The Impact of Contingent Liabilities upon Government Solvency:The Case of Colombia
Abstract
The accumulation of contingent liabilities, which may be overlooked in the traditional fiscal analyses limited to flow variables such as the budget deficit, may result in higher vulnerability and hidden fiscal risks. Empirical literature has revealed the faults in the traditional deficit measurements as they overlook off-budget liabilities. These contingent liabilities render government solvency vulnerable to shocks; namely, exogenous or endogenous events which result in an unexpected drain of government resources. This paper presents a theoretical model in which these shocks are included as a “jump” in the country’s solvency constraint. in such a way that a country with an apparently sound fiscal stance, can suddenly be deemed insolvent. This fact is exemplified further with an analysis of Colombia’s fiscal imbalances, where despite having traditionally low levels of deficit and debt, the inclusion of contingent and implicit liabilities in the public sector’s balance sheet results in a negative net worth of approximately 90% of GDP.
1. Motivation
The sustainability of public finances lies at the core of sound macroeconomic policy-making. The concept of fiscal sustainability is associated with the risk of debt default. It is intrinsically a dynamic concept as it entails complying with the government’s intertemporal budget constraint. This ultimately requires for the current net market value of debt to be smaller than the present discounted value of current and future government surpluses. Hence, a fiscal - financial programme is sustainable if it ensures the solvency of the government (Buiter, 2003).
According to Bean and Buiter, cited by Blejer and Cheasty (1991):
“ A government is solvent if its spending programme, its tax transfer programme and its planned future use of seigniorage are consistent with its outstanding, initial, financial and real assets and liabilities (in the sense that the present value of its spending programme is equal to its comprehensive net worth).” (pg 1668).
However, the public sector in reality is more than the national central entity that extracts taxes and undertakes expenditure. It comprises public enterprises, the public share of the social security system, subnational levels of government, and it should also include the guarantees issued to concessions of infrastructure projects undertaken by the private sector, as well as contingencies like the eventual bailouts to the financial system, or rescue operations of public enterprises. The definition of solvency should therefore include this broader understanding of the public sector, since the sources of uncertainty and the magnitude of eventual financial setbacks can be bigger than those directly related to the functioning of the central government. Therefore fiscal sustainability directly depends on the government’s net worth and hence demands theconstruction of a comprehensive consolidated public sectorbalance sheet. This implies that a complete and accurate picture of sustainability of the public finances should include all financial assets and liabilities of the general government, including all off budget expenditures and receipts, such as contingent claims and liabilities (Buiter, 2003).
Explicit contingent liabilities constitute legal obligations of the government to undertake certain expenditures if a particular event occurs, and are not directly associated with any budgetary programme. “A government’s commitment to accept obligations contingent on future events amounts to a hidden subsidy and may cause immediate distortions in the markets and result in a major unexpected drain on government finances in the future” (Polackova, 1998). Additionally, implicit contingent liabilities are associated with expectations of government intervention, leading to a problem of moral hazard, the scope of which depends on the magnitude of government led minimisation of market failures, and of financial setbacks in branches of the public administration.
The importance of taking into consideration both explicit and implicit contingent liabilities when determining the sustainability of fiscal policy is evidenced by the fact that these have the power to dramatically and rapidly alter the perspective of a government’s solvency. While a nation may appear to be solvent at some point in time, liabilities triggered by a determinedevent at an uncertain moment may suddenly deem it insolvent.In this context, “liabilities” should be understood as net-liabilities, or changes in public sector net worth, since the solvency condition can be affected by variations in both assets and liabilities.
The latter sets forth the dynamic nature of fiscal policy making and the importance of efficient risk allocation through time. This in turnsupports a stock(intertemporal) based approach towards fiscal policy making, related to public sector net worth, as opposed to an analysis limited tothe achievement of flow variable targets such as debt and deficit levels. A flow approach to fiscal sustainability disregards the fact that the issuance of contingent liabilities may not impact the current budget, while having severe cash-flow implications for the future, which under a dynamic analysis may reveal a situation of insolvency (Easterly, 1999).
The reduction of current deficits through time reallocation of revenue and expenditure flows may overlook or even elevate fiscal risks. Apparently sound financial fiscal packages may favour budget programmes that do not immediately require cash, temporarily hiding the underlying fiscal cost. This implies that short–term flow stability does not necessarily mean fiscal sustainability. Prudent fiscal policy making must be based upon dynamically efficient strategies. Such strategies need to be based upon a comprehensive public sector balance sheet, which incorporates the stocks of contingent liabilities and assets (i.e. the present discounted value –PDV- of tax revenues or contributions to the public social security system, which can be also subject to shocks). This should allow for the evaluation of risk exposure through time, according to the costs of providing for such risks and the State’s ability to manage risk and absorb contingent losses.
The purpose of this paper is to expose the fragility of government solvency due to the presence of contingent liabilities. It will be shown how the accumulation of contingent and implicit liabilities mounts to a hidden risk, not perceived in annual flow variables. The latter provides evidence for how traditional budget deficit measures can lead to misleading results regarding long term fiscal policy sustainability.
The paper is divided into 7 sections including this motivation. The next section presents the international evidence on public sector contingent liabilities, a topic which recently has received growing attention. Section 3 deals with the impact of contingent and implicit liabilities upon government solvency within the framework of a theoretical model of sovereign debt, following the set-up used by Miller and Zhang (1999). Contingent liabilities are introduced as shocks upon the government’s capacity to pay its debt. These are modelled as jumps which follow a Poisson process. Such a framework evidences how contingent liabilities affect a government’s solvency through their impact upon the solvency constraint.
A particular case in which contingent and implicit liabilities can deem a country insolvent is illustrated in section 4, where an amplified version of Colombia’s public sector balance sheet, including such liabilities, results in a negative net worth of approximately 90% of GDP. An identification of the most important contingent and implicit liabilities, the manner in which these have been accumulated is the subject of section 5. Section 6 discusses the institutional arrangements devised to control them, and section 7 concludes.
2. International Evidence of the Relevance of Contingent Liabilities
Contingent liabilities represent a major source of fiscal risk, as uncertain events trigger a substantial drain of governments’ resources when they are compelled to assume off-budget obligations. Recent examples provide evidence of the manner in which contingent liabilities have represented an important challenge to government finances. According to Polackova and Shick (2002), the explicit and implicit government insurance schemes in the domestic banking sector that emerged from the 1997 financial crisis in East Asia added approximately 50% of GDP to the stock of government debt in Indonesia, 30% in Thailand and over 20% in Japan and Korea. Similar schemes in the 1980’s generated a fiscal cost of over 40% of GDP in Chile and approximately 25% in Cote de Ivoire, Uruguay and Republica Bolivariana de Venezuela. In the 1990’s, Brazil and Argentina exhibited an escalation in their debt levels as the central government had to bail out commitments made at sub-national government levels. Malaysia, Mexico and Pakistan presented a severe deterioration in their fiscal stances due to defaults on government guarantees that had been issued to promote private participation in infrastructure.
Furthermore, Kharas and Mishra (1999) find that the inclusion of contingent liabilities in the analysis of fiscal imbalances provides evidence supporting a relation between budget deficits and currency crises. According to these authors “the lack of evidence on the relationship between currency crises and budget deficits has arisen primarily because budget deficits as measured and reported do not truly reflect the actual fiscal position of the countries”.
Blejer and Cheasty (1991) provide an analysis of deficit measurement and state that the deficit has tended to be restricted to a summary of government transactions during a single budget period, usually one year, disregarding their long run implications. Hence fiscal policy analysis based upon conventional deficit measures represents a flow approach to fiscal sustainability, which they assert can be “misleading and inadequate”. Based upon the deficiencies of traditional deficit measures in analyzing a country’s fiscal stance, Blejer and Cheasty (1991) promote balance-sheet-based deficit measures which are consistent with the dynamic framework of fiscal policy. Namely, they support a stock approach to public finances as it provides an intertemporal rather than annual framework. Such an approach stresses the incidence of contingent liabilities upon fiscal sustainability, evidencing its effects on fiscal imbalances, which can’t be observed in the short run.
According to Blejer and Cheasty (1991), the conventional deficit can be severely affected by revenues which create liabilities for the future or expenditures which represent the liquidation of past liabilities. This evidences the vulnerability of such measure to shocks, which in turn poses great risks upon government solvency. For example, higher social insurance contributions, which are accounted for as higher revenues may overstate the government’s ability to pay as they actually confer entitlements on contributors and as such commit the government to higher future spending. On the other hand, they are contingent claims, depending on demographic changes and susceptible to variations in government legislation, hence the magnitude of the outlays is difficult to determine. Such problems are exacerbated when dealing with unfunded pension schemes. An additional example is provided by the way the conventional deficit can dramatically be elevated in any year by a government’s payment of previously guaranteed debt or insurance contracts, such as exchange guarantees or bail outs of underwritten entities, such as insolvent public enterprises. The government usually fails to make provisions for expected defaults, hence “the costs of risk bearing are not spread out over the life of the risk, but are charged only upon realization of the risk’s downside” (Blejer and Cheasty 1991). Hence the same authors conclude that “[…] at any time the conventional deficit provides an over-optimistic indicator of government’s long-run ability to pay, because it does not factor in the expected future cost of entitlements and contingent liabilities assumed by government. Moreover, the calculation of the expected cost of contingent claims is complicated by the possibility of moral hazard.”
Taking into consideration the deficiencies of conventional deficit measures, Kharas and Mishra (1999) construct an alternative measure denominated the actuarial budget deficit, which is a stock concept, and name the difference between the two the hidden deficit. The authors show that hidden deficits have stemmed mainly from the cost of realization of contingent liabilities and realized risks in the government debt portafolio. Subsequently they provide empirical evidence of currency crisis being systematically linked to the size of hidden deficits for Malaysia, Indonesia, Korea, Philippines and Thailand. This is particularly important considering that all of these countries exhibited either small budget deficits or surpluses.
Hence, it can be seen that contingent liabilities, have dramatic effects upon flow variables such as the traditional deficit, thereby representing a major source of instability while challenging government solvency. Conventional flow variables do not provide a complete picture of a country’s fiscal stance, making the accumulation of hidden liabilities possible and therefore elevating an unperceived fiscal risk. The consequences of this are only appreciated in the long run, when they entail substantial fiscal costs.
3. The Model
A flow budget identity, which determines the levels of debt and deficit, while useful for assessing the fiscal stance at any given moment in time, does not highlight the dynamic nature of the financing constraint that the public sector typically faces (Agenor and Montiel, 1996; Kotlikoff, 1999 and 1993; Poterba, 1997). The sustainability of fiscal policy is determined by the government’s compliance of an intertemporal budget constraint. The latter can be expressed in terms of a solvency constraint:
(1)
Where D is the stock of total public debt, τs is tax revenue at time s, gs is government expenditure at time s and r is the real interest rate. According to equation 1, a government is solvent if the present discounted value of future resources available to it for debt service is at least equal to the face value of its initial stock of debt. If this holds, the government will be able to service its debt on market terms (Agenor and Montiel, 1996).
Nevertheless, equation (1) is deterministic and hence doesn’t account for the risk or uncertainty which may be associated to the government’s expenditures and revenues. Hence complying with equation 1 doesn’t imply that the government will remain to be solvent in the event of a contingency which demands a sudden increase in government expenditure. As it will be exhibited through an example of Colombia’s finances, a country’s net worth will be more exposed to such contingencies, the more contingent liabilities it has accumulated. Contingent and direct implicit liabilities mount to hidden liabilities which attempt against government solvency by increasing its vulnerability to shocks.
With the purpose of theoretically illustrating the effects of contingent liabilities upon the solvency constraint, Miller and Zhang’s (1999) version of Bartolini and Dixit’s (1991) model of sovereign debt will be used as an analytical framework.
Hence equation (1) can be re-written as:
(2)
where Xs= , and is reinterpreted as the country’s capacity to pay its debt.
Assuming that the country’s capacity to pay exhibits a growth rate of µ so that:
(3)[1]
it is obtained that = , thereby the solvency constraint is reduced to:
(4)
Hence a country is considered to be solvent as long as its stock of debt is less than the present discounted value of its capacity to pay (W); .
When (andµ is positive), the country is always able to service its debt in full out of current surplus. But, when Xt<rD, full payment of interest requires the issue of new debt to satisfy:
(5)
The dynamics of debt and capacity to pay are depicted in Graph (3). The two Eigen Vectors are the vertical axis and the line W which represents the solvency constraint.
The line represents the liquidity constraint, implying that current capacity to pay is sufficient to comply with current debt servicing. If the debt level is above the net present value of the capacity to pay (W), debt will be explosive and the country will be deemed insolvent. If a country is situated between the solvency and liquidity constraints, it is solvent, though may face liquidity problems, as debt and the capacity to pay are both growing. In the region to the right of the liquidity constraint, the capacity to pay is growing faster than debt and hence the country is growing out of debt.
Taking contingent liabilities into consideration implies allowing for variable X to jump downwards in the event that such liabilities are triggered; therefore X is subject to shocks. Assuming that the risk of a contingent liability is exercised according to a Poisson process of a parameter λ, where the associated density function is , it is obtained that X faces a probability λdt of jumping downwards at time t. If such a jump takes place Xwill be reduced to a share of its initial value, becoming φX, where φ is a variable between zero and one. This represents the manner in which a country’s capacity to pay is diminished as a result of a sudden drain of resources derived from a hidden liability, such as the exercise of a government guarantee. Therefore, after the shock, the present discounted value at time t of the country’s capacity to pay is reduced to
φ(6)
The present discounted value of the capacity to pay, between time zero and time t is:
(7)
Therefore, the total present discounted value at time zero, of the country’s capacity to pay, subject to a downward shock at time t is obtained by discounting equation 6 to time zero and adding it to equation (7):
(8)