” allow insol-vent enterprises and banks to avoid bankruptcies; and so on.

In some instances, government support in the form of contingentliabilities may be justified. In Europe and the United States, few wouldargue against the immediate provision of a government guarantee tocover the legal liability of airlines after the September 2001 terroristattacks in the United States. Government support was deemed justi-fied for the political risk negatively affecting the airlines. Governmentguarantees, as the form of support, also were appropriate because theairlines would, in their own interest, try to avoid further terrorismonboard.2

In many cases, however, governments have assumed contingent li-abilities either in pursuing low-priority objectives—that is, on pro-grams that would not have withstood public scrutiny—or in usingoff-budget support when other forms would have been more appropri-ate. Some governments have provided letters of comfort to cover thecommercial risk of foreign investors that have taken a position in do-mestic financial institutions or enterprises. But with the ensuing moralhazard, bailouts have often followed, frequently financed directly fromspecial government funds rather than through the budget, and havetended not to be a good use of public money.

A common example of off-budget forms of support that are notappropriate is the provision of credit guarantees to enterprises thatcontinually incur losses. While the government may have a good rea-son to support some of such enterprises (for example, the nationalrailways, if their losses are the result of government fare pricing policy),budgetary subsidies or direct government loans would sometimes bemore effective and almost always less expensive.

Whether for railways or airlines, often the best response to calls forgovernment support is to encourage restructuring, privatize enterprisesand financial institutions (and recapitalize them in the process if needed),break down monopolies, and liberalize prices. But the ease of issuinggovernment guarantees and other promises of future possible govern-ment support allows the government to postpone these sometimes dif-ficult and, in the short term, costly actions.

In most countries, government is able to offer a promise of futurecontingent support without seriously considering the future cost to thetaxpayer. Governments doing their accounting and budgeting on a cashbasis have particularly wide scope to behave opportunistically.3 In con-trast to commercial accounting practices, which in most developedcountries require firms to recognize the future cost of pensions andother risks on their balance sheets, few governments disclose the pro-spective costs of their off-budget commitments. At the time of signing

6 brixi and schick

a letter of comfort or a guarantee contract, the government is able toclaim no cost to the budget. In some countries, a variety of govern-ment entities are able to take on such commitments—sometimes with-out even informing the ministry of finance or any other authority. Othercountries have centralized the guarantee-issuing authority at the min-istry of finance or similar entity, but still do not require such an entityto report the government’s off-budget commitments until they fall due.And even after they fall due, government may just issue more debt orfind alternative ways to cover them, without ever recording the eventin any reports. As a result, guarantees and similar forms of off-budgetsupport that create contingent liabilities turn out to be a relativelyeasy way for government to avoid scrutiny of the risks inherent inchanneling its support.

As these examples of the inappropriate use of off-budget forms ofgovernment support indicate, fiscal opportunism that gives rise to gov-ernment contingent liabilities tends to grow out of a narrow scope ofconventional fiscal analysis and fiscal management. Scrutiny that fo-cuses solely on the government’s cash-basis budget and deficit invitespolicymakers to generate contingent liabilities and other fiscal risksoutside the budgetary framework (see Box 1). Many countries havelearned firsthand that a narrow focus on cash-basis budget, deficit,and debt compels governments to delay investments and structuralreforms, run down public assets, raise temporary revenues (sometimesby assuming long-term liabilities in exchange for cash), and distortspending priorities and the timing as well as the form of governmentsupport (see, for example, Forte 1998, Polackova 1998, and Easterly1999). As reforms (such as pension reform, the downsizing of publicemployment, and enterprise and bank restructuring) that may requirehigher deficits in the short term are put on hold, fiscal opportunismputs economic growth at risk. Whether contingent liabilities are as-sumed in the effort to maintain the status quo and avoid reforms, orjust to provide government support outside the budget and thus con-ceal its cost and financing, their existence generates uncertainties aboutfuture public financing requirements and so threatens future fiscal sta-bility and the country’s development. In this context, Selowsky (1998)has emphasized that reported deficit reduction does not necessarilyimply “quality” of fiscal adjustment, which has the dimension ofsustainability as well as efficiency.

Overall, development tends to be correlated with a shift in risk fromindividuals and individual economic agents and sectors to the state. Asgovernments promote development and economic conditions improve,policymakers are pressured to take on commitments they may haveavoided earlier. Social security programs, various state insuranceschemes (targeting various beneficiaries, including enterprises, devel-opers, farmers, and depositors), umbrella guarantees covering agen-

introduction 7

Box 1. Fiscal Risks as a By-product of Deficit Targeting

When loose rules for fiscal management are accompanied by pressurefor fiscal adjustment, vote-seeking politicians and budget-seeking bu-reaucrats have additional cause for opportunism. Paradoxically, theincentive to mask the true cost of risks often rises when governmentcomes under pressure to tighten its budget constraints. When pressurefor adjustment is slack, the government may have little incentive tohide the costs of its financial commitments. But when stringent fiscaltargets are imposed, wily spenders have incentive to substitute illusoryadjustments for actual ones. And when proper accounting rules andstrong enforcement mechanisms do not accompany the targets, thespenders have ample opportunity to evade the controls.

Various studies have shown that weak enforcement produces bud-getary opportunism. In 1985 the United States enacted the Gramm-Rudman-Hollings law, which promised to progressively reduce the sizeof the deficit and to produce a balanced budget by 1991. But, as Schick(1995) points out, instead of genuine austerity, the law spawned bud-getary legerdemain that increased the government’s exposure to fiscalrisk. The volume of loan guarantees escalated, the government wasslow in responding to a costly crisis in the banking sector, and it adoptedpolicies (such as asset sales) that weakened its long-term fiscal posture.In effect, as Rubin (1997) shows, faced with the Gramm-Rudman con-straint on fiscal deficits, the U.S. Congress has reduced direct lendingby $50 billion and increased loan guarantees by $178 billion, replacingbudgetary outlays by explicit contingent liabilities.

In the process of fulfilling all the criteria for EU membership, theMaastricht criteria on government deficit and debt were applied bysome countries in ways that escalated fiscal risk. The ploys, well de-scribed by Forte (1999), included defining government narrowly, sothat the finances of various state-owned or controlled institutions werenot included in the calculation; hiding a portion of the governmentsdebt in various nongovernmental accounts; substituting guarantees forloans and grants; recording subsidies as purchases of assets; devisingoff-budget expenditures in lieu of direct financing; and deferring ex-penditures on infrastructure and maintenance. Some European Uniongovernments received one-time payments from enterprises in exchangefor assuming future pension liabilities; others reduced their reportedpublic debt by reclassifying certain state enterprises as private entities.in Italy, the railways have raised funds through the financial marketsto cover their deficits for many years with government agreement andan explicit guarantee from the treasury. Yet, those operations had noimpact on the measured fiscal deficit or on the measured stock of gov-ernment liabilities (Glatzel, 1998).

(Box continues on the following page.)

8 brixi and schick

cies in particular lines of business (for example, agricultural credit andguarantee funds, housing funds, and export credit funds), and specificguarantees that cover anything from borrowing by state-owned enter-prises to commercial risks facing private investors, all tend to growsignificantly as countries progress in their development.

Transition and emerging market economies face particularly largefiscal risks. Their dependence on foreign private financing, weak regu-latory and legal enforcement systems, opaque ownership and distortedincentive structures, inadequate information disclosure, and the weakdisciplinary effects of the international financial markets tend to in-crease the incidence of failures in the financial and corporate sectors.Such failures in turn often generate political pressure on governmentsto intervene through bailouts. A history of bailouts, particularly ifcoupled with a lengthy tradition as a paternalistic state, only contrib-utes to the spread of moral hazard in the markets.

In addition, transition and the emergence of new markets involveenormous risks: by entrepreneurs in starting new businesses or ac-quiring old ones; by investors in providing venture capital; by im-porters and exporters in building new trade opportunities; by farmersin facing volatile prices and competition; by state-owned enterprisesin taking on excessive risk pursuing profit or being barred from charg-ing market prices; by workers in seeking employment free of govern-ment intervention. Understandably, some economic agents seek totransfer the risk to government explicitly by obtaining guarantees orother forms of assurance that government support will be forthcom-ing. Without extensive guarantees, there is some likelihood that pri-vate enterprise will be stillborn or stunted, the inflow of capital will

Creative accounting and budgeting practices have been used also indeveloping countries to portray their fiscal condition in a much morefavorable light than is warranted. When pressured by adjustment pro-grams administered by the World Bank or IMF, some developing coun-tries have privatized assets, disinvested in infrastructure and other publicgoods, and replaced subsidies by directed credit and credit guarantees.Widespread recourse to illusory adjustments has led Easterly (1999) toconclude that when outside institutions demand a reduction in the deficitor debt, the affected government often responds by creating a fiscalillusion: achieving more favorable deficit and debt figures while di-vesting assets, accumulating contingent liabilities, and in other wayseroding the government’s net worth.

Box 1 (continued)

introduction 9

be inadequate, investors will be unwilling to acquire state enterprises,and depositors will be reluctant to place their money in domesticbanking institutions.

Markets that have a short history and offer limited informationrestrict the understanding that investors as well as politicians have ofthe risks they are taking. Imperfect knowledge induces both investorsand politicians to underestimate the future potential cost of their deci-sions. Underestimation tends to be greatest when costs are contingenton future occurrences, such as repayment of loans or the performanceof enterprises, and when the government bears implicit obligationsthat depend on future decisions, such as on whether to make good onuninsured bank deposits. This factor explains in part why in manytransition and emerging market economies creditors have toleratedexcessive risk exposure by domestic financial institutions and enter-prises before fleeing. During the early years of change in an economicsystem, it is tempting for politicians to take the position that risks arejustified because they enable the economy to grow more robustly. Later,politicians often feel that they have no choice but to assist troubledenterprises and financial institutions. As economies integrate with theinternational markets, more reliable data become available and morescrutiny is demanded. This tendency enhances the ability of both gov-ernments and investors to estimate risks with standard methodologies.Investors are then more likely to become more cautious in buying gov-ernment debt instruments and thus to subject governments to greaterdiscipline.

Scope for Fiscal Opportunism

Across countries, the main sources of fiscal risk and their underlyingpolitical economy tend to be similar. We now review the most com-mon examples and highlight the scope for fiscal opportunism that ex-ists in the various cases. We do not claim, however, that fiscalopportunism actually arises in all countries and in all such cases.

The largest scope for fiscal opportunism is traditionally offered bythe financial sector. Governments are accustomed to using financialinstitutions, private or state-owned, to finance various projects andsupport programs. Development banks, policy banks, and credit andguarantee funds are authorized by the government to borrow in themarkets to finance its programs. They raise resources to build roads,power plants, or schools; provide credit to farmers, enterprises, orhealth insurance funds—sometimes for new investment projects, othertimes to cover operating losses; and offer guarantees to exporters ordevelopers. Because many such programs, although sometimes justifi-able on policy grounds, are not profitable financially, financial institu-tions accumulate liabilities without securing the revenues to pay them

10 brixi and schick

off. For the government, financial institutions appear to be a conve-nient channel for promoting various agendas without directly burden-ing the budget. But later, when the financial institution is unable toroll over its debt, it ultimately needs government resources. If theseresources are provided directly from the proceeds of government bor-rowing, the budget deficit remains unaffected. In some countries, gov-ernment exercises substantial influence over the banking sector, andfinancial institutions do not pursue the interest of their creditors anddepositors (without relying on government bailout). As noted earlier,the result is widespread losses and possibly a banking crisis. In resolv-ing a banking crisis, many governments again use the financial sectorto create a fiscal illusion. Often asset and management companies arecreated for the sole purpose of raising revenues to recapitalize banksoutside the budgetary framework of the government (Klingebiel 2000).

In some countries, state-owned enterprises are the vehicle used toimplement programs of a fiscal nature. By giving state-owned enter-prises the responsibility for providing unemployment benefits, pen-sions, schooling, housing, and such, the government may again ensureservice delivery without directly burdening its budget. Later on, shouldenterprises be short of resources to cover the cost of all these services,the government would provide support—possibly through a financialinstitution. When privatizing an enterprise, the government may haveto take over its obligations, which sometimes can be done in the formof a guarantee issued by an autonomous privatization fund or creditand guarantee fund (for example, by an environment fund to cover thefuture environmental liabilities of the enterprise). On the other hand,the government may be able to obtain a cash payment for assumingsome of the enterprise obligations, as was recently done in France forenterprise pension obligations (Forte 1998). The government also mayrequire enterprises to charge artificially low prices for “necessities,” ineffect avoiding the need to pay family transfers from the budget. Tocover the ensuing losses, the government may then issue a guaranteeon a credit to be taken by the enterprise from a commercial bank.Ultimately, when the government has to provide financing it may doso via a guarantee fallen due—again outside the budgetary framework.

Subnational governments are able to devise similar routes for op-portunistic fiscal behavior. Many create their own financial institu-tions to raise revenues for off-budget programs, issue guarantees, orborrow directly in the financial markets. Because their obligationsappear to be backed implicitly by the central government, they find itpossible to raise funds even if the financial sustainability of their ac-tivities raises doubts. Fiscal risks taken by subnational governmentsare complicated by the fact that subnational policymakers may them-selves rely on an implicit promise of the central government’s help.Depending on the political clout of each individual subnational gov-

introduction 11

ernment, it may be untenable for a central government to let asubnational government go bankrupt. Because most countries do nothave clear regulations or a monitoring system for subnational govern-ment risk-taking, as financial markets develop, subnational govern-ments tend to accumulate excessive obligations that eventually maycompel the central government to provide a bailout.4

In recent years, government promotion of private participation ininfrastructure, although often justified on policy grounds, has become amajor source of fiscal risks. The justifiable objective of promoting pri-vate initiative may be diluted by the lack of political will to establish anadequate pricing mechanism, unbundle monopolies, and introduce arisk-sharing mechanism with the private developers and creditors. Ex-plicitly through build-operate guarantee contracts, or implicitly througha perceived responsibility for the provision of core services, the govern-ment may be called on to step in with financing in case of failure.5

Public pension and health schemes are another common, albeit pre-dictable, source of fiscal risk for governments. Arguably, society isbetter off when such risks are pooled and when the pool is expandedto cover all citizens or residents. But whatever its advantages, poolingtransfers the risk to future rather than current government budgets. Inan aging society, a promise of high pension and health benefits affectsfuture government finances enormously. Most governments, however,still do not consider this intergenerational impact.

Reforms

Reforming any of these areas or, more broadly, how government dealswith fiscal risk is likely to be costly politically, because constituenciesfrom pensioners to bank owners have reasons to oppose such reforms.The average taxpayer would benefit—but he or she usually lacks lob-bying power. Furthermore, such reforms imply that policymakers mighthave considerably less scope for fiscal maneuvering in the future. Chap-ters of this book address the various aspects of fiscal opportunism asthey arise in different circumstances and make recommendations forimprovements in the light of their political feasibility.

This book has been prepared in recognition of the probability thatnational governments will continue to shoulder various fiscal risks.The contributors to this volume recognize that risk-taking by the gov-ernment is justified in some instances. But they take the position that ifrisks are here to stay, they should be properly regulated and managed,with appropriate information and oversight and full accounting forthe costs that may be imposed on government.

It is assumed here that a necessary first step toward fiscally prudentpolicies is for policymakers to identify, classify, and understand thefiscal risks facing the government. Comprehension of the fiscal risks

12 brixi and schick

and their consequences may encourage governments to avoid the risksthat are bound to surface within a politically meaningful time horizon.For risks that extend beyond that time frame, achievement of fiscallysound behavior may depend on market discipline. In particular,policymakers are more likely to gravitate toward fiscally sound deci-sions if the media, the public, investors, credit-rating agencies, andmultilateral institutions understand the government’s fiscal performancein its entirety and if there are sanctions when politicians expose thestate to excessive risks and then conceal those risks.

The contributors to this volume seek to identify institutional mecha-nisms that can be applied domestically and internationally to optimizethe amount of risk-taking by government. Domestically, an agencythat is insulated from direct political pressures—for example, a su-preme audit institution or an autonomous government debt manage-ment office—can assess and report on the direct and contingent fiscalrisks of each government agency and of government as a whole. Al-though voters do not necessarily care about government fiscal risk,public explanation of the fiscal risks by an independent audit officemay encourage the international forces of restraint. To be effective,international restraint should be used to ensure that the governmentapplies the international rules for fiscal analysis not only to the budgetand debt, but also to contingent liabilities. Specifically, internationalpressure may compel the government to meet certain quality stan-dards: to define, measure, and monitor its full fiscal performance, us-ing sound indicators and methods as defined by international authoritiessuch as the International Monetary Fund, World Bank, European Com-mission, or sovereign credit rating agencies and investors.

Organization of This Book

This book explores the problem of fiscal risk along two dimensions.One dimension is that of the entire government portfolio of fiscal risks;the other is that of selected specific sources of government fiscal risk.Accordingly, the book is divided into two parts, each offering a con-ceptual treatment of the issues along with country examples.

Part I begins with an overview of different approaches to dealingwith government fiscal risks (Chapter 1 by Hana Polackova Brixiand Ashoka Mody). The overview offers a classification of fiscal risks(the Fiscal Risk Matrix) and, with extensive references to the exist-ing literature and country practice, summarizes various analyticaland institutional approaches toward government management of fis-cal risk. In particular, it outlines an approach to managing govern-ment fiscal risk in the context of the portfolio of government assets,sources of future revenues, and direct and contingent liabilities; sets

introduction 13

policy formulation in the context of fiscal risk management; and of-fers some guidance on structuring guarantees and government pro-grams to minimize their risk.

Next, the book explores the institutional factors affecting the op-portunistic behavior of policymakers and suggests corrective measureswith examples of good practice across countries. In this context, Chap-ters 2 and 3 by Murray Petrie and Allen Schick, respectively, illustratethe inadequacies of conventional cash-basis reporting, accounting, andbudgeting, and call for more comprehensive and sounder approaches.These chapters particularly highlight the usefulness of requiring gov-ernment to publish a statement of contingent liabilities and fiscal risk.They also outline the benefits of accrual-basis accounting and budget-ing for government fiscal risk management.6 These chapters providemany examples of country practice from developed, transition, anddeveloping countries.

Subsequent chapters explore the practice of risk management in theprivate sector and its applicability to government. Chapter 4 by SureshSundaresan provides an overview of the analytical tools and practicesused by financial institutions and corporations to manage their riskexposures, and then applies the methodology to valuing governmentguarantees. Similarly, Chapter 5 by Krishna Ramaswamy applies afactor model to government risk analysis—particularly for risk-takingby public sector entities, including state-owned enterprises.

Then, linking the discussion of government and private sector prac-tice, the chapters that follow focus on approaches to expanding fiscalanalysis to incorporate fiscal risks and to bringing market incentivesinto the government’s thinking about fiscal sustainability. Chapter 6by Daniel Cohen integrates contingent liabilities with the traditionalfiscal sustainability analysis and offers an institutional arrangement tointroduce market discipline into government risk-taking. Chapter 7 byRichard Hemming and Murray Petrie further expands the fiscalsustainability framework and introduces a framework for assessingthe exposure of a government’s future fiscal performance to risks.

The country examples in Part I offer additional conceptual ap-proaches and illustrate some of the discussion in the earlier chapters.Reflecting on the ability of policymakers to generate fiscal illusion,Chapter 8 by William Easterly and David Yuravlivker applies a com-prehensive approach to fiscal analysis in the form of evaluating the networth of the governments of Colombia and Républica Bolivariana deVenezuela. Chapter 9 by Hana Polackova Brixi, Allen Schick, and LeilaZlaoui recognizes the special challenges in fiscal risk management fac-ing transition countries and evaluates various aspects of the quality offiscal adjustment and fiscal management related to government con-tingent liabilities in the Czech Republic, Bulgaria, and Hungary. In Chap-ter 10, Kathie Krumm and Christine Wong incorporate contingent

14 brixi and schick

liabilities into the fiscal sustainability analysis for China. Looking atthe portfolio of contingent liabilities and risks from the perspective ofgovernment debt, Chapter 11 by Hana Polackova Brixi and SudarshanGooptu presents scenarios for government debt management in Indo-nesia and Thailand. In a similar spirit, Chapter 12 by Juan CarlosEcheverry and others discusses reforms in dealing with contingent li-abilities as implemented under the leadership of the Colombia Treasury.

Part II presents analytical and institutional approaches that gov-ernments might consider when facing risks in specific governmentprograms or sectors. Chapter 13 by George Pennacchi focuses on therisk of guarantees that are often taken on by governments imple-menting pension reforms and utilizes an option-pricing methodologyto value a government’s risk exposure. In Chapter 14, Stijn Claessensand Daniela Klingebiel analyze the ways in which to measure andreduce the government’s risk exposure in the banking sector. Chapter15 by Ron Feldman discusses risks arising from government insur-ance programs. Recognizing the implicit responsibility of the fiscalauthorities (and thus of the government budget) for the central bank’spositive net worth, Chapter 16 by Mario I. Blejer and LilianaSchumacher utilizes a value-at-risk approach to assessing the centralbank’s own risk exposure.

Looking at country experience and practice, Chapter 17 by AshokaMody analyzes the lessons of the 1997 East Asian financial crisis forprivate participation in infrastructure and associated government con-tingent liabilities. For fiscal risks taken on by subnational governments,Chapter 18 by Jun Ma offers a framework that would allow the cen-tral government to monitor and discipline the subnational governments’risk exposure and thereby reduce the associated exposure by the cen-tral government. Chapter 19 by Sweder van Wijnbergen and NinaBudina applies option-pricing methodology to evaluating governmentforeign debt restructuring agreements for Bulgaria. Finally, the fiscalrisk of floods, particularly in the case of Argentina, is explored inChapter 20 by Alcira Kreimer.

Reflecting on available country experience and on the new con-cepts presented in the book, the concluding chapter by Allen Schickdraws together a list of policy recommendations for governments seek-ing to bring their fiscal risks under control.

The descriptions and discussions in this book of the concepts andpractices of dealing with contingent liabilities and other fiscal risksuggest that a broad range of approaches for governments to use inanalyzing and managing such risks are available. In this respect, thebook illustrates that contemporary practices have yet to be standard-ized. Under these circumstances, the book seeks to motivate policy-makers and policy analysts to pay attention to the fiscal risks govern-ments face, and it provides a rich menu of practices that may be appliedin countries that are serious about confronting such risks.

introduction 15

Notes

1. For an overview and analysis of the cost of banking crises, see Honohanand Klingebiel (2000).

2. In addition, countries argued that they could not afford to let severalbig airlines go under simultaneously, because the effect on jobs and confi-dence could be too great. A temporary, targeted government subsidy to over-come the temporary financial shock may be appropriate to smooth jobreductions and allow the strongest to survive. It should be acknowledged,however, that the credit guarantees for which the airlines lobbied may havethe additional effects of delaying the restructuring in the airline industrythat, given the increasing losses of many airlines even before the attacks, wasconsidered overdue. For analysis of the pros and cons of various scopes andforms of government support to the airline industry after the terrorist at-tacks, see, for example, the Economist (“More Pain Ahead,” September 22,2001, and “Uncharted Airspace,” September 28, 2001).

3. In cash-basis accounting, expenses and liabilities are accounted not whenthe obligation is incurred, but only when the government makes the actualcash transfer. Thus a government collecting a fee for assuming a liability (forexample, when it issues a guarantee or accepts the pension liability of anenterprise under privatization) reports the transaction as a net revenue gain.

4. Dillinger (1999) discusses the economics and political economy of cen-tral government bailouts of subnational governments in South America.

5. Irwin and others (1998) provide examples and analysis of public risk inprivate infrastructure.

6. An accrual-basis accounting system without accrual budgeting will notensure that governments adequately consider contingent fiscal risks in policy.Although this system encourages governments to prepare a statement of con-tingent liabilities and financial risks, it generally does not require that theliabilities be included in the balance sheet and that the associated risks beevaluated and quantified. International accrual accounting standards requirethat liabilities be accounted only when the obligation is due with certainty.For a discussion of the rules of probability and risk assessment, see Interna-tional Accounting Standards Committee (1997).

References

Dillinger, William. 1999. “Fiscal Management in Federal Democracies: Ar-gentina and Brazil.” Policy Research Working Paper 2121. World Bank,Washington, D.C.

Easterly, William. 1999. “When Is Fiscal Adjustment an Illusion?“ EconomicPolicy (April).

Forte, Francesco. 1998. “Accounting and Financial Practices in Light of Con-text of the Maastricht Treaty.” In European Union Accession: The Chal-lenges for Public Liability Management in Central Europe. Washington,D.C.: World Bank.

16 brixi and schick

Honohan, Patrick, and Daniela Klingebiel. 2000. “Controlling Fiscal Cost ofBanking Crises.” Policy Research Working Paper 2441. World Bank, Wash-ington, D.C.

International Accounting Standards Committee. 1997. International Account-ing Standards 1997. London.

Irwin, Timothy, Michael Klein, Guillermo Perry, and Mateen Thobani, eds.1998. Dealing with Public Risk in Private Infrastructure. World BankLatin American and Caribbean Studies. Washington, D.C.: World Bank.

Kharas, Homi, and Deepak Mishra. 2001. “Fiscal Policy, Hidden Deficits,and Currency Crises.” In S. Devarajan, F. H. Rogers, and L. Squire, eds.World Bank Economists‘ Forum. Washington, D.C.: World Bank.

Klingebiel, Daniela. 2000. “The Use of Asset Management Companies in theResolution of Banking Crises: Cross-country Experience.” Policy ResearchWorking Paper 2284. World Bank, Washington, D.C.

Polackova, Hana. 1998. “Contingent Government Liabilities: A Hidden Riskfor Fiscal Stability.” Policy Research Working Paper 1989. World Bank,Washington, D.C.

Rubin, Irene. 1997. The Politics of Public Budgeting: Getting and Spending,Borrowing and Balancing. Chatham, N.J.: Chatham House.

Schick, Allen. 1995. The Federal Budget: Politics, Policy, and Process. Wash-ington, D.C.: Brookings Institution.

Selowsky, Marcelo. 1998. “Fiscal Deficits and the Quality of Fiscal Adjust-ment.” In The Challenges for Public Liability Management in CentralEurope. Washington, D.C.: World Bank.

U.S. GAO (General Accounting Office). 1998. Budgeting for Federal Insur-ance Programs. Washington, D.C.: Government Printing Office.