Download The sustainability of public finances lies at the core of sound

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
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 the construction of a comprehensive consolidated public sector balance 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).
2
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 determined
event 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 turn supports a stock (intertemporal) based approach
towards fiscal policy making, related to public sector net worth, as opposed to an analysis
limited to the 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,
3
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.
4
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
5
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.
6
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.
7
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:

D    s  g s e r s t  ds
t
(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:
8

D   X s e r s t  ds
(2)
t
where Xs =  s  g s , 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:
X t  X t dt
it is obtained that


t
X s er s t ds =
(3)1
Xt
, thereby the solvency constraint is reduced to:
r
D
Xt
r
(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); D  W .
When X t  rD (and µ 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:
D t   X t  rDt
(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.
1
Which implies that X t  X 0 e
t
9
Graph 3: Capacity to Pay and Debt Dynamics
Dt
Debt explodes over time
X  0
W
There may be
liquidity
problems
D  0
Debt level will
converge to
zero
1/r-µ
1/r
Xt
The line D  0 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  e t dt  1 , it is obtained that X faces a
0
probability λdt of jumping downwards at time t. If such a jump takes place X will be reduced to
10
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
Xt
r
(6)
The present discounted value of the capacity to pay, between time zero and time t is:
t
 rs
 X s e ds 
0

X0
1  e r   t
r

(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):


X0
1  e r   t   1
r
(8)
Weighting equation (7) by the probability of occurrence of the shock the new present
discounted value of the capacity to pay is obtained (W’).

 r   1  e
X0
 r   t
  1 e t
0
 X   r     

  0   
r  r  
(9)
 r     
where 
 < 1, given that φ<1.
 r   
11
 r     
The term β = 
 captures the effect upon the solvency constraint of a one-off
 r   
contingent liability. The solvency constraint will now be:
Xt
 X 
D   t    <
r
r
(10)
This result is depicted in Graph (4). The shocks implied by contingent liabilities lead to a
change in the slope of the solvency constraint. Hence a country that seems to be in the region
in which it is growing out of debt can suddenly prove to be insolvent as the solvency
constraint becomes more restrictive. Therefore, if a country is located in zone Z in Graph (4),
with a debt level equal to D(0), and a contingent liability is triggered, pivoting the solvency
constraint from W to W’, it will suddenly pass from a situation in which it is solvent, to one in
which it is not. Essentially, the region in which the country is solvent is reduced, and the
present discounted value of the country’s capacity to pay is no longer sufficient to pay the
initial level of debt.
12
Graph 4: Capacity to Pay and Debt Dynamics with one-off
Contingent Liabilities
Dt
W
W’
W>D(0)>W’
Debt explo des over time
1/r-µ
Government is solvent
Z
D(0)
D(0)>W
D(0)<W’
β/r-µ
1/r
Xt
Equation (10) depicts how the extent to which the solvency constraint becomes more
restrictive depends on  which in turn is a function of  . The latter determines the impact of
contingent liabilities on long term public finances. According to equation (6), a contingent
liability reduces the net present value of a country’s capacity to pay in a proportion (1-  ). The
analysis of the impact of contingent liabilities upon fiscal sustainability depends on the
magnitude of  . As it will be seen through the analysis of the case of Colombia,  depends on
the type of contingent liabilities a country is exposed to. Its magnitude is in occasions very
difficult to estimate as it is a long term variable which depends on a variety of uncertain
factors.
Equation (10) also sets forth that government solvency is independent of budget deficits or
surpluses at determined moments in time. This implies that effective fiscal policy management
can not be limited to controlling such flow variables, but requires restricting parameter (1-  ).
13
This entails limiting and providing for the accumulation of contingent liabilities in order to
minimize the exposure shocks and, thereby, reduce fiscal risk.
14
4. Evidence from Colombia
Analyzing Colombia’s fiscal stance within this theoretical framework captures the manner in
which contingent liabilities affect the Nation’s solvency. Indeed, a country with apparently
sound fiscal indicators is revealed to be insolvent when taking into account the stocks of
contingent liabilities.
This evidences the “fragility” of government solvency given the
vulnerability of its net worth, as it is exposed to the negative shocks associated with
contingencies.
Relative to most of South America, until the mid 1990’s, Colombia was characterized by its
prudential fiscal management. This was denoted in relatively low and stable deficit and debt
levels which implied a controlled level of fiscal imbalance.
Graph 5: Public Sector Deficit
1.00%
2000
2002 (pr)
% of GDP
-2.00%
1998
1996
1994
1992
1990
1988
-1.00%
1986
0.00%
-3.00%
-4.00%
-5.00%
-6.00%
-7.00%
-8.00%
Source: Ministry of Finance and National Planning Ministry, Colombia
15
Graph 6: Public Debt as a Share of GDP
60
50
% GDP
40
External
30
Internal
20
10
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0
Source: Ministry of Finance and National Planning Ministry, Colombia
According to Easterly and Yuravliver (2002) a stock approach, namely balance sheet
accounting, “can produce a better long run perspective on fiscal sustainability than can be
obtained from conventional deficit measures”. ¨This approach implies the assessment of
whether the public sector net worth is positive or negative. If it is negative, then sustainability
will require that the present discounted value of the flows of government revenues minus
consumption be sufficient to cover the negative net worth. The official estimation of the
Colombian public sector balance sheet as of 1997 drew a positive value for the public sector
net worth equal to 62.3% of GDP.
Table 1: Consolidated Public Sector Balance Sheet, 1997
(as a percent of 1997 GDP)
140.5
Total Assets
Current Assets
29.5
Fixed Assets
110.9
78.2
Total Liabilities
Current Liabilities
26.1
Long Run Liabilities
51.8
Net Worth
62.3
Total Liabilities + Government Net Worth
140.5
Source: Contaduría General de la Nación, Colombia.
16
Nevertheless, this balance sheet estimation excluded all contingent liabilities. The inclusion of
the latter, as was subsequently demonstrated by Echeverry et al (1999 and 2000), revealed the
weakness of Colombia’s public finances, as the government was proved to be insolvent.
Table 2: Amplified Public Sector Balance Sheet
(as a percent of 1997 GDP)
Total Assets
Current Assets
Fixed Assets
Total Liabilities
Current Liabilities
Long run Liabilities
Contingent liabilities
Pension liabilities
Non Pension liabilities
Direct liabilities
Other Liabilities
162.3
29.5
132.8
252.2
26.1
225.8
174.0
159.2
14.8
51.8
0.3
Net Worth
-89.9
Total Liabilities + Government Net Worth
162.3
Source: Echeverry and Navas (2000)
The construction of the amplified balance sheet implied the inclusion of both explicit and
implicit contingent liabilities, as well as the re-estimation of direct liabilities and assets.
The crucial issue in constructing a comprehensive amplified balance sheet is determining what
should be included as contingent liability and how it should be quantified. According to
Polackova (1998), fiscal risk can be divided in four categories, depending on the characteristics
of the liabilities. The latter can be direct or contingent, and in either case, explicit or implicit.
While direct liabilities are obligations that will arise with certainty, contingent liabilities depend
on being triggered by a discrete event. The probability and magnitude of such contingency may
be exogenous, as is the case of a natural disaster, or endogenous in the case of the increasing
provision of State guarantees.
17
Explicit liabilities are specific obligations of the government, established by a particular law or
contract. Examples include the repayment of sovereign debt and repayment of nonperforming laws guaranteed by the government. Implicit liabilities in turn respond to a moral
obligation of the government, which is not established in any contract but is based on public
expectations. Examples include State intervention in the event of default of a large bank on
non guaranteed obligations.
The amplified balance sheet for Colombia included explicit contingent liabilities such as public
body debt guarantees and guarantees for infrastructure contracts. Similarly, the implicit
contingent liabilities included the bailing out of financial institutions, bailing out of regional
bodies (public enterprises, regional and municipal governments), natural disasters,
contingencies arising from legal actions against the Nation, constitutional obligations with no
contractual basis and the anticipated cost of peace negotiations (Table 3).
Both, assets and liabilities need to be recalculated, as contingencies can affect either of them.
The revaluation of assets amounts to 162.3% of GDP, in contrast to the 140.4% reflected in
the official balance due to a recalculation of the value of natural resources such as oil and coal
reserves in addition to the inclusion of the electromagnetic spectrum as a source of income.
On the other hand, government liabilities rise from 78.2% of GDP to 252.2% after the
recalculation of pension and contingent liabilities. This translates as a deterioration of
government net worth from 62.3% to -89.9% of GDP.
In order for the transversality condition to hold, so as to ensure solvency, such net worth
should equal the present discounted value of a future flow of fiscal surpluses. Roughly, the
present discounted value of a perpetual surplus of x, at a discount rate of r and a GDP growth
rate of g, would be x/ (r - g). Considering that the average real interest rate of domestic and
foreign public sector debt in Colombia over the past two decades has been 8% (Trujillo, 1999),
while the average GDP growth rate has been 3.5% the required primary surplus would
approximately be 4.04% of GDP to cover a negative net worth of 89.9%. Nevertheless, when
considering the deficit for the consolidated public sector it must be taken into account that the
Central Government has already included a yearly transfer of 3% of GDP to cover pension
liabilities. Hence, the latter is already accounted as part of the deficit. Taking this transfer into
18
account, over a period of fifty years, significantly reduces the total PDV of the pension liability
from 160% of GDP to approximately 100% of GDP2. This implies that taking into
consideration these governmental transfers aimed at financing pension liabilities increases the
government net worth from -89.9% to -30.7%. Therefore it is necessary to re-calculate of the
flow of net surplus required to cover such negative net worth, in order to take into account the
consolidated public sector finances. This results in a surplus value of 1.38% of GDP. Data on
public finances in Colombia3 indicate that such a value has never been achieved in the past
fifty years.
This calculation was performed using the same discount rate that was used in calculating the flow of surplus
required to cover the negative net worth of 89.9% of GDP, namely 4.5%.
3
Sources include Banco de la Republica (the Colombian Central Bank) and the Ministry of Finance
2
19
Table 3: Contingent Liabilties
CONTINGENCIES
Natural Disasters
Earthquakes
Floods
Financial Entities Bail Out
Pension Liabilities
Percent of
GDP
1.1
1.1
0.01
2.2
159.2
Infrastructure
Roads
Airports
Energy
Telecommunications
Mass Transportation
6
0.1
0.7
0.5
0.2
4.4
Foreign Debt
0.7
Judicial Decisions
0.2
Territorial Debt
0.5
Peace
4.1
TOTAL
174.0
Source: Echeverry et al (1999)
The inclusion of “hidden” liabilities in the public sector’s balance sheet unveils the
unsustainability of fiscal policy in Colombia. Contingent liabilities and the implicit liability
represented by the pension debt mount to 174% of GDP. This evidence stresses the incidence
of such liabilities in public finance dynamics and hence government solvency, an issue which is
not apparent when focusing only on conventional deficit or debt measures.
20
5. The accumulation of contingent liabilities in Colombia
 Infrastructure
The privatization of State functions, accompanied by implicit or explicit government
guarantees has become an important cause for the increasing fiscal risk and uncertainty
currently faced by governments. State guarantees and insurance schemes represent an
alternative to budgetary subsidies and direct financing of financial services, which has become
a common method of government support. “These off-budget programmes and obligations
involve hidden fiscal costs with implicit and contingent liabilities that may result into excessive
requirements for public financing in the medium and long term” (Polackova, 1998).
This has been the case in Colombia in the sector of infrastructure, where contracts between
the public and the private sector have become a considerable source of contingent liabilities, as
State guarantees represent an important incentive to attract private investment. Across the
guarantees issued, the net present value of contingent liabilities in the infrastructure sector was
estimated at approximately 6% of GDP.
The 1991 Constitution provided the judicial tools that allowed for the private sector to
provide goods and services which had previously remained as a State monopoly. This led to
private investment in roads, energy and telecommunications, through contracts in which the
Nation assumed a great share of the risk, which was translated into contingent liabilities.
In contracts for the concession of road construction, rehabilitation and maintenance, the State
granted traffic volume guarantees and to a lesser extent excess cost guarantees (Echeverry and
Navas, 2000)4. The former are invoked if anticipated income falls below an agreed minimal
level, related to predicted traffic volume. However, if income rises above an allowed maximum
it becomes a contingent asset and the excess is returned to the State. Nevertheless, the
financial sustainability of most road projects has been uncertain, given to lower levels of
demand than were expected. Effective traffic has been between 74% and 85% of the
Excess cost guarantees forced the State to assume the totality of the initial 30% of excess costs in construction,
and a 75% of those between 30% and 50%.
4
21
guaranteed levels. Therefore, in average, since 1996, the government has had to pay
approximately 0.012% of GDP every year due to guarantees (Reyes, 2002). The present
discounted value (PDV) of this contingent liability, included in the amplified balance sheet is
0.1% of 1997 GDP.
Similarly, the contract for the construction of the second runway at El Dorado International
Airport (Bogota), includes traffic volume guarantees, which constitute a minimum income
guarantee. Additionally the government is to provide compensation for tariff modifications.
The liquidity for such guarantees has been ensured through the formation of a Government
fund. The PDV of this contingency for the duration of the project (20 years) is 0.7% of 1997
GDP.
In the telecommunications sector, Law 37 (1993) set Joint Venture contracts as the basis for
the association of the public and private sector for investment projects. Within this scheme the
State telecommunications company (Telecom) provided the existent infrastructure, while a
private partner performed all new investment in order to install new telephone lines. To insure
private agent participation Telecom guaranteed a cash flow, determined by the number of
installed, projected or sold lines. If the project’s income falls below 90% than its forecasted
value, the State must compensate its partner. The State guaranteed a profit rate of 12% in
dollars, covering its partners against both commercial and currency risk.
Once again, demand levels have fallen below expectations, generating an increasing pressure
upon Telecom’s finances. According to the National Council of Economic and Social Policy of
Colombia (CONPES), the State company is presently obliged to pay an amount between
US$800 and US$1600, depending on the interpretation of the contracts.
Private participation in electric energy generation is regulated by decree 700 of 1992, and has
taken the shape of Power Purchase Agreements (PPA). The latter are contracts in which the
private investors are committed to the construction of electric energy generation plants in
exchange for a guarantee of energy purchase from the power distributors, for a period of 15 to
20 years, at an agreed rate. These payments are in turn guaranteed by the State either directly or
through a decentralized agency. Nevertheless, these contracts have been granted under
22
onerous conditions, and the price at which purchases are agreed is above market price. Hence
the Government has had to assume this difference. The PDV, until 2009, for existent
guarantees under this scheme mount to 0.5% of 1997 GDP.
The above, represent examples of explicit contingent liabilities, resultant from government
contracts, all of which have a significant negative impact upon public finances. They provide
evidence of how risk accumulated in a decentralized manner at a micro level can jeopardize
macroeconomic stability in the longer term through their incidence upon government
solvency.
 The financial sector
In addition to these, there exist implicit contingent liabilities which are accepted by the
government only after a failure takes place in the market and a bail-out is granted. “Contingent
implicit liabilities often pose the greatest fiscal risk to governments. The event triggering the
liability is uncertain, the value at risk difficult to evaluate, and the extent of the government
involvement often difficult to predict. In short, it is very hard to identify and estimate the size
of contingent liabilities” (Polackova, 1998).
According to Polackova (1998), the financial system is a government’s most serious contingent
liability. Considering that the soundness of the financial system is crucial to a country’s
macroeconomic stability and economic growth, government’s have incentives to intervene
providing liquidity, backing deposits, assuming bad loans and injecting equity capital in order
to avoid a systemic crisis. These practices have the additional consequence of exacerbating the
moral hazard problem in the financial sector.
The fiscal costs associated to a financial crisis are both direct and indirect. The direct ones
correspond to deposit insurance granted by the state; the indirect emerge from the too big to
fail implicit guarantee for some financial intermediaries. The value included in the amplified
public sector balance sheet in Echeverry et al. (1999), is associated to the direct costs incurred
in through the financial sector bail out in Colombia in 1998/9. This is the cost of liquidation of
insolvent public institutions, governmental payments to house owners in fulfilment of a
Constitutional Court ruling which favoured mortgage debtors, and public schemes aimed at
23
the re-capitalization of private financial institutions that presented net worth deterioration. The
contingent liability included in the amplified balance sheet represents the difference between
the resources provided by the State through re-capitalization and those which are subsequently
recovered in the future through the sale of financial institutions. This value varies between
1.24% and 1.68% of 1997 GDP depending on assumptions on the financial system’s recovery.
On the other hand, according to Standard and Poor’s (2002): “While upfront costs are a
superior measure of direct pressures on public finances stemming from banking crises, they fail
to capture the potentially larger, albeit unquantifiable, indirect costs to the economy in the
future. No matter how successfully handled, banking crises are always followed by a period of
financial sector consolidation, during which credit is scarce and expensive, policy credibility
and predictability weak, and consumer and investor confidence bearish. As a result, economic
growth decelerates to below-trend rates, sometimes for extended periods, as the corporate and
household sectors de-leverage. In addition to its obvious welfare and social implications,
slower growth adversely impacts public finances by reducing fiscal revenues and pressuring
expenditures.”
Considering the perverse effects of stressed financial sectors upon macroeconomic stability,
economic growth and governmental financial flexibility, Standard & Poor’s acknowledge their
impact upon sovereign creditworthiness. Thus, they formally include an examination of the
contingent risks posed by the financial sector in their sovereign risk analysis.
Therefore, they develop a broader measure aimed at capturing both the direct and indirect
costs incorporated in contingent liabilities associated to financial crises. Indirect economic
costs include inefficiencies associated with credit scarcity and high interest rates, corporate and
household deleveraging, the likelihood of excessive real economic adjustment and the
opportunity cost of poorly invested capital yielding sub par returns. The proxy for both the
direct fiscal and indirect economic costs of financial system stress is the gross level of
problematic assets in the financial system, as a percentage of domestic credit, during a cyclical
down turn (GPA). In this manner, Standard and Poor’s aims at analyzing banking systems as a
contingent liability to the government in order to assess the fiscal stance of the sovereigns.
24
According to Standard and Poor’s methodology, the contingent liability of the financial sector
in Colombia is estimated at a level between 3.9% and 7.8% of GDP5.
 Public Sector debt guarantees
Additional implicit contingent liabilities are derived from public sector debt guarantees to subnational governments and enterprises. The latter have been exacerbated as a result of a process
of increased decentralization set forth with the Constitution of 1991. Even though current
legislation does not include explicit mechanisms through which the central government is to
bail out sub-national governments, there exists an implicit obligation derived from the risks
upon the central government’s debt due to imbalances at a sub-national level. Indeed,
Colombia’s track record in servicing public debt has been impeccable for decades; this has
implied that in several occasions the Central Government has been forced to service loans of
sub-national Governments, as it has been the case of the Metro de Medellin and the Cali
Public Utilities Enterprise (EMCALI), whose servicing capacity vanished years ago.
EMCALI became financially unviable as a result of poor administration which was translated
in low revenues and high labour costs, due mainly to poignant pension liabilities. Growing
deficits led to the accumulation of unsustainable levels of domestic and external debt, and its
subsequent default. The National government has guaranteed EMCALI’s external debt and
has been forced to honour it.
Furthermore, in the case of domestic debt, a crisis confronted by a sub-national government
poses serious risks upon the stability of the financial sector. These factors lead to a problem of
moral hazard regarding sub-national entities’ financial discipline.
The 1991 Constitution granted sub-national entities with greater autonomy in their
indebtedness capacity. Until 1993, the domestic credit operations performed by such entities
Financial systems are placed in the six GPA ranges based on Standard & Poor's appraisal of financial institution
management, prudential supervision, the pace of change in the regulatory and operating environment, the degree
of macroeconomic imbalances and volatility, and the extent of systemic moral hazard in the country in question.
Within this framework Colombia was placed in the GPA range of 15% - 30%. Subsequently the measure is
calculated as a share of GDP, as it represents a better measure of pressures on fiscal and monetary policy deriving
from financial sector stress. It is worth noting that the larger the financial sector and level of intermediation,
ceteris paribus, the larger the contingent liability.
5
25
did not require of any previous control from the Finance Ministry besides their registration. At
that time, regulation established that entities were entitled to greater indebtness if their debt
service during the respective fiscal period was below 30% of the entity’s ordinary income.
These facts, together with higher levels of current income, led to accelerated growth in subnational government debt. Only until 1997, through Law 358, was sub-national government
debt limited constitutionally to levels which were proportional to the entities’ payment
capacity. The latter was determined through indicators based upon the entities’ operational
savings (a flow concept). Nevertheless, current regulation has proved insufficient to restrain
sub-national government debt growth and ensure its quality, therefore leaving it to remain as
an important implicit contingent liability for the national government.
The valuation of a sub-national government bail out is based upon territorial entities’ debt
levels with commercial banks. The latter is assessed according to the entities’ solvency and
liquidity situation. Assuming that 50% of the debt which is at a critical level6 will not be paid
generates a liability for the national government which mounts to 0.48% of 1997 GDP
(Echeverry et al 1999).
 Pensions
Through the amplification of Colombia’s public sector balance sheet, pension liabilities were
revealed as the most poignant threat to fiscal sustainability given their size and long-term
implications. Even though these constitute a direct implicit liability for the National
government, their characteristics make them vulnerable to various contingencies which add
greater uncertainty to the sustainability of fiscal policy, and thereby to governmental solvency.
Colombia’s pension scheme until 1993 was a partially unfunded, defined benefit system. Being
a pay-as-you-go (PAYG) system its sustainability is vulnerable to changes in demographic
trends, mismanagement and economic downturns.
The PDV of the implicit pension liability was estimated by Echeverry et al (1999) to be 159%
of GDP. Nevertheless, subsequent assessment has led to a valuation of the PDV of the
pension liability, between 2000 and 2050, to be 210% of GDP (Echeverry et al, 2001).
Sub-national debt is considered to be critical if the ratio debt interests/operational savings is greater than 60%,
and the ratio debt level/current income is greater than 80%.
6
26
Unfunded pension payments performed by the National government out of taxes have tripled
between 1990 and 2002, passing from 0.8% to 3.0% of GDP. According to Echeverry et al
(2001), in the absence of a major pension reform, the annual deficit associated to pension
unfunded payments (within the PAYG system) would be approximately 6% of GDP during
the next 20 years.
The accumulation of such a liability is the result of a variety of factors, which were taken into
consideration in its re-estimation. Primarily Colombia’s pension scheme was initially conceived
in a decentralized fashion which disregarded the government’s intertemporal budget
constraint. Hence as the appropriate reserves weren’t made, the pension deficit was financed
with government debt. The situation has been aggravated by high administrative costs and
corruption in the various State pension funds, in addition to the heterogeneity in benefits for
different public employees implying excessive privileges for determined groups.
Law 100 (1993) attempted to solve some of these issues, by allowing for the participation of
private pension funds, characterized by defined contributions, and hence being fully funded.
Nevertheless, this reform proved insufficient to resolve the unsustainability of Colombia’s
pension scheme, while creating a greater burden to public finances through the guarantee of a
minimum pension. The latter constitutes a contingent liability for the National government
derived from the guarantee of a minimum wage to those pensioned from either the PAYG or
defined contribution systems. A proxy of the value of such contingent liability was calculated
for the defined contribution system in roughly US$ 3 billion (Echeverry et al, 2001)7. In order
for the guarantee not to have to be invoked, and the defined contribution system to be self
sustained, the Ministry of Finance estimated that current contribution reserves would have to
earn a real profit rate of approximately 12%. In the Colombian economy this rate is between 5
and 6%. This indicates the imminent incidence of such a guarantee upon public finances.
This exercise was performed assuming an individual that earns a minimum wage during his entire life,
contributes 13.5% of his wage to a defined contribution system, during 1150 weeks (22.1 years) as required by law
to be entitled to a pension. This implies he would have saved an amount equivalent to 74.8 minimum wages (of
the year 2001). Assuming a 6% profit rate, this would represent 95 minimum wages (MW). If the individual lives
16 years after he is pensioned, he will be entitled to 192 MW. The difference between what he is entitled to and
what he has saved is 97 MW, which will have to be paid by the State. Considering the wage structure of those
affiliated in the defined contribution system by 2001, where approximately 80% of contributors to either system
earn less than two MW, this represents a total value of US$3 bn.
7
27
Changes in demographic trends presently represent a threat to Colombia’s PAYG system. The
aging of the population is reflected in a fall of the share of people within the age range of 20 –
45, constituting the major part of the working force, from 39% in year 2000 to 33% in year
2050. Similarly the share of population aged above sixty is rapidly increasing, passing from 7 to
22% in the next fifty years (Echeverry et al 2001). This reflects the generation of an important
imbalance between contributors and beneficiaries of the PAYG system which may deem the
pension system unsustainable, directly affecting government solvency. The problem is
aggravated as contributors move from the PAYG system into the private funds, increasing the
gap between contributions and benefits and thereby the government’s intertemporal fiscal
imbalances.
Based on these considerations, the Government presented to Congress a pension reform that
was approved at the end of 2002. The latter reduced the PDV of the total pension liabilities in
approximately 50% of GDP, according to the National Planning Ministry. Therefore,
presently, the estimation of the PDV of the pension liability is approximately 160% of GDP,
close to the initial calculation included in Tables 2 and 3.
An additional contingency which has challenged the sustainability of the PAYG pension
system has been economic recession. The economic downturn has led to increasing levels of
both unemployment and informal employment, thereby reducing the levels of contributions to
the pension system and deepening the system’s deficit. The National Planning Ministry in
Colombia estimated that for these reasons, the pension system stopped receiving over US$ 330
million in the year 2000. The latter evidences a very interesting factor, namely, that the pension
liability is endogenous to the business cycle via the fall in contributions. However, the effects
of the endogeneity of contingent liabilities lies beyond the scope of this piece.
Evidence provided so far proves the vulnerability of fiscal sustainability and thereby, of
government solvency due to the presence of contingent and direct implicit liabilities for
Colombia. Traditional measures of fiscal soundness do not evidence the risk placed upon the
government’s net worth as it is exposed to shocks which trigger such liabilities and suddenly
drain vast amounts of public resources. The accumulation of contingent and implicit liabilities
entails an increased exposure to such shocks.
28
In terms of the theoretical model this can be represented as a jump in the solvency constraint
which is suddenly made more restrictive. This is equivalent to the Colombian government
initially being in zone Z, in graph (4), where it faced a problem of illiquidity but was growing
out of debt, and suddenly being made insolvent due to the jumps associated to contingent and
implicit liabilities. The uncertainty associated with the country’s fiscal stance has direct
consequences upon the valuation of the government’s debt, the analysis of which is beyond
the scope of this paper.
29
6. The Institutional Underpinnings
As it was previously mentioned, confronting the fiscal risks associated to Colombia’s partially
unfunded pension scheme has led to a structural pension reform, aiming at achieving a balance
between contributions and benefits and reducing the PDV of the liabilities. Nevertheless,
between the reform and governmental funding, the pension liability has been reduced in PDV
to approximately 100% of GDP, therefore it continues to be a grave threat to long run
financial sustainability. Furthermore, because of its nature, the pension debt remains to be a
source of substantial instability for public finances, given that contributions continue to be
subject to exogenous shocks which translate into contingent liabilities for the government
which are presently not provided for.
Contingent liabilities arising from government guarantees emerging from contracts with the
private sector have set forth the inefficiencies in risk allocation. Poorly designed projects have
been undertaken due to loopholes in government fiscal management which have made it
possible for such projects to obtain government guarantees, with which the government
assumes most of the risk. The government lacked regulation for the issuance and oversight of
guarantees, in addition to other contingent liabilities. Furthermore, accounting rules required
that outlays on contingent liabilities that fell due be acknowledged as investment overruns. In
the budget, however, investments were already restricted. Lack of budgetary funds thus meant
that payments due to the guarantee beneficiaries grew at high penalty interest rates.
When the size and unpredictability of payments grew beyond the handling capacity of some
public entities, budgetary adjustments (most notably in the so-called vigencias futuras, or future
expenditure commitments) and structuring adjustments (in mechanisms that insure liquidity
for the project) were made. These adjustments gave the government greater ability to honor its
guarantees in a more timely fashion. Nevertheless this did not tackle fundamental problems in
terms of both government liquidity and solvency. The government did not have the capability
to value its obligations and more importantly did not have the adequate assets to offset its
obligations.
Handling contingent liabilities through vigencias futuras implied that future budgetary
expenditures could be ear marked, ensuring budgeting while explicitly recognizing the
30
obligations. Even though this mechanism ensured the availability of funds to support liabilities
in the short run, it introduced severe rigidities for future government budgets and was based
on crude valuation methodologies for contingent liabilities. Liquidity provision mechanisms
have taken the form of trusts or standby loan facilities, which imply important costs as the call
for greater than necessary budget provisions and have failed in providing the liquidity required
by private investors. Therefore recent projects have relied on the participation of financial
intermediaries that manage the resources allocated to cover these liabilities when they emerge.
Measures have been taken from a normative perspective through the issuance of Law 448
(1998) and Decree 423 (2001) which are aimed at providing liquidity as contingencies become
effective. Law 448 regulated the valuation, budgeting and control of contingent liabilities;
created the State Entities’ Contingency Fund and defined resources to be devoted to financing
such liabilities. Namely, Law 448 establishes the obligation for public entities to budget
contingent liabilities as debt service, implying that they must make appropriate provisions to
face them. Decree 423 assigns the CONPES responsibility for establishing the guidelines for
contractual relationships between public entities and the private sector in the development of
infrastructure. Additionally it creates the State Policy for contractual risks, which determines
the type of risk each sector is allowed to undertake, while unifying the economic policy on risk
management.
The Contingency Fund is meant to ensure a close relation between the value and the liquidity
of guarantees in infrastructure projects. Government entities are to include in their budgets the
contribution to the Fund that corresponds to the current year. This improves the credibility of
guarantees, because deposits in the Fund constitute the offsetting asset required to cover the
contingency, and the resources’ value is maintained over time as earned interests are
reinvested. The Fund acts as an account in the sense that it is only held responsible for an
amount equivalent to the contribution made by the respective entity. Deposits within the fund
are broken down by both project and individual risk levels, therefore deposits made by
different entities are not pooled together. In the event that the contingency does not arise, the
entities’ payments may be reimbursed or transferred to other projects.
31
7. Conclusions
Government solvency is a long term concept immersed in a dynamic framework, hence its
analysis can not be limited to the examination of flow variables such as annual budget deficits.
A long term, stock perspective unveils the vulnerability of such flows to shocks which have
dramatic effects on the government’s net worth, which is the basis for the determination of
solvency.
Nevertheless, the analysis of solvency is constructed upon flow variables such as annual
deficits. Empirical literature has revealed the faults in the traditional deficit measurements as
they overlook off-budget liabilities, such as contingent liabilities. These faults are ultimately
translated in the analysis of government solvency, as the accumulation of contingent liabilities
renders it vulnerable to shocks.
A flow based approach to public finances provides incentives for the accumulation of
contingent liabilities within fiscal adjustment frameworks, as these take the shape of deficit
ceilings. This sets forth the importance of the quality of fiscal adjustment, stressing its
consequences in terms of efficient risk allocation.
Fiscal adjustment, aimed at complying with the government’s solvency constraint needs to be
performed within an intertemporal framework which takes into consideration the long term
implications of policies, including the risks they entail.
Contingent liabilities have substantial effects upon flow variables, thereby representing a major
source of instability while ultimately 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.
The importance of taking into consideration contingent liabilities when determining the
sustainability of fiscal policy is evidenced by the fact that these have the power to dramatically
alter the perspective of a government’s solvency. While a nation may appear to be solvent at
32
some point in time, liabilities triggered by a determined event at an uncertain moment may
suddenly deem it insolvent.
The risk associated to the accumulation of contingent liabilities, can hence be expressed as the
vulnerability of a government’s capacity to pay to “jumps”, which alter its solvency constraint
making it more restrictive. This is exemplified by the case of Colombia, where the
amplification of the government’s balance sheet through the inclusion of contingent and
implicit liabilities reveals an otherwise hidden problem of insolvency. In terms of graph 4, this
is equivalent to the Colombian government initially being in zone Z, where it faced a problem
of illiquidity but was growing out of debt, and suddenly being made insolvent due to the jumps
associated to contingent and implicit liabilities.
The contingencies which reduce a government’s capacity to pay may be endogenous or
exogenous. This paper has modeled contingent liabilities as exogenous shocks. Nevertheless,
implicit liabilities such as pension liabilities are subject to shocks which are endogenous to the
country’s economic performance.
Further research should focus on endogenizing  , as well as the probability of occurrence of
shocks. Indeed. The value of  may depend on certain characteristics of the public sector, in
every country, or on institutional features. The study of these elements can shed light on the
sources of unsustainable public finance dynamics observed in cases such as that of Argentina.
Furthermore, the study of the triggering elements in different countries can improve our
understanding to assess macroeconomic and debt default risks.
In short, a stock based approach of public finances including the analysis of contingent
liabilities exposes the vulnerability of fiscal solvency to shocks and is hence crucial in the
determination of the sustainability of fiscal policy.
33
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