1. 0 Lecture Six FINA 522: Project Finance and Risk Analysis Updated: 2 April 2006

2. MANAGING CONTINGENT LIABILITIES

3. 2 Types of Public Sector Liabilities Governments face four types of fiscal liabilities: explicit, implicit, direct and contingent. Explicit liabilities are specific obligations of the government established by a particular law or contract. Common example is the repayment of sovereign debt. Implicit liabilities involve a moral obligation or expected responsibility of the government that is not established by law or contract but instead is based on public expectations and political pressures. Examples of implicit liabilities are disaster relief for uninsured victims, and compensation to savers from the default of a large bank on nonguaranteed obligations.

4. 3 Types of Public Sector Liabilities Direct liabilities are obligations that will arise in any event and are therefore certain. For example, future public pensions specified by law are a direct liability whose size reflects the expected amount of the benefit, eligibility factors, and future demographic and economic developments. Contingent liabilities are obligations triggered by a discrete event that may or may not occur. The probability of the contingency occurring and the magnitude of the government outlay required to settle (such as sovereign debt) the ensuing obligation are difficult to forecast.

5. 4 The Fiscal Risk Matrix Liabilities Direct (Obligation in any event) Contingent (obligation if a particular event occurs Explicit Government liability is recognized by law or contract Foreign and domestic sovereign borrowing Expenditures by budget law Budget expenditures legally binding in the long term (civil service salaries, civil service pensions) State guarantees for nonsovereign borrowing and obligations issued to subnational governments and public and private sector entities (development banks) Umbrella state guarantees for various types of loans (such as for mortgages, students studying agriculture, and small businesses) State guarantees for service purchase agreements e.g. electricity, water, roads. State guarantees (for trade and the exchange rate, borrowing by a foreign sovereign state, private investments) State insurance schemes (for deposits, minimum returns from private pension funds, crops, floods, war risk)

6. 5 The Fiscal Risk Matrix Liabilities Direct (Obligation in any event) Contingent (obligation if a particular event occurs Implicit A “moral” obligation of the government that mainly reflects public expectations and pressures by interest groups Future recurrent costs of public investment projects Future public pensions (as opposed to civil service pensions) if not required by law Social security schemes if not required by law Future health care financing if not specified by law Default of a sub national government and public or private entity on nonguaranteed debt and other liabilities Cleanup of the liabilities of privatized entities Bank failure (beyond state insurance) Investment failure of a nonguaranteed pension fund, employment fund, or social security fund (social protection of small investors) Default of the central bank on its obligations (foreign exchange contracts, currency defense, balance of payments stability) Bailouts following a reversal in private capital flows Residual environmental damage, disaster relief, military financing, and the like Financial collapse of private provider of public service- electric company.

7. 6 The Increasing Problem of Fiscal Risks Recently, the high volumes and volatility of private capital flows and increasing economic dependence of countries on foreign capital have exacerbated the vulnerability of their domestic financial and corporate sectors and, implicitly, of the government. States have been transforming their role, moving from directly providing and financing services to guaranteeing that the private sector will accomplish certain outcomes. Governments may be biased toward off-budget policies, which pose more financial risk but require less immediate financing. Explicit state guarantees and insurance schemes, or any implicit understanding that a government will come to the rescue in the case of various market failures, generate serious moral hazard problems in the markets. For example, loans and investments with a full guarantee suffer from insufficient analysis and supervision by creditors.

8. SPECIFIC EXAMPLE OF CONTINGENT LIABILITY GOVERNMENT GUARANTEES

9. 8 A financial incentive often used by government Firm borrows from commercial financial institution and government guarantees interest and principal It is a future obligation Magnitude and timing of outlay unknown

10. 9 Cost depends on the future economic performance of firm whose securities are guaranteed Guarantees usually not subject to budgetary oversight Programs not subject to budgetary oversights are not as carefully evaluated Usually only included in budget when they result in cash outlays, and then it is too late

11. 10 Not included in budget in past because there was no operational measure of cost Other forms of financial assistance such as cash grant or tax incentives are often brought into budget Evaluation techniques now exist for calculation cash grant equivalents of complex financial contracts including guarantees

12. 11 If have guarantees of many small loans then expenditure on defaults in a normal year will reflect the approximate cost of a year of guarantees Guarantees of few big loans will cause only periodic large defaults. Hence, annual budget of a normal year will not reflect true accrued cost for the year Cost of guarantee = (Amount of loan) * (Probability of default)

13. 12 Probability of default = f(1/Financial Health of Firm) Cost of Guarantee much higher for under- capitalized risky ventures where probability of default is high These ventures yield lower social benefits but higher costs of guarantee Should budget for subsidy content of guarantee, not for the total amount of loan

14. 13 Cost measure of guarantee should permit comparisons across different types of subsidies Cash grant equivalent = Present Value of Future Transfers appropriately adjusted for risk Contingent claims analysis (see Jones and Mason, 1989, Journal of Banking and Finance 4:89-107) Value of contingent claim = f(Amount of Guarantee, financial risk+Business risk), where business risk = f(standard deviation of annual returns) Financial risk = f((Current liabilities + Loan and Debt interest+dividends)/(Total value of firm))

15. 14 BUDGETING FOR CONTINGENT CLAIMS Charge cash grant equivalents (CGE) to annual budget when guarantee is given Alternatively could be spread out over time if a large obligation Need to create a fund out of CGE charges for guarantee to finance loans going into default. This is an advantage of pooling the account for loan guarantees as portfolio needs to be administered