Managing Fiscal Risks Teresa Ter-Minassian Annual Meeting of the Spanish Economic Association Zaragoza, December 12, 2008 Overview of presentation Definition and sources of fiscal risks Assessing and disclosing fiscal risks Managing fiscal risks Fiscal risks from public-private partnerships (PPPs) Fiscal risks from financial crises Definition and sources of fiscal risks What are fiscal risks, and how significant are they? Fiscal risks are defined here as factors outside government control that can cause fiscal outturns to differ from their initial forecasts. Empirical analysis shows that such deviations can be large, on both the upside and the downside. They are significant in both advanced and developing countries, although on average larger in the latter. The materialization of large unexpected fiscal risks can jeopardize macro-economic stability and longer-term fiscal sustainability. How Large Are Fiscal Risks? Surprise Deviations in Debt/GDP Deviations of Debt/GDP--All Countries -4sd -3sd -2sd -1sd mean +1sd +2sd +3sd +4sd +5sd 40 60 80 10th Percentile 0 20 Frequency 100 120 140 -5sd -30 -20 -10 0 10 20 In percent of GDP; positive deviation if actual > forecast Total obs. 398; mean=-0.77; sd=6.78; skewness=0.21; kurtosis=6.96 30 How Large Are Fiscal Risks? Surprise Deviations in Balance/GDP Deviations of Balance/GDP--All Countries 120 160 200 240 280 320 80 10th Percentile 0 40 Frequency -6sd -5sd -4sd -3sd -2sd -1sd mean +1sd +2sd +3sd +4sd +5sd +6sd -20 -15 -10 -5 0 5 10 15 In percent of GDP; positive deviation if actual > forecast Total obs. 1397; mean=-0.36; sd=3.21; skewness=-0.47; kurtosis=8.96 20 Sources of fiscal risks Sources of fiscal risks can be grouped into two main categories Unforeseen exogenous developments In real GDP growth and inflation In commodity prices In exchange rates and interest rates In external assistance flows to low-income countries Contingent liabilities Government obligations, whose amount and time of realization depend on events outside the government’s control Can be explicit or implicit Contingent Liabilities Contingent Liabilities Explicit Implicit (obligations based on contracts, laws, or clear policy commitments) (political or moral obligations, rather than contractual) Guarantees Bailouts (loan; trade and ER; minimum pension; income, profit and rate of return guarantees under PPPs) (of PEs, financial institutions, subnational govts., strategic private firms) Natural disaster spending Natural disaster relief Legal claims against the state Environmental cleanup Other e.g. ideminities; insurance programs; uncalled capital 8 Incentives for governments to accumulate fiscal risks Incentives for optimistic bias in budget forecasts To facilitate budget approval To demonstrate ex-ante compliance with numerical fiscal rules To improve market perceptions of the country’s credit worthiness Incentives to provide guarantees, in lieu of direct budget support To minimize explicit outlays in proposed budgets To show as revenues any fees received for guarantees Assessing and Disclosing Fiscal Risks Assessing fiscal risks Appropriate assessment methodologies vary with nature of the risk. To assess budgetary implications of unexpected macro-economic developments, systematic use of sensitivity analysis of budget baseline, and preparation of comprehensive, internally consistent alternative scenarios are needed. Assessment of contingent liabilities (CL) requires estimation of their expected value, which may be difficult to quantify, if the probability distribution of their realization is not well known (e.g. for natural disasters). Monte-Carlo simulations used in some instances (e.g. for guarantees included in PPP agreements). Disclosing fiscal risks Benefits of disclosure requirements Reduce government incentives to accumulate risks Strengthen accountability for their identification and management Promote earlier and smoother policy responses Can improve markets’ perception of a government’s fiscal transparency and responsibility, and over time moderate its financing costs Disclosure requirements should be embedded in a robust legal framework, and underpinned by adequate institutional capacity, to ensure consistent compliance over time International disclosure standards Disclosure practices are shaped by international accounting, statistical and transparency standards The International Public Sector Accounting Standard (IPSAS) requires inclusion of the expected fiscal cost of a CL in government’s financial statement, if it can be measured and its probability of realization exceeds 50%; disclosure in notes to the statement, if its probability is less than 50%, but “not remote” The IMF’s Government Fiscal Statistics Manual (GFSM 2001) requires disclosure of key CLs as memorandum items in governments’ balance sheets The IMF’s Code and Manual of Fiscal Transparency, and the OECD’s Best Practices for Budget Transparency recommend inclusion of a comprehensive statement of fiscal risks in budget documentation Disclosure practices Many countries include (more or less comprehensive) disclosure requirements for fiscal risks in their national budget frameworks, fiscal responsibility or fiscal transparency laws. The range of risks disclosed has been increasing, and the detail and quality of information provided are improving. Many implicit contingent liabilities (e.g. risks of bailouts) are excluded from disclosure, because of moral hazard concerns. Best practices are generally found in advanced counties (e.g. New Zealand, UK, Australia); but more recently also in some emerging markets (e.g. Chile, Colombia, Brazil, Indonesia). Managing Fiscal Risks Mitigating fiscal risks Some useful approaches to mitigating fiscal risks Preparation by fiscal policy-makers of appropriate contingency responses to the materialization of macro-economic risks to the budget baseline. Separation of the responsibility for risk assessment from that for deciding on the assumption of the risk. Vesting of overall responsibility for managing the portfolio of fiscal risks in a central authority, preferably the Ministry of Finance. However, line ministries and agencies should also be responsible for managing the specific risks relating to their activities. Mitigating fiscal risks Sharing of a risk between a government and other entities should be guided by an assessment of which party is best placed to bear that specific risk. Risk-bearing by the government can be mitigated by capping the amount of guarantees, and by levying risk-adjusted premiums for their provision. Guarantees should have automatic sunset (or at least periodic review) clauses. For some risks, governments can purchase private reinsurance (e.g. hedging for oil price changes; catastrophe bonds). Decisions to do so require careful analysis of expected costs and benefits. Integrating fiscal risks into the budget Fiscal risks should be systematically incorporated into fiscal analysis and the budget process Medium to long-term public debt sustainability analyses should include stress tests of underlying assumptions, and incorporate the expected value of significant contingent liabilities Annual budgets should include appropriations for expected calls on guarantees, and adequate provision for the materialization of other risks Parliamentary approval should be sought for annual ceilings on main categories of guarantees, or at least their aggregate amount PPPs and Fiscal Risks Types of fiscal risks in PPPs An appropriate sharing of risks between the government and the private partner is crucial to promote the realization of efficiency gains from PPPs (compared with direct government procurement) Risks should be shared in line with each partner’s ability to bear it The government should bear policy-related risks (e.g. risks of expropriation, and of significant changes in legal or regulatory frameworks) The private partner should bear normal commercial (construction and supply) and financial (interest rate and exchange rate) risks Demand risk may need to be shared (on both the upside and the downside) Managing PPP-related risks Governments need significant institutional capacity (robust legal frameworks; trained manpower) to structure PPP projects appropriately, evaluate bids, and monitor effectively project execution, so as to minimize attendant fiscal risks and maximize value-for-money (VFM). There should be a central “gatekeeper” unit (preferably in the Ministry of Finance) to review and approve all proposed PPP projects. The choice between PPP and direct public procurement should be based on a careful assessment of respective VFMs, not on their upfront budgetary cost. Managing PPP-related risks Appropriate budgeting and accounting rules are essential to ensure that PPPs are entered into for the right reasons The annual expected value of guarantees and other contingent liabilities should be provisioned for in the budget The stream of expected service payments for PPPs and calls on guarantees should be incorporated in medium-to-long term debt sustainability analyses, with appropriate sensitivity tests Some countries have found it useful to cap the total value of government exposure under PPP projects, or the total projected amount of PPP-related annual budget expenditures Financial Crises and Fiscal Risks Types of fiscal risks created by financial crises Financial crises give rise to different types of fiscal risks Revenue losses from declines in output and in asset prices Increases in cyclically-sensitive primary expenditures Increases in public debt and its service, reflecting increased sovereign risk premiums, and/or exchange rate depreciation Increased rollover risk for the public debt Pressures for bailouts: Of state-owned enterprises Of sub-national governments Of financial institutions and non-financial private enterprises “too big to fail” Available empirical estimates focus on the cost of bank bailouts Main types of financial sector bailouts Crisis containment Liquidity injections by central bank (CB). Deposit or loan guarantees Forbearance measures Administrative measures (e.g. deposit freezes; bank holidays) Bank restructuring Capital injections (grants, loans or equity) Purchases of troubled bank assets Other forms of support to asset values Take-over by governments of bank liabilities Some of these interventions result in immediate budget outlays; most in CL (e.g. calls on guarantees; need to recapitalize the CB) Eventual fiscal cost depends on the extent of realization of CL, and on the rate of recovery of assets taken over by government. The net costs of bank bailouts in last three decades have varied widely ge nt in a In 19 do 8 n 0 Ja e s m ia Th aic ai a la Tu nd D om rk in K ey i c or an ea R M ep. ex ic C o Ec hi u le Bu ado Ph l g r i li ari N ppi a ic ne Ve ara s ne gu zu a Fi ela n U lan ru d gu a B Pa ra y r z Ar V agu il ge ie a nt tn y in am a Ar 2 ge C 00 r nt oa 1 in t i a a 1 R 989 us C J sia ze a ch pa C M Re n ol om al p. bi ays a i Sr 19 a i L 82 an k La a Li tv th i a ua C ol om B nia o U bia l iv i ni Ar t e 19 a d ge S 98 nt t a in te a s 1 Es 99 t 5 N oni a or w ay Ar Banking Crises: Net Fiscal Costs (in percent of GDP) 60% 50% 40% 30% 20% 10% 0% Fiscal costs of the current financial crisis… ….are also likely to vary widely across countries, but to be large for many The expected relatively deep recession will impact budgets adversely through the operation of automatic stabilizers, and through any discretionary fiscal stimulus The recent decline in commodity prices will affect adversely countries dependent on natural resource revenues, but reduce the fiscal burden of price subsidies Both advanced and emerging market countries have already announced a panoply of measures to support financial institutions, the cost of which is likely to increase in the short term, as bank losses mount during the recession Pressures will also rise to support sub-national governments, and to bailout large non-financial enterprises (both public and private) Fiscal costs of the current financial crisis… …as a result, public debt levels will rise to levels that may prove unsustainable in the longer run (especially in light of pressures from aging populations and climate change) To ensure medium-to-long term fiscal sustainability, governments will need to credibly commit to fiscal consolidation when the economy recovers Through fiscal rules or fiscal responsibility legislation, possibly coupled with the creation of independent fiscal “watchdogs” By strengthening countercyclical features of their fiscal systems; and By implementing needed structural fiscal reforms, including reforms of entitlement spending programs that adequately address the fiscal cost of aging populations Thank you!