Fiscal Adjustment and Contingent Government Liabilities: Case Studies of the Czech Republic and the Former Yugoslav Republic of Macedonia

Our work in the Czech Republic and in FYR Macedonia demonstrates the importance of including contingent liabilities when assessing the magnitude of the true fiscal adjustment, and when analyzing fiscal sustainability. To the extent that explicit expenditures are shifted off-budget or replaced by the issuance of guarantees, the achieved improvement in fiscal balances is overstated. For the Czech Republic we find that adjustment may have been overstated by some 3–4 percent of GDP annually. The accumulation of contingent liabilities today is a threat to future fiscal stability. Hence, a stabilization program that is accompanied by a build-up of contingent liabilities may not be sustainable. In the case of FYR Macedonia, we found that the present fiscal equilibrium may be temporary, because the stock of existing contingent liabilities could add 2– 4 percent of GDP to future deficits. Moreover, the methods used to reduce the “traditional” deficit are unlikely to be sustainable without further modification. Our work also shows that fiscal adjustment and structural reforms are closely linked. The most obvious example is that failure to improve banking sector performance can over time lead to an accumulation of implicit contingent liabilities for governments. This article was originally issued as World Bank Policy Research Working Paper 2177 in 1999. Currencies cited in this article include the Czech crowns (CZK) and the Macedonian denars (DIN). 50 Hana Polackova Brixi, Hafez Ghanem, and Roumeen Islam Faced with external and domestic pressures, governments all around the world have been lowering their fiscal deficits. At the same time, economists are increasingly coming to realize that focusing exclusively on traditional measurements of the fiscal deficit to assess the extent of fiscal adjustment that has been attained can be misleading for two reasons. First, as Selowsky (1998) points out, quantitative improvements in fiscal policy have not always been accompanied by progress in the “quality” of adjustment. Traditional deficit measures (government budget deficits on a cash basis) do not shed sufficient light on two key dimensions of “quality”: sustainability and efficiency.1 Second, governments can reduce their measured deficit without carrying out any “true” adjustment. Easterly (1999) argues that fiscal adjustment can be just an “illusion” when it lowers the budget deficit, but leaves government net worth unchanged.2 When an outside agent forces a reduction in a government’s conventional deficit, the government often responds by lowering asset accumulation or by increasing hidden or off-budget liabilities, giving the illusion of a fiscal adjustment. Fiscal adjustment of this nature may not be either sustainable or efficient. This article focuses mostly on the issue of sustainability. Building up explicit or implicit contingent government liabilities is an important way of reducing the measured traditional fiscal deficit while avoiding difficult adjustment. Kharas and Mishra, in a separate article in this volume, show that contingent liabilities are mainly responsible for the fact that the past increases in governments’ debts have significantly exceeded their reported budget deficits in most developing and emerging-market economies. Many examples of this type of government behavior exist. In Italy the railways have raised funds through the financial markets to cover their deficits for many years with government agreement and an explicit guarantee from the treasury. Yet, those operations had no impact on the measured fiscal deficit or on the measured stock of government liabilities (Glatzel 1998). Similarly, faced with the Gramm-Rudman constraint on fiscal deficits, the U.S. Con1. Efficiency is a broad concept that includes issues such as (a) where the government should spend resources, (b) what the nature of its intervention should be, and (c) how it should obtain fiscal revenues in the least distortionary manner. 2. For other examples and explanations why change in net worth is the right conceptual measure of the deficit, see Buiter (1983 and 1985) or Blejer and Cheasty (1991). FISCAL ADJUSTMENT AND CONTINGENT GOVERNMENT LIABILITIES 51 gress has reduced direct lending by $50 billion and increased loan guarantees by $178 billion, replacing budgetary outlays by explicit contingent liabilities (Rubin 1997). Implicit liabilities often arise from the financial sector. The savings and loan crisis in the United States, which eventually cost the government about $200 billion, is a notable example (Kotlikoff 1993). In many other countries, governments have used financial institutions to hide their fiscal deficits, often by asking them to extend subsidized loans to public entities (Easterly 1999). Several factors are working to increase contingent government liabilities and fiscal risk in countries around the world: rapidly increasing volumes of private capital flows, leading to fast growth of financial systems and volatility in these flows; transformation of the state from financing of services to guaranteeing particular outcomes; and related to both of these, moral hazard in the markets and fiscal opportunism of policymakers.3 Transition and emerging-market economies face particularly large fiscal risks. Their dependence on private foreign financing, weak regulatory and legal enforcement systems, often distorted incentive structures, opaque ownership structures, and low information disclosure elevate failures in the financial and corporate sectors. Such failures, in turn, often generate political pressures on governments to intervene through bailouts. A first step toward controlling the expansion of contingent government liabilities and reducing fiscal risk is being able to identify and measure them. In this article, we discuss how this may be done and demonstrate how assessment of fiscal adjustment may change substantially when a broader picture of government liabilities is included. The article is based on our experience in analyzing fiscal adjustment in the Czech Republic and in the former Yugoslave Republic of (FYR) Macedonia. The Czech case provides an example of the deliberate use of guarantees and other support provided through off-budget institutions, which have reduced the (traditional) measured fiscal deficit and public debt. The Macedonian example demonstrates how ignoring implicit liabilities arising from financial sector and enterprise restructuring could lead to 3. The relationship between financial flows and fiscal deficits works in two ways: large capital outflows can increase implicit contingent liabilities, and large capital inflows in poorly regulated financial sectors set the stage for the accumulation of implicit contingent liabilities and even without outflows increase fiscal risk. Moreover, outflows may be prompted by the accumulation of contingent liabilities. 52 Hana Polackova Brixi, Hafez Ghanem, and Roumeen Islam a serious underestimation of the extent of fiscal adjustment needed to ensure sustainability. Both case studies provide examples of how to deal with some difficult conceptual and measurement issues when trying to estimate contingent government liabilities. The article is divided into four sections. The first section, “A Simple Framework for Identifying Government Liabilities,” presents a simple framework for identifying and classifying contingent liabilities. The next two sections—”What Is the True Fiscal Deficit in the Czech Republic?” and “Is Fiscal Stabilization in FYR Macedonia Sustainable?”—describe our work in the Czech Republic and FYR Macedonia. The “Concluding Remarks” summarize our main conclusions and suggestions for future work. A Simple Framework for Identifying Government Liabilities: The Fiscal Risk Matrix As in Polackova (1998) government liabilities are divided into four types: direct explicit, direct implicit, contingent explicit, and contingent implicit (table 1). Government direct explicit liabilities are specific obligations that will fall due with certainty and are defined by law or contract. They are the subject of traditional fiscal analysis and include repayment of sovereign debt, expenditures based on budget law in the current fiscal year, and expenditures in the long term for legally mandated items, such as civil service salaries and pensions. Government direct implicit liabilities represent a moral obligation or political, rather than legal, burden on the government that will occur with certainty. They often arise as a presumed consequence of public expenditure policies in the longer term. For example, in a public pay-as-you-go pension scheme, in a country where the government is not legally obliged to pay future public pensions, future pensions constitute a direct (expected with certainty) or implicit (political but not legal) liability. Explicit contingent liabilities represent government’s legal obligations to make a payment only if a particular event occurs. State guarantees and financing through state-guaranteed institutions are examples of this type of liability. Implicit contingent liabilities are those that are not officially recognized until a failure occurs. The triggering event, the value at risk, and the required size of the government outlay are uncertain. In most countries, the financial system represents the most serious source of implicit contingent liabilities for government. International experience indicates that markets expect the government to support the financial system far beyond its legal obligation in the aftermath of a systemic crisis, or to prevent such a crisis. FISCAL ADJUSTMENT AND CONTINGENT GOVERNMENT LIABILITIES 53 TABLE 1. THE FISCAL RISK MATRIX: EXAMPLES Direct Contingent Liabilities (obligation in any event) (obligation if a particular event occurs) Explicit Government • Foreign and domestic • State guarantees for nonsovreign liability as sovereign borrowing borrowing and obligations issued recognized (loans contracted and to subnational governments by a law or securities issued by and public and private sector contract central government) entities (development banks) • Budgetary expendi• Umbrella state guarantees for tures various types of loans (mortgage • Budgetary expendiloans, student loans, agriculture tures legally binding loans, small business loans) in the long term • Trade and exchange rate (civil servants’ guarantees issued by the state salaries and pensions) • Guarantees on borrowing by a foreign sovereign state • State guarantees on private investments • State insurance schemes (deposit insurance, income from private pension funds, crop insurance, flood insurance, war-risk insurance) Implicit A “moral” • Future public pensions • Default of subnational governobligation of (as opposed to civil ment, and public or private government service pensions) if entity on nonguaranteed that reflects not required by law debt and other obligations public and • Social security schemes • Liability clean-up in entities interest group if not required by law under privatization pressures • Future health care • Banking failure (support beyond financing if not required state insurance) by law • Investment failure of a nonguar• Future recurrent cost anteed pension fund, employment of public investments fund, or social security fund (social protection of small investors) • Default of central bank on its obligations (foreign exchange contracts, currency defense, balance of payment stability) • Bailouts following a reversal in private capital flows • Environmental recovery, disaster relief, military financing, and so forth Note: The liabilities listed above refer to the fiscal authorities, not the central bank. Source: Polackova (1998). 54 Hana Polackova Brixi, Hafez Ghanem, and Roumeen Islam