Budgeting for Fiscal Risk

1. Budgeting for Fiscal Risk Allen Schick Presented to the Fiscal Affairs Division International Monetary Fund 17 September 2008

2. What Are Fiscal Risks? IMF Report The possible deviation of fiscal outcomes from budget estimates or other projections Alternative Definitions The contingency of future revenues or expenditures on uncertain future events

3. The Risk-Taking State Macro-Economic Management • More important to balance the economy than the budget • Automatic (built-in) stabilizers • Taking risks in good times, which become due in bad times • Economic shocks The Entitlement State • Shift of risks from households to government • The changed composition of national expenditure • Universalization of major income support schemes • Moral government more important than moral hazard • Government as payer or guarantor of last resort

4. Incentives for Governments to Accumulate Fiscal Risks • Inadequate Accounting Rules The cash basis does not recognize liabilities for no payment has been made or is due: the accrual basis does not recognize liabilities that are contingent on “unlikely” events • Weak Budget Constraints Contingent liabilities are not expensed in the budget until payment is made • Guarantees are Treated as Costless Substitutes for State Ownership and Direct Expenditures In some countries, upfront fees for guarantees are booked as current revenues, thus showing a “profit” from risk-taking programs • Inadequate Insurance Arrangements and Weak Capital Markets Impel Governments in Less Developed Countries to Guarantee Private Transactions IFIs require state guarantees as a condition for lending funds for sectoral programs and other purposes

5. Why it is Hard to Control Contingent Liabilities • Risk typically is underestimated when it is taken: the true cost is only known later when it is too late to do much about it. • Risk taken in good time often becomes due in bad times • There is no such thing as a risk-less guarantee or a cost-less risk: if there were no risk or cost, there would be no incentive to seek government guarantees • Risk taken in one fiscal year becomes due in later years • When government issues guarantees, affected parties have incentives to behave in ways that transfer risk from themselves to the state • If government hides the cost in one budget, the true cost will be higher in later budgets • Risk begets risk: the more guarantees government accepts, the more guarantees it will be pressured to accept • When government issues guarantees, economic agents assess the quality of the guarantee rather than the soundness of the transaction

6. The Inadequacy of Conventional Budget Procedures • Cash basis of budgeting • Short or medium-term fiscal horizon • Incentive to underestimate future costs • Opportunistic politicians • Perverse effects of fiscal rules • Lack of budget constraint on total risk • Risk taking by extra-budgetary entities • No effective limit on payouts from past risks • Implicit liabilities do not exist until government makes them explicit

7. Managing Fiscal Risks Requires an Extended Time Horizon The Problem • Contingent liabilities entered into one year typically come due in future years • Annual budgets do not recognize the downstream costs of contingent (and other liabilities) • MTEF does not cover risks beyond the usual 3-5 year horizon Lengthening the Time Frame • Long-term sustainability estimates that project future liabilities over a 30-50 year time frame • Publications of detailed schedules of all contingent liabilities, including the amount of risk, the period during which the risk is extant, and events that may trigger calls • Recognizing the present value of future calls on the balance sheet or budget

8. Managing Fiscal Risk • Separation of risk assessment responsibility from risk commitment function • Prudential assessment of risk before commitments are made • Limit on the volume of contingent liabilities outstanding or undertaken in a fiscal period • Expensing the estimated present value of future payments in the budget or MTEF • Contingent liabilities reported in the budget or supplemental financial statements • Vesting responsibility for managing the portfolio of risks in a central agency or independent authority

9. Strategies that Reduce the Shift of Risk to Government • Risk-adjusted premiums for guarantees and other contingent liabilities • Through co-pays and deductions, risk is shared with enterprises and households • Government indemnifies last (rather than first) loss • Government exposure limited to amount provisioned • Government purchases reinsurance from private firms

10. Draft IMF Guidelines for Fiscal Risks (1) • Fiscal Risks Should be Identified and Disclosed • The government should compile a list of the material fiscal risks to which it is exposed: where possible, the amounts and probability of occurrence should be quantified • The government’s accounting standards should require disclosure of contingent liabilities • It would be useful to include a consolidated statement of fiscal risks in the budget documents. The statement would address sources of fiscal risk, including the budget’s sensitivity to macroeconomic risks, public debt, contingent liabilities, the fiscal impact of natural disasters, public-private partnerships, state-owned enterprises, and sub-national governments • The guidelines do not recommend disclosure of implicit liabilities when doing so would generate moral hazard, or prejudice the government’s legal or bargaining position

11. Draft IMF Guidelines for Fiscal Risks (2) • Fiscal Risks Should be Mitigated in a Cost-Effective Manner • Government should have a clear policy framework for assessing whether to take assume a particular risk • Risks should be allocated to economic actors on the basis of ability and incentives to manage them • When economic actors transfer risk to government they should either pay a fee for reduced exposure or bear a portion of the risk • Government should issue contingent liabilities only in case of market inadequacy or only when it is better positioned to manage the risks • Guarantee proposals should be subject to scrutiny and prioritization to appropriately balance insurance and incentives, through fees, partial guarantees, quantitative limits, termination provisions or collateral • It may be appropriate for government to ex ante control risk taking by actors who impose possible costs upon it

12. Draft IMF Guidelines for Fiscal Risks (3) • There Should be a Clear Legal and Administrative Framework to Manage Fiscal Risk • The entity with primary responsibility for managing finances should have the necessary authority to monitor and manage fiscal risks • It may be desirable for line agencies to have clearly specified responsibilities and capacity to prudently manage the risks to which they are exposed • Risks should be assessed before the government enters into contractual arrangements. These arrangements should be clear about the apportionment of risk: they should be reflected in government accounts, and should be publicly accessible • Responsibility for taking on risks should be separated from responsibility for estimating potential costs • Fiscal activities that create risk should be subject to internal audit and audit by the supreme auditing institution

13. Draft IMF Guidelines for Fiscal Risks (4) • Fiscal Risks Should be Systematically Incorporated into Fiscal Analysis and the Budget Process • Exposure to fiscal risk should be incorporated into fiscal sustainability analysis • The risk of uncertain expenditures may be handled through contingency appropriations whose magnitude reflects the country’s specific circumstances • Decisions on guarantees and other contingent obligations should be integrated with the budget and considered alongside alternative instruments intended to achieve similar objectives • Parliamentary approval should be required for issuance of guarantees, through an aggregate ceiling on guarantees, a ceiling on categories of guarantees, or approval of individual guarantees • An annual appropriation should be made to cover expected calls on guarantees during the fiscal year