Contingent Liabilities For Philippines, By Tarun Das

Management of Contingent Liabilities in PhilippinesPolicies, Processes, Legal Framework, and Institutional Arrangements

Tarun Das*, Economic Adviser, Ministry of Finance, India. And Consultant to the World Bank

March 2002

* The author is grateful to the World Bank to provide an opportunity to prepare this report and the government of India for granting necessary permission for that. Paper expresses personal views of the author, which may not reflect views of the World Bank or the Government of India.

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Management of Contingent Liabilities in PhilippinesPolicies, Processes, Legal Framework, and Institutional Arrangements Tarun Das, Economic Adviser, Ministry of Finance, India. And Consultant to the World Bank 1. Background and Objectives 1. This report is a part of a wider study on the Public Expenditure, Procurement and Financial Management Review (PEPFMR) for the Philippines being prepared by the World Bank. The objective of the PEPFMR exercise is to examine selected issues in the allocation and management of public resources, which are of interest to the Government of Philippines and the World Bank. In particular, the objectives of the World Bank study are as follows: (i)

To help the authorities establish more effective and transparent mechanisms and policies to allocate, utilize and manage available public resources so as to promote economic growth, improve delivery of basic social services, and reduce poverty; and

(ii)

To fulfill the World Bank’s fiduciary responsibility and serve as the core background analytical framework for future operations in Philippines. The PEPFMR findings and recommendations will constitute part of the core analytical work for a proposed Public Finance Strengthening Loan (PFSL), and attendant programs and adjustment loans.

2. A key focus area of the PEPFMR is the identification and management of public contingent liabilities, which pose threats to fiscal stability and overall macroeconomic stability and, therefore, require better monitoring and management. These liabilities include exposures under obligations such as government guarantees on loans; performance guarantees to BOT projects, guarantees on guarantee institutions and deposit insurance, and fiduciary guarantees to public pension, provident and insurance institutions. Certain other categories of government's contingent liabilities include forward contracts for foreign exchange, various implicit obligations associated with bank failures, and possible recapitalization of failing corporations. These issues donot come under the purview of the PEPFMR. 2. Scope and Methodology 3. This report examines the largest components of contingent liabilities such as exposures under government guarantees on loans, BOT projects, guarantees on guarantee institutions, public pension institutions, deposit insurance, un-funded liabilities of pension institutions and the increasing debt of the National Power Corporation (Napocor). The report suggests systems for monitoring and

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dissemination of information on outstanding guarantees of the government guarantee institutions that are explicitly or implicitly backed by the national government. 4. The report examines the legal framework, policies, processes and institutional arrangements for monitoring public contingent liabilities in the Philippine government with special emphasis on state guarantees to Government Financial Institutions (GFIs) and Government Owned and Controlled Corporations (GOCCs). The report identifies the key issues and concerns, and describes, analyzes and assesses the steps already taken by the authorities. In addition, it provides countryspecific recommendations in the short-, medium- and long term for the improvement as per international sound practices. 5. The findings are based on examination of available reports on the subjects and discussions with the concerned entities involved in receiving, issuing, approving, managing and recording state contingent liabilities (focusing for the present on explicit ones which are recognized under legal laws and contracts for both domestic and external liabilities) during a mission to Manila during 17 February to 2 March 2002. 6. The consultant has worked under the continual guidance of the PEPFMR task team leader (TTL) Mr. Amitabha Mukherjee who specified the broad objectives and scope of the study and also indicated the key technical officials and policy makers in the Philippines who are responsible for the approval, issue, recording, monitoring and management of contingent liabilities. 7.

During visit to Manila, the Consultant maintained close interactions with Mr. Lloyd McKay, Lead Economist, World Bank Office at Manila (WBOM), Ms. Laura Pascua, Under-Secretary, Department of Budget and Management (DBM) and the Chairperson of the counterpart team (PER Working Group) established by the Government of Philippines; Ms. Nieves Osorio, Undersecretary, Department of Finance (DOF), Government of Philippines (GoPh), Ms. Soledad Emilia J. Cruz, Director, Corporate Affairs Group, DOF, GoPh., and Ms. Xuelin Liu, Country Economist, Philippines Country Office, Asian Development Bank.

8. The Consultant has also benefited greatly from detailed discussions with various officials of the government of Philippines and GOCCs, who are responsible for issuing, approval, monitoring and auditing of contingent liabilities and formulation of policies. A list of key officials with whom detailed discussions were held in Manila is given at Annexure-D. 3. Contingent liabilities- definitions and measurement Contingent liabilities are defined by the System of National Accounts 1993 as contractual financial arrangements that give rise to conditional requirements either to make payments or to provide objects of value. A key characteristic of such financial arrangements, as distinguished from the current financial liabilities, is that one or more conditions or events must be fulfilled before a contingent liability takes place. A key characteristic that

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makes such liabilities different from normal financial transactions is that they are uncertain. Contingent liabilities represent potential claims against the government, which have not yet materialized, but which could trigger a firm financial obligation or liability under certain circumstances. Several studies have shown that contingent liabilities, once materialized, can be a major factor in the build up of public sector debt and can pose significant risks to the government’s balance sheet. Contingent liabilities are of two main types- explicit and implicit. Explicit contingent liabilities are based upon legal and contractual commitment or formal acknowledgement of a potential claim, which can be realised in particular situations. Explicit contingent liabilities include bonds or other liabilities contracted by the government with put options for lenders, credit-related guarantees, performance guarantees, various types of government insurance schemes (e.g., against banking deposits, crop failure, natural disasters, etc.), or legal proceedings representing claims for tax refunds or against government providers of services such as health care, education, defense, housing, etc. Implicit contingent liabilities represent potential claims where the government does not have a contractual obligation to provide financial support, but society expects the government to provide assistance because of moral considerations. Implicit contingent liabilities arise when the cost of not assuming them are considered to be very high in terms of social and economic disruptions. For example, bailing out weak banks or failed financial institutions or meeting the obligations of the subnational (state and local) governments or the Central Bank in the event of default following systematic crisis may be viewed as an implicit contingent liability of the central government. Other implicit contingent liabilities include disaster relief, corporate sector bail outs, municipal bankruptcy, defaults on non guaranteed debt issued by sub-nationals and stateowned enterprises or government obligations under a fixed exchange rate regime to defend its currency peg. These risks can be particularly significant in emerging market countries undergoing financial sector and capital convertibility reforms and where the regulatory and disclosure standards may be weak. As for example of contingent liabilities, in the case of Philippines, the national government assumed about US$7.5 billion (or P152 billion) of liabilities from the Philippine National Bank (PNB) and the Development Bank of the Philippines (DBP) in the process of rehabilitation of these GFIs. Most of these liabilities were due to the default of private external borrowings, which were guaranteed by PNB and DBP. While the national government had not extended counter-guarantees to PNB and DBP for these external loans, it was constrained to assume these liabilities because of automatic government guarantees provided for in these bank charters and to avoid adverse impact on the credit rating of sovereign debt. Again in 1993, the Philippine government assumed liability of US$8.1 billion or P331 billion of cumulative losses of the Central Bank of Philippine (CBP). The losses of CBP was primarily due to mismatch between its assets and liabilities caused by fluctuations of the exchange rate and also due to bearing the

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forward exchange losses of the oil companies during the oil crisis of the late 1970s and rehabilitation of weak banks. Contingent liabilities are complex and not easy to quantify. A single and uniform framework for their measurement may not be appropriate. The choice of a technique depends on the type of contingent liability being measured and the availability of requisite data and information. It is well recognised that cash based accounting systems, even supplemented by off-budget and off-balance sheet transactions, are not suited for managing contingent liabilities. Only the accrual based accounting systems can capture contingent liabilities as they are created. Within such systems, contingent liabilities can be recorded at full face value or maximum potential loss as well as expected value and expected present value of contracts. Following Polackova (1998), contingent liabilities can be best described in terms of a Fiscal Risk Matrix cross-classifying sources of potential risks on government finance by two distinct characteristics: direct or contingent and explicit or implicit. Table-1 presents a typical fiscal risk matrix for the Philippines government. Table 1: Fiscal Risk Matrix for Philippines Government Liabilities Explicit: Government liability by law or by a contract

Direct: Obligation in Any event • • •

Contingent: Obligation if a Particular event occurs

Sovereign debt (domestic and external) Budgeted expenditures of different departments Expenditures – nondiscretionary and legally binding in the long term (civil service salaries and pensions)

• • • • • • • •

Implicit: A moral obligation of the government which reflects public and interest group pressures

•

• • •

Future recurrent costs of public investment projects

• • •

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Direct guarantees on obligations of GOCCs Guarantees on currency risks of GFIs' foreign loans Guarantees on various types of risks (including market, currency, regulatory, political) in BOT contracts Umbrella guarantees for various types of loans (agriculture, microenterprise, housing) Deposit insurance (P100k per account) Guarantees on benefits (unfunded liabilities) of the social security system and GSIS Future health care financing Tax credit certificates Bank failure (beyond state insurance) Possible default of the central bank Possible need to further recapitalize government banks Cleanup of the liabilities of privatised entities Support to enterprises (covering losses and assuming non-guaranteed obligations) Liabilities and other obligations of subnational governments

4. Practices of Managing Contingent Liabilities in Philippines At present, the government of Philippines does not have a comprehensive Act to monitor all contingent liabilities. It has only one tool to manage its contingent liabilities related to external sector. Republic Act 4860 (Foreign Borrowings Act), as amended from time to time, sets a ceiling of $7.5 million on outstanding government guarantees for foreign loans of the government-owned and controlled corporations (GOCCs). Items, which are required to be charged against this ceiling, are the guaranteed principal amounts (i.e., disbursements less repayments, excluding interest payments and other bank fees) of loans incurred and bonds issued. The national government charges a fixed 1 per cent annual guarantee fee regardless of the risk profile of the guaranteed loan or institution. The Department of Finance (DoF) reviews and approves requests of GOCCs for national government guarantees. After approval by the DoF, the Bureau of the Treasury (BTr) is mandated to keep track of government guarantees issued and to ensure that total outstanding guarantees at any time donot exceed the ceiling prescribed under RA 4860. However, borrowings of certain GOCCs (e.g., LRTA, MWSS, NDC, NEA, NIA, NPC, PNOC, and PNR etc.) are explicitly exempted in their charters from being charged against this ceiling. These exemptions render the ceiling a less effective control mechanism, especially since some of the exempted corporations are the giant GOCCs with large outstanding loan balances. A study by AGILE (Accelerating Growth Investment and Liberalisation with Equity- a Consortium of the Development Alternatives Inc., Harvard Institute for international Development, Cesar Virasta & Associates Inc. and PricewaterhouseCoopers) made an analysis of contingent liabilities of the Philippines government for 30 GOCCs. The AGILE study identified 15 GOCCs with automatic guarantees in their charters. However, a more comprehensive study made by Bernardo and Tang (2001) indicates that 22 GOCCs, out of 32 GOCCs, enjoy automatic guarantees in their charters (Annexure-A). Except guaranteed GOCC loans; other types of government contingent liabilities are largely unmonitored. There are efforts in the DoF and BTr to monitor government guarantees for various types of risks under BOT contracts but these are still in the initial stages. The government also does not monitor exposures related to foreign exchange cover for loans of government financial institutions secured by the Land Bank and the Development Bank of the Philippines from official creditors in foreign exchange and relent to accredited private financial institutions in pesos. Likewise, the unfunded liabilities of the pension institutions (Social Security System, Government Service Insurance System, Home Development Mutual Fund), also guaranteed by the government, are not monitored and managed. In addition, there is currently no system for bringing together information on outstanding guarantees of government guarantee institutions that are explicitly or implicitly backed by the national government.

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Based on current practices, guarantee fees collected are treated as part of government's general revenues and are not kept in a separate account to fund future guarantee calls. Given government's cash-based accounting and budgeting frameworks, government does not presently provide reserves for expected guarantee calls. The corporations are also not required to conform to standard prudential norms in provisioning and reserve policy for contingent liabilities. The GOCCs donot estimate and disclose their off-balance sheet contingent liabilities in their annual reports. Only when a guarantee is called does the government set up the needed budget to fund payments and only for that portion due in the current year. As in most countries, government budgets in the Philippines are done on a cash basis and not on accrual basis. Non-cash expenditures such as depreciation of assets, taxes owed but not yet paid, donot appear in the budget. Consequently, guarantees and other offbudget arrangements are made liberally and there is no hard budget constraint. Although it is possible to note guarantees and other non-cash items as memorandum items in the cash-based budgets and accounts, complete incorporation of these liabilities requires a shift from cash-based to accrual based budgeting and accounting.

5. Extent and Nature of government contingent liabilities Total contingent liabilities of the Philippines government due to government guarantees on loans, BOT projects, guarantees on guarantee institutions, public pension institutions and deposit insurance are estimated to be Pesos 3.4 trillion, which is equivalent to 111 per cent of public debt and 95 per cent of GDP. The most dominant component involves exposures in unfunded liabilities of pension institutions, amounting to P1.8 trillion or 55 per cent of GDP or 64 per cent of national government debt. At the distant second position come the government guarantees on loans (which account for 15 per cent of total contingent liabilities, equivalent to around 15 per cent of GDP and 17 per cent of national government debt), closely followed by government guarantees BOT projects (which account for about 14 per cent of total contingent liabilities, equivalent to around 14 per cent of GDP and 16 per cent of national government debt). Deposit insurance has also a significant share (11 per cent) in total contingent liabilities, equivalent to 11 per cent of GDP and 12 per cent of public debt. However, these contingent liabilities do not include government's contingent liabilities under forward contracts for foreign exchange and various implicit obligations associated with bank failures and possible recapitalization of failing corporations.

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Table-2: Summary of government contingent liabilities Maximum exposure for each type as in October 2001 Type of contingent liability

Amount (P billions)

Share in total contingent liability (%)

As % of GDP

As % of public debt

Guarantees on loans BOT Projects Guarantee institutions Public pension institutions Deposit insurance

491 455 40 1,828 352

15.5 14.3 1.3 57.7 11.1

14.8 13.7 1.2 55.0 10.6

17.2 16.0 1.4 64.2 12.4

Total 3,166 100 95.2 111.3 Source: Bernardo and Tang (2001) and AGILE (2001) except for guarantees on loans, which are updated by the author on the basis of, most recent data.

Table-3: Total Contingent liabilities (CLs) of the National Government as of October 2001 Type

Levels (Pbln)

% Share in Contingent Liabilities

% of GDP

% of total NG debt

Domestic debt Guaranteed Assumed

15.3 15.1 0.2

3.1 3.1 0.0

0.5 0.5 0.0

0.5 0.5 0.0

External debt Guaranteed Assumed

476.1 458.7 17.4

96.9 93.3 3.5

14.3 13.8 0.5

16.7 16.1 0.6

Total CLs Memo items NG total debt  Domestic  External

491.4

100.0

14.8

17.2

85.6 37.3 48.3

100.0 43.6 56.4

2844.0 1239.4 1604.6

Source: Bureau of the Treasury

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(a) Direct guarantees on loans As per the data supplied by the Bureau of the Treasury, as of October 2001, total contingent liabilities of the national government due to guaranteed loans amounted to P491.4 billion, which is equivalent to 14.8 per cent of GDP or 17.2 per cent of national government debt. This includes P17.6 billion in assumed guarantees of formerly rehabilitated GOCCs (mainly Philippine National Bank and Development Bank of Philippines). The bulk (97 per cent) of the contingent liabilities consist of guarantees on foreign debts of GOCCs, including borrowings of GOCCs whose charters exempt them from the ceiling provided under RA 4860. Domestic debts guaranteed include bond issuances of the Home Development Mutual Fund and the National Development Company as well as agrarian reform bonds of the Land Bank. A breakdown of the above data by GOCCs is not readily available. Instead, information culled from 1999 Commission on Audit reports indicate that National Power Corporation, which enjoys automatic government guarantee on its bonds, has the largest share (42 per cent) of outstanding foreign loans of GOCCs in 1999. Government financial institutions, like Bangko Senetral ng Pilipinas (21 per cent) and Development Bank of Philippines (15 per cent) also have large outstanding foreign loans. There are some weak corporations, for which the risk of government being called to service their loans is very high. A review of the financial performance on the basis of Audit Reports indicate that LRTA and PNR had negative networth for the past three years, and four others (NEA, NFA, NIA, NPC) had been registering losses leading to declining networth. Guarantees to GOCCs need to be more tightly managed and monitored. Decisions to providing guarantees should be subject to the same process of appraisal as that for providing loans. The recent decision of the DOF to make a provisioning in the budget by one percentage of guarantees is a positive move. But, these charges are modest and the uniform provisioning does not reflect an assessment of the differing risk characteristics of the projects or loans being guaranteed. In the short run, government should systematically assess the financial health of each of GOCCs to ascertain their creditworthiness and the government's risk in guaranteeing their debts. The existing guarantee limit under RA 4860 must be enforced for all GOCCs. Based on this assessment, government may opt to impose more stringent criteria before guaranteeing loans and adjust guarantee fees depending on credit rating of the institutions. In the medium term, the government should review and amend the charters of GOCCs as necessary to ensure that the guarantee limits apply to all GOCCs. Where desirable and possible, GOCCs could be privatised to avoid the risk. Weak GOCCs either need to be strengthened with feasible capital and manpower restructuring or closed with legal compensations to all stakeholders. In general, the process of auditing for the GOCCs

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needs to be strengthened with discloser of all contingent liabilities in their balance sheets. In any case, there should be no automatic guarantee of contingent liabilities by the national government and risk based fees be charged for all guarantees. The government has already taken some steps in the right direction. The Investment Coordination Committee of the DOF has created a Technical Working Group to help it complete an inventory of all contingent liabilities, review the sources of contingent liabilities, develop means for minimizing and sharing risks across government and quasigovernmental organizations, monitor projects guarantees, and build institutional capacity for effective management of contingent liabilities. The government has recognized the complexity of issues relating to continent liabilities and is devoting resources to the difficult task of measuring them. (b) BOT Projects In order to attract private sector participation and financing for critical infrastructure projects in power, road, rail transport and water supply, the government of Philippines issued guarantees for BOT projects for mitigating some of the risks posed by the political and economic environment in the Philippines. Some of the risks assumed by the government include currency, market, political and regulatory risks as well as force majeure events (such as natural calamities, war, revolution, labour agitation and strikes, changes of law, compulsory acquisition of assets by government in public interest etc.). A recent study commissioned by AGILE (2001) attempted to estimate national government exposure to BOT project-related risks for 40 power projects, six transport projects and five other projects (on water supply, housing, tourism, information technology, thermal coating and printing plant). The study assessed risks in the BOT projects and computed the expected losses of the government from these projects using Monte Carlo or stochastic simulation methods. The study estimated that the indicative exposure in these projects amounted to P1412 billion and explicit exposure at P455 billion. The explicit exposure represents the maximum contractual obligation of the national government that arises if all the contingencies, including force majeure, are triggered in all the contracts. However, it may be mentioned here that the likelihood of such happening is remote and the expected loss from some of these exposures (e.g., force majeure) is zero. The results indicate that the Sual and Pagbilao power projects and the MRT-III light rail transit project have the highest risks for losses, and the main risk factors arise from currency and demand risks and time-overruns in implementation of projects. However, it may be noted that in the case of the power projects, neither the NPC nor the national government assumes the costs of these risks as these costs are actually passed on to consumers. For MRT-III on the other hand, the government already provided US$76 million in subsidy in 2000.

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Table 4: Indicative and Explicit NG Exposures under BOT Projects* (In P billion)

Power Transport Water Others

Indicative*

Explicit*

1,210 167 4 31

253 167 4 31

Total 1,412 455 • Indicative exposures refer to the present value of future payments by the national government to BOT operators and their creditors; • Explicit exposures refer to the financial cost of buyout or termination payments as determined in contracts. Source: AGILE (2001) (c) Government guarantee institutions In the Philippines, several corporations have been set up to guarantee loans in the agriculture, small enterprise, housing and export sectors. The biggest among these is the Home Guaranty Corporation (HGC). HGC is particularly noteworthy because it has an authorized capital of P50 billion and an allowable guarantee limit of 20 times its networth. Since all of HGC's obligations and loan guarantees are backed automatically by sovereign guarantees, the government is potentially exposed to over P1 trillion in contingent liabilities from HGC alone. In addition to loan guarantees, HGC's bond issuances also carry sovereign guarantees. These bonds are issued mainly to pay for calls on the corporation's loan guarantees, payment of which are based on the total guaranteed amounts. Since the real estate slump following the Asian crisis, guarantee calls on HGC have risen substantially and have strained HGC's cash position. Reorienting HGC's guarantee scheme towards cashflow guarantee may be needed to help HGC manage the guarantee calls. A further point of concern would be pressure for it to do "formula lending" for low-income housing similar to what NHMFC was doing (i.e., with no credit evaluation). Aside from HGC, there are a host of much smaller government guarantee institutions which include the Trade and Investment Development Corporation of the Philippines (TIDCORP), the Guarantee Fund for Small and Medium Enterprises (GFSME), the Small Business Guarantee Fund Corporation (SBGFC) and the Quedan and Rural Credit Guarantee Corporation (Quedancor). Except for the SBGFC (which will be merged with the GFSME), guarantees of the TIDCORP, Quedancor and GFSME are backed by the national government.

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A 1998 study on the Quedancor, SBGFC and GFSME noted substantial losses in these programs, with all three-guarantee institutions suffering negative net operating income from 1992 to 1997. The study, moreover, observed that the number of loans guaranteed by the programs is small and the additional number of loans that were stimulated by the guarantee schemes is even smaller. Government decision to continue infusing hefty sums into these institutions should thus take these factors into consideration. (d) Public pension and provident fund institutions Social Security System (SSS) The most current audited balance sheet (2000) of the SSS shows a total reserve fund of P170.4 billion comprising Pension Reserve Fund of P151.8 billion, Employees compensation Fund P18.4 billion and Mortgagors’ Insurance Fund P0.2 billion. However, this does not accurately represent the unfunded liabilities of the institution. In 2000 the benefits of the SSS exceeded contributions by PhP3.5 billion. But, it managed to overcome the gap by its earnings from investment. However, this may not be feasible for all the years to come. According to estimates made by the Secretariat of the Presidential Retirement Income Commission (PRIC) on the basis of the World Bank PROST model, the implicit public debt in the case of termination of the program in 1999 would have amounted to P1.48 trillion or about 50% of GDP. The program's unfunded liabilities were estimated at P1.3 trillion. The PRIC Secretariat further estimated that cash flow will turn negative and the benefit payments will start dipping into reserves by 2003. Actuarially it is headed for the morgue with reserves expected to run out by 2011. Office of the Chief Actuary of the SSS also agrees with these estimates. In fact, for a long period there had been deteriorating actuarial fund life of the social security system and fund ratio due to the following factors: (a) (b) (c) (d)

Benefit enhancements without increase in contribution rate since 1979, Subsidized interest rates on housing, development and member loans Decreasing interest rates in treasury bills in 1990s, and Increasing life expectancy.

The SSS has been experiencing contributions-to-benefits as well as contributions-toexpenditures imbalances for the past several years, especially since 1993. The major problem with the SSS is that for many years, benefits have been increasing without corresponding increase in contributions. The last increase in the contribution rate from 7.4 per cent to 8.4 per cent was done in 1979. Since then the benefits had been enhanced 23 times due to political reasons, but there had been no commensurate increase in the contribution rates. This deficiency is largely accounted for by the basic mismatch between the benefit rate and the contribution rate. In the case of the SSS, even for the high-income contributor, the ratio between the present value of the stream of benefits divided by the present value

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of the stream of contributions, or the benefit ratio works out to 1.60. For the beneficiaries of the minimum pension, the benefit ratio is estimated at 7.93. Table-5 below indicates that by international comparisons, the SSS contribution rate is low while its administrative cost is high and the return on investments is poor. At present the SSS contribution rate at 8.4 per cent (comprising 3.3 percent contribution by the employee and 5.1 percent by the employer) is much smaller compared to that of GSIS and similar funded and aged social security programs in other countries. It compares unfavorably with the GSIS with a contribution rate of 21 per cent. The SSS contribution rate is also one of the lowest among the similar pension systems for other countries such as Malaysia with a contribution rate of 23 per cent, Singapore 32 per cent, China 30 per cent, Vietnam 20 per cent, Turkey 20 per cent and Egypt at 30 per cent. Table-5: Features of the Mandatory Pension Schemes in Selected Countries Country

Retirement Length of age Service required (Years) for pension (years)

Combined contribution Rate (%)

Average retirement Rate

Real rate of return on investments

Administra tion cost

China 60/ 55 5-15 30 60-90 Negative High Indonesia 55 5.7 10 Poor High Korea 60 20 9 60 Poor Malaysia 55/ 50 23 20-25 3.44% Low Philippines 60 10 8.4 89 Poor High Singapore 62 32 20-30 2% Low Thailand 55 15 5 15 Poor Medium Source: Holzmann, Robert, Ian W. Mac Artjir and Yvonne Sin “Pension Systems in East Asia and the Pacific: Challenges and Opportunities”, Social Protection Unit, The World Bank, June 2000. The SSS funds are also being utilized to subsidize consumer loans, housing loans and development loans, which constitute about 50 per cent of total investments. At the end of October 2001, housing loans comprised 26 per cent of total investments, member loans 15 per cent, development loans 8 per cent, government sector loans 17 per cent, equities in private sector 29 per cent, and real estate 4 per cent. Moreover, because of political considerations, the SSS is not allowed to diversify its investments by investing in foreign assets. The result is that the SSS has become actuarially unsound. Demographic transition in Philippines has also exacerbated the SSS’s financial plight. Due to an increase in expectation of life, more people are living longer and the pension benefits have to be paid for a longer period. Government Service Insurance Corporation (GSIS) As the name suggests, Government officials are the members of the GSIS while private employees are the members of SSS. The most current audited balance sheet (2000) of the GSIS shows a total reserve fund of P166 billion comprising Social Insurance Fund pf 14

P154 billion, Optional Life Insurance Fund P6.8 billion, General Insurance Fund P4.8 billion, and Employees Compensation Insurance Fund P0.5 billion. However, this does not accurately represent the unfunded liabilities of the institution. The PRIC Secretariat estimated that the implicit public debt of GSIS at the end of 1999 stood at P538 billion compared with a pension reserve of P136.4 billion resulting in its unfunded liabilities amounting to P401.6 billion. According to a study made by the World Bank (2000) the implicit total public pension debt for the Philippine is estimated to be 107 per cent of GDP. It may, however, be noted here that the Philippines is not the only country having problem with contingent liabilities relating to pension and provident funds. Governments all over the world face similar problems, many of which are yet to explicitly recognize that the problem exists. Table-6 below highlights the severity of the problem with implicit pension debt in some countries, which indicates that the situation in Philippines is not as bad as in some emerging markets. Table-6: Implicit Pension Debt in 26 emerging market economies (percent of GDP) Country % Country % Country % Brazil 390 Uruguay 214 Costa Rica 121 Slovenia 298 Hungary 203 Philippines 107 Macedonia 291 Croatia 201 Argentina 85 Poland 261 Estonia 189 Ecuador 63 Ukraine 257 Kyrgyz Rep 185 Senegal 51 Romania 256 Moldova 159 Mauritius 47 Malta 234 Lithuania 155 Korea 33 Portugal 233 Turkey 146 Morocco 32 Slovakia 210 Nicaragua 131 Source: Holzmann, Robert, Ian W. Mac Artjir and Yvonne Sin “Pension Systems in East Asia and the Pacific: Challenges and Opportunities”, Social Protection Unit, The World Bank, June 2000. Although the financial position of GSIS is better than that of the SSS, it is estimated that the current benefits of GSIS at the existing rates would exceed the current contributions in 1924, and there would be serious liquidity problem in 2041 and the reserves would be exhausted in 2068. The better health of GSIS is due to a better match between benefits and contribution with the benefit ratio ranging between 1.05 for the highest income bracket and 1.40 for the lowest income member. The contribution rate at 21 percent is almost two and half times of that of SSS. Although there is little scope for enhancing the contribution rate, which is reasonable at 21 per cent, there is scope for improving the compliance rate and to rationalize the benefits among the members in different income brackets. There is also scope for enhancing the qualifying period for getting pension and to increase the retirement age commensurate with the increase in expectation of life.

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It may not be politically feasible to amend the Act for removal of automatic government guarantee in the case of financial problem faced by GSIS or SSS. However, both the systems should move from defined benefits system to defined contribution system. There is also need for strengthening the Asset Liability Management (ALM) system in both these organizations to minimize the risks given defined contributions. The present thrust of the GSIS on the “Back to Basics Policy” is in the right direction. Under the policy, the GSIS concentrated on essential activities where it is efficient such as administration of benefits, limiting direct lending operations to salary and housing loans to its members, and phased out peripheral programs, which can be more efficiently handled by the private sector. The SSS can learn from these experiences of GSIS. There is also a need to separate life and non-life components of insurance. While government can provide some subsidies for life insurance for targeted groups of people due to social reasons, there should be no subsidies for non-life insurance, which can be fully funded and better managed by the private sector. The Home Development Mutual Fund (HDMF) HDMF. or Pag-IBIG is a mandatory savings program where accumulated contributions from employees and employers are used primarily for housing finance. Forty-four percent (P42.5 billion) of Pag-IBIG's assets at the end of 1999 are in the form of mortgage loans to members. Members are allowed to withdraw their account balances after 20 years of contributions (or upon retirement, death or disability) with an option to withdraw partially after 10 years. For a large number of the early contributors, PagIBIG's commitments are expected to fall due starting in 2001 up to 2005. Reserves, amounting to P25 billion, are sufficient to meet P16 billion in gross benefit claims in 2000. While Pag-IBIG appears in better shape financially than the pension institutions, the quality of its portfolio is a point of concern. It is reported that the institution's nonperforming mortgage loans comprise 30% of its mortgage portfolio, which under the worst case scenario (no recoveries) translates into a potential loss of P12 billion based on mortgages outstanding at the end of 1999 (net of loan loss provisions). Actual losses, however, would most likely be lower given recoveries on acquired assets and a 22% government guarantee on a portion of the portfolio. (e) Financial Performance of banks Philippines banks had very difficult time in recent years. Despite internal and external shocks, the banking system continued to hold its ground in 2000 with growing deposits, manageable asset quality, and desirable capital adequacy ratio. Deposits of commercial banks grew by 7.5 per cent in 2000. While savings deposits accounted for 60.7 per cent of total deposits, time and demand deposits comprised 28.4 per cent and 10.9 per cent respectively.

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BSP is the regulator for all banks – which are categorized as expanded commercial banks, non-expanded commercial banks, government banks and foreign banks. It is mandatory for all banks to disclose the off balance sheet (i.e. contingent) liabilities in their balance sheet. However, BSP itself does not disclose its contingent liabilities in national interest. There are strict prudential norms for making provisions for loss assets and sub-standard assets. Commission on Audit is responsible for auditing all GOCCs including government banks and BSP. Philippines banks, particularly the government banks, at present are beset with the problems of high levels of non-performing assets and low rate of return, although they have reasonable capital adequacy ratios. Moreover, both the capital and the nonperforming assets are unevenly distributed among the banks. The asset quality of the banking system exhibited steady worsening since 1997. The nonperforming loan (NPL) ratio of the banking system increased to 17.3 per cent at the end of 2001 compared to only 2.8 per cent at the end of 1996 (Table-7). The NPL ratio for the non-expanded commercial banks (NEKBs) was the highest at 22.8 per cent, and that for foreign banks was the lowest at 4.8 per cent, while the NPL ratio for government banks stood at 17.8 per cent at the end of 2001. Restructured loans of commercial banks increased substantially in 2000-2001 and accounted for 6 per cent of total loans. Table-7 Gross NPL ratios (Non performing loans as percentage of total loans) Year 1996 1997 1998 1999 2000 2001

Total Commercial Banks (KBs) 2.8 4.7 10.4 12.3 15.1 17.3

Expanded Commercial Banks (EKBs) 2.4 4.2 10.4 13.0 16.8 19.4

Non-Expanded Commercial banks (NEKBs) 3.7 7.2 13.7 16.4 17.6 22.8

Government Foreign banks banks 4.4 6.1 10.1 12.6 15.0 17.8

3.3 4.4 7.8 3.5 3.8 4.8

However, the banking system remained adequately capitalized. The average capital adequacy ratio (CAR) of the banking system stood at 16.4 per cent at the end of 2000, lower than 17.5 per cent achieved in 1999. Notwithstanding the decline, the ratio remained well above the BSP statutory floor rate of 10 per cent and the Bank for International Settlements (BIS) standard of 8 per cent. Meanwhile, bank provisions for possible loan defaults improved to 6.5 per cent of total loans at end-December 2000 from 5.8 per cent in 1999. On the other hand, the proportion of banks’ reserves for probable losses to total NPLs declined to 43.5 per cent at the end of December 2000 from 45.2 per cent at the end of 1999.

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The ratio of real estate loans to total loans (inclusive of inter bank loans) of commercial banks dropped marginally to 11.3 per cent at the end of 2000 from 11.6 per cent at the end of 1999. The current ratio continued to remain well below the BSP’s norm of 20 per cent ceiling on bank lending to the real estate sector. Bank’s profits continued to fall with the average return on equity (ROE) declining from 3.3 per cent in 1999 to 2.6 per cent in 2000. Return on assets (ROA) also declined from 0.5 per cent in 1999 to 0.4 per cent in 2000. The rural banks posted the highest ROE at 7 per cent followed by the commercial banks at 2.9 per cent. The ROE of the thrift banks deteriorated to (-) 1.7 per cent in 2000 from the positive ROE of 7.4 per cent in 1999. With outstanding guarantees at PhP40.4 billion the government commercial banks account for almost two-thirds (63.6 per cent) of total outstanding guarantees of PhP63.5 billion for the total banking sector. As in the case of most emerging markets, the government of Philippines is also exposed to significant explicit and implicit risks from the financial sector. Explicit risk arises from the deposit insurance system under which deposits up to PhP100, 000 (about US$2000) are fully insured. Under the assumptions that the existing deposits would not be split in anticipation of a bank failure, the maximum exposure faced by the system is about PhP352 billion (amounting to 10 per cent of GDP). In contrast, the deposit insurance fund has reserves on only PhP20 billion so the failure of any of the country’s large banks would probably exhaust the reserve. There is also an implicit risk from the possibility of a “too big to fail” bank facing a bank run or imminent failure. While it is difficult to estimate the probability for the occurrence of such an event, there are troubled banks in the Philippines. In a study on the basis of 1999 data, Standard and Poor’s has estimated that in the event of a “worst case scenario” the gross non-performing assets of the Philippines banking system would be in the range of 15 to 30 per cent of all banking system assets. This would lead to a fiscal cost to the government amounting to 7 to 15 per cent of GDP in the event of a systematic crisis. This is roughly the magnitude of the Mexico’s crisis in 1994-95 and much larger than estimates of the fiscal cost of the Philippine banking crisis in the 1980s. (f) External Sector Related Contingent Liabilities Explicit contingent liabilities in the external sector include the following: • • •

Government guarantees for non-sovereign borrowing from non-resident, Exchange rate and trade related guarantees (e.g. exchange rate guarantees, forward arrangements, letters of credit for external borrowing), Indemnities and guarantees relating to external-sector for BOT projects in infrastructure or recently privatised enterprises.

Implicit liabilities in the external sector include the following:

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• • • • • • • •

External guarantees provided by nationalised banks, developmental financial institutions, EXIM banks etc. Default of an institutional government and public or private entity on external nonguaranteed debt and other external liabilities. Clearing the liabilities of privatised entities with significant foreign participation Take-over of strategically important foreign companies Bank failure (beyond state institutions) where deposits of non-residents are also affected Investment failure of a state-run investment fund with participation by foreigners Default of the central bank on its obligations to foreign exchange contracts Environmental damage affecting offshore areas, where foreign claims are involved

Information on all these liabilities are not readily available. However, as indicated earlier, the bulk (97 per cent) of the national government guarantees consist of guarantees on foreign debts of GOCCs, and the National Power Corporation, which enjoys automatic government guarantee on its bonds, has the largest share (42%) of outstanding foreign loans of GOCCs. Government financial institutions, including the BSP, also have large outstanding foreign loans. Forward cover for foreign exchange risks Government financial institutions (GFIs), such as the Land Bank (LBP) and the Development Bank of the Philippines (DBP), are allowed to incur foreign loans from multilateral funding agencies and re-lend funds to private sector entities for industrial, agricultural and other development projects. While the concerned GFI generally takes on the credit risk, it also seeks national government guarantee to cover the foreign exchange risk. The national government provides the service, in the absence of hedging facilities in the private market, to take advantage of concessional loans from the multilateral funding agencies. In exchange, it charges guarantee fees based on the difference in peso T-bill and the interest rate on the foreign loan. These fees are generally adequate to cover exchange rate risk over time, since the expectations on peso depreciation are factored in the T-bill rates. Unfortunately, the BTr does not monitor these loans with foreign exchange cover separately. External Debt As per the World Bank’s classification, Philippines is categorised as a“Moderately indebted country” with the present value of debt to GNP ratio at 66 per cent and the present value of debt to gross exports (both goods and services) ratio at 111 per cent (Table 9-B). Philippines ranks 12th among the top 15 debtor countries and other debt indicators are quite favourable. Its debt service ratio is 14 per cent, concessional debt constitute 26 per cent of total debt (second highest after India among the top 15 debtor countries) and short term constitutes 11 per cent of total external debt (Table-9-A).

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Table-9-A: International Comparison of Top Fifteen Debtor Countries in 1999 Country and Rank in terms of stock of external debt

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Brazil Russian Federation Mexico China Indonesia Argentina Korea, Republic Turkey Thailand India Poland 12. Philippines 13. Malaysia 14. Chile 15. Venezuela

Total external debt (US$ bn)

Share of concessio nal debt in total debt (%)

244.7 173.9 167.0 154.2 150.1 147.9 129.8 101.8 96.3 94.4 54.3 52.0 45.9 37.8 35.9

External debt to GNP ratio (percent)

0.7 0.2 0.8 19.2 20.8 1.4 0.6 5.5 10.1 47.3 13.4 25.7 5.4 1.1 0.2

33.5 46.3 35.5 15.9 113.3 53.7 32.3 54.3 79.9 21.3 35.6 64.8 62.5 55.9 35.6

Ratio of shortterm debt to total debt (%)

Ratio of shortterm debt to foreign exchange

12.1 9.1 14.4 11.5 13.3 21.3 26.8 23.1 24.3 4.3 11.0 11.0 16.4 14.6 6.3

84.8 186.2 75.7 11.2 75.7 120.0 47.0 100.6 68.7 12.4 24.2 43.4 24.7 38.1 18.5

Ratio of debt services to exports of goods and services 110.9 13.5 25.1 9.0 30.3 75.8 24.6 26.2 22.0 15.0 20.4 14.3 4.8 25.4 23.2

Source: Global Development Finance, 2001, Country Tables, the World Bank. Table-9-B: International Comparison of Top Fifteen Debtor Countries in 1999 Country and Rank in terms of present value of external debt 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

11. 12. 13. 14. 15.

Brazil Mexico Argentina Indonesia China Russian federation Korea, Republic Turkey Thailand India Philippines Poland Malaysia Venezuela, RB Chile

Present value (PV) of Total external debt (US$ billion) 242.7 172.0 154.4 149.7 134.5 130.9 124.3 97.5 94.3 70.5 51.9 51.2 47.1 37.8 35.9

PV to GNP ratio (per cent) 32 40 54 103 14 37 31 49 75 16 66 34 59 40 51

PV to exports of goods and services (per cent) 380 119 429 246 61 141 73 168 128 114 111 118 50 155 172

Indebtedness classification Severe Less Severe Severe Less Moderate Less Moderate Moderate Less Moderate Less Moderate Moderate Moderate

Source: Global Development Finance, 2001, Analysis and Summary Tables, The World Bank. Note: For Severely Indebted countries, either PV/XGS > 220 or PV/GNP > 80 For Moderately Indebted countries, either 132 < PV/XGS < 220 or 48 < PV/GNP < 80 And For Less Indebted countries, Both PV/XGS < 132 and PV/GNP < 48.

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Total external debt of the Philippines declined marginally from US$52 billion at the end of 1999 to US$51.1 billion at the end of 2000. Public sector accounted for 66 per cent of total debt stock at the end of 2000 and around 66 per cent of the public debt consisted of liabilities of the National government. By creditor type, bilateral and multilateral creditors combined accounted for the bulk (48 per cent) of the country’s sources of external financing. Foreign holders of bonds and notes represented 25.8 per cent of total external debt while banks and other financial institutions provided 21.5 per cent of total credits. In terms of the currency composition, liabilities were largely denominated in US dollar (55 per cent) followed by Japanese Yen (27 per cent) and the multi-currency loans (10 per cent) from the World Bank and the Asian Development Bank. All the debt indicators are favourable as indicated below: • • •

The ratio of debt services to exports of goods and services improved from 14.3 per cent in 1999 to 12.3 per cent in 2000. The maturity profile of the country’s external debt remained concentrated in medium- and long term (MLT) loans constituting 88.6 per cent of total debt at the end of 2000. The average maturity of MLT loans stood at 16.6 years in 2000, although it declined marginally from 16.9 years in 1999.

All these indicators indicate that although the current situation is manageable, government has substantial exposure to external sector risks and needs to have appropriate policies to deal with exchange rate fluctuations. It is desirable that the government fixes benchmarks for the interest rate, maturity and currency mix of the future external loans. It may also like to put a limit on external debt and the national government guarantees to be provided on external debt.

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6. Management of Contingent Liabilities- cross Country Experiences The issue of managing contingent liabilities in an emerging economy like Philippines is to be seen in the broader context of economic development. The approach is to view contingent liabilities as a potential tool for furthering the developmental process. The critical aspect is the more effective management of contingent liabilities so that the associated risks are minimised and the costs are not unlimited. Further, since the origin of problem was the need to manage country risks on private investment flows, such liabilities need to be seen in the overall risk management framework in the emerging economy. Such a framework should cover the management of both the existing liabilities and the future issue of such liabilities, and both the explicit and implicit contingent liabilities. The broader framework should also include the direct liabilities of the government as in the case of many developed countries like Australia, Canada, New Zealand, UK and USA. Provision of government guarantees per see is not bad. But, problems of contingent liabilities arise when the risks inherent in such contingent liabilities are not properly assessed and quantified, and adequate provision is not made in the event of default by the borrower. As a result, when guarantees are invoked, it leads to heavy budgetary burden on the issuing Governments. Contingent liability, therefore, became a bad word. The conventional budgeting system on the basis of cash accounting followed by most Governments also contributed to the growth of contingent liabilities. In such a budgeting framework, guarantees appeared as an off balance-sheet item or a memorandum item in the Budget. Since they did not appear as part of the overall balance sheet and resource utilisation statements, they were often viewed as a free resource, which encouraged Governments to issue guarantees liberally for attracting private sector investment, Even in cases where the risks were understood, very often the Governments did not bother because the implications of such contingent risks was to be felt in the long run only and there was no immediate budgetary implications. The problem of moral hazard also surfaced. With Governments willing to extend all support to foreign investment, investors sometimes insisted on blanket guarantees. Once they could get commitment for assured returns as in the case of many BOT projects on power, the investors sometimes did not make serious appraisal of the projects and their risk/return profile. As a result, unviable and uneconomic projects were also taken up for investment, which led to situations where Governments often ended up paying the minimum assured returns to the investors from its own budgetary resources. However, there is no fundamental difference between the risks associated with direct loans taken by the Government and those associated with Government guarantees. If there is a shortfall of demand or income of a project funded by direct loans, the Government has less revenues than expected, and it must use general taxes to pay back lenders. With a guarantee, the Government also must use taxes to pay out the contingent

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liability if the primary borrowers default. If the Government takes the preservation of the facility, in both cases it is responsible for making debt service payments. In some cases, guarantees can be better than direct loans because guarantees can be made more explicit and can cover only sub sets of risks, while the rest of the risks can be assigned to the private operators and insurance companies. But Government should make proper appraisal and use discretion while granting guarantees. Explicit contingent liabilities may represent a significant balance sheet risk for a government and are a potential source of future tax rate variability. However, unlike most government financial obligations, contingent liabilities have a degree of uncertainty. They are exercised only if certain events occur or do not occur and the size of the actual fiscal outgo depends on the structure of the undertaking. Sound public policy requires that a government needs to carefully manage and control the risks of their contingent liabilities. The most important aspect of this is to establish clear criteria as to when contingent liabilities will be used and to use them sparingly. In a wellmanaged program, the government debt office may be called on to assist in evaluating the government’s cost and risks under the contingent liabilities, and to recommend policies for managing these risks. For a government seeking to manage risks for contingent liabilities the first step should be to determine its degree of risk aversion in the area of contingent liabilities and the extent of the balance sheet risk it wishes to be accountable for. It also needs to decide whether it wishes to manage its own balance sheet solely, or whether to be accountable for risks generated in other parts of the public sector or in the private sector. Experience in the industrialised countries suggests that more complete disclosure, better risk sharing arrangements, improved governance structures for state-owned entities and sound economic policies can lead to very substantial reductions in the government’s exposure to contingent liabilities. Annexure-B presents a brief survey on the experiences of ten countries viz. India, Australia, Canada, Columbia, Czech Republic, Hungary, New Zealand, Philippines the United Kingdom and United States with regard to the management of contingent liabilities. The choice of countries was based on the advanced nature of the consideration of the problem of contingent liabilities and the ready availability of such information. Individual country practices differ in dealing with contingent liabilities, but all countries share a common set of principles to capture maximum contingent liabilities affecting government budget. In all the countries surveyed, the consideration of contingent liabilities was an integral part of improving transparency in government operations in general and fiscal transparency in particular. Indeed it is tied to a process of bringing “open government” so that citizens and outsiders (foreign investors, commercial banks, credit rating organisations, multilateral financial institutes etc.) can more accurately assess the government’s financial position.

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All countries adopted the Government fiscal framework in line with the IMF’s Guidelines on Fiscal Transparency. In addition, these countries also publish information of the International Investment Position and report information on the new foreign exchange reserves template introduced by the IMF under the SDDS. Cross-country experiences with respect to various aspects of management of contingent liabilities are summarised below. (a) Transparency in recording and reporting (i)

Authority for Approval and Issue of government guarantees:

In all the countries either the Department of Finance or the Ministry of Finance or the Treasury is in charge of approval and issue of government guarantees except in the United Kingdom where the respective Ministries/ Departments are empowered to approve such guarantees. (ii)

Centralised Unit for monitoring of government guarantees:

In most of the countries either the Department of Finance or the Ministry of Finance or the Treasury is in charge of monitoring of guarantees. However, in the countries such as the United Kingdom, Columbia, Hungary and New Zealand where a full-fledged Public Debt Office (PDO) exists, the PDO monitors guarantees as a part of overall risk management for the government in ALM framework. (iii)

Automatic guarantee:

In general the USA and New Zealand avoid automatic guarantee and makes proper evaluation of risks before providing any kind of guarantee. However, other countries provide automatic guarantees, particularly fiduciary guarantees for insurance or certain items for social reasons. Government of India provides automatic guarantee to Small Savings Scheme, Public Provident Funds and Life Insurance, Australia to certain liabilities of government controlled financial institutions, Canada to Crown Corporations on insurance, Hungary to reinsurance of priority lending, Philippines to some of the GOCCs under their respective charters and UK to items of national security. (iv)

Contingent liabilities not monitored:

Generally implicit contingent liabilities relating to Pension, Provident and Insurance are not monitored regularly due to lack of proper methodology and adequate information. (v)

Ready up-to-date data on contingent liabilities:

Up-to-date data are readily available at regular intervals in Australia, Canada, Hungary, New Zealand, U.K. and U.S.A. But no such data, except for government guarantees, are made available for India, Columbia, Czechoslovakia and Philippines.

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(vi)

Reporting to general public:

All information relating to monitored contingent liabilities are disseminated for general use. However, some countries may not reveal certain information in national interest or for their adverse effects on the financial markets. For example, in the case of the United Kingdom, the law allows non-reporting of certain contingent liabilities, which are important for reasons of national security or commercial confidentiality. (b) Accountability, Auditing and Legal and Institutional System (i)

Legal requirements for reporting contingent liabilities:

All the countries, as indicated below, either have in place or in the process of enacting particular legislation for monitoring and reporting of contingent liabilities. India: Proposed Fiscal Responsibility and Budget Management Act under article 292 Australia: Charter of Budget Honesty Act (BHA) 1998 Canada: Financial Administration Act Columbia: Law 448 enacted on 21-07-98 Czech Republic: Law of Budgetary Rules Hungary: Public Finance Act 1992 New Zealand: Fiscal responsibility Act, Public Finance Act, Local Government Act, Philippines: Republic Act 4860 (for only guarantees given to foreign loans) UK: Code of Fiscal stability USA: Federal Credit Reforms Act 1990

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(ii)

Contingent liabilities regulated by law:

The scope of contingent liabilities, which are monitored, vary across the countries depending on their magnitudes and importance. Items, which are monitored regularly in different countries, are indicated below: India: All Guarantees, Public Provident Fund, Small Savings Scheme, Life Insurance Australia, Canada, New Zealand: Guarantees, indemnities, uncalled capital Columbia- Contingent Liabilities of state entities Czech Rep- Guarantees, hidden debt Hungary- Guarantees, reinsurance Philippines- Guarantees to GOCCs UK, USA- All material contingent liabilities (iii)

Limits on contingent liabilities:

For effective management of risk, it is desirable to have limits on contingent liabilities; otherwise it may put pressures on fiscal sustainability. Respective laws in Canada and New Zealand indicate ceilings on contingent liabilities as percentage of GDP. In Hungary also there is limit on contingent liabilities as percentage of revenue. In the USA there is automatic limit through appropriation of subsidies relating to contingent liabilities in their annual budget. Other countries viz. India, Australia, Columbia, Czech Republic, Philippines, UK donot have any statutory limits on contingent liabilities. However, India is in the process of enacting the Fiscal Responsibility and Budget Management Act, which sets an annual limit of 0.5 per cent of GDP on the issue of new contingent liabilities. (iv)

Audit by Independent Auditors:

In all the countries, there are independent audit organizations, which audit not only the annual balance sheet but also the contingent liabilities. The details of the Audit Offices in different countries are indicated below: India: Comptroller General of Accounts Australia: National audit Office Canada, Columbia, Czech Rep: Yes Hungary- State Audit Office New Zealand: Yes, applies Generally Accepted Auditing Principles (GAAP) Philippines- Yes by Commission on Audit UK: National Audit Office USA: Yes, applies Federal Financial Accounting Standards

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(c) Policy Framework and Practices (i)

Medium term policy framework:

While presenting Budget, governments of Australia, Canada, Hungary, New Zealand, Philippines, U.K. and U.S.A. provide a medium term fiscal strategy and fiscal outlook and projections. But the governments of India, Columbia, and Czech Rep donot provide such policy framework and outlook. However, India’s proposed Fiscal Responsibility and Budget Management Act provides such requirements in the Annual Budget every year. (ii)

Designated contingent liability redemption fund

India, Australia, Canada, Columbia, Hungary, New Zealand and U.S.A. have designated Contingency Redemption Fund, which can be used in the case of recall of guarantees. But the governments of Czech Rep, Philippines and U.K. donot have any such funds. (d) Risk Management Capacities (i)

Accounting practices

It is generally accepted that the accrual accounting is the best suitable accounting methodology for measuring risk relating to contingent liabilities. In Australia, Canada, Hungary, New Zealand, and U.S.A., budgeting is done on the basis of accrual accounting. But the countries of India, Columbia, Czech Rep, Philippines, and U.K. still use mainly cash accounting, although accrual accounting may be used for certain items like committed loan repayments and interest payments. (ii)

Statement on fiscal risk included in the budget

Governments of Australia, Canada, Hungary, New Zealand, U.K., and U.S.A. include a statement on fiscal risk in their budget, while so such statements are given in the budgets of India, Columbia, Czech Rep, and Philippines.

(iii) A full fledged and independent public debt office In Australia, Canada, Columbia, Hungary, New Zealand, U.K., and U.S.A., a full-fledged Public Debt Office (PDO) exists. The PDO is in charge of managing overall risk of both loans and guarantees in the framework of Asset Liability Management (ALM). But, no such integrated PDO exists in India, Czech Republic, and Philippines.

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7. Tasks for Philippines Government An efficient fiscal management system requires that the government treat any non-cash program involving a contingent fiscal risk like any budgetary or debt item. Most importantly, the system has to make the potential fiscal cost of off-budget programs visible ex-ante. Accrual-based budgeting and accounting systems help fiscal discipline but are neither sufficient nor necessary in their entirety. Disclosure of full fiscal information is most critical. Disclosure of face values of contingent liabilities as in the case of the USA enables the markets to analyse and measure the complete fiscal risks and thus indirectly assist the government in its risk assessment. Formulation of efficient rules and regulations on the use of government guarantees, pension funds and insurance programs, and on the operations of the government owned and controlled corporations (GOCCs) and subnational governments are also equally important. To minimize future outflows on contingent government liabilities, the Philippine government needs to further elaborate its tools, procedures and capacities in analyzing and dealing with risks on program-by-program basis. As evidenced by the comparative country experiences discussed above, the existing rules for guarantees, government-guaranteed agencies and other off-budget obligations in Philippines are not effective in limiting the total face value of contingent government liabilities. The system is weak to minimize the likelihood of contingent government liabilities being called and the size of public outlays required when they are called. Specifically, before the government adopts a program of contingent support, it needs to have a systematic and comprehensive analysis on the attributes of the underlying risks, factors influencing the size of these risks, and the incentive mechanisms of the parties under the program. The Government should avoid providing blanket guarantees too many GOCCs. All these activities require the establishment of a full-fledged risk analysis office equipped with up to date methodology and expertise. On the basis of effective risk analysis, the government can design the appropriate programs that would still deliver the desired outcomes but minimise the government’s risk exposure. The objective would be particularly to expose the government only to those risks that are beyond control of the parties under the program and that would spread the potential cost of the program between the government and the beneficiaries. Under a state guarantee, for instance, the government would identify and cover in the guarantee contract only selected risks, which may be shared by it, while other risks may be left to be assumed by other stakeholders or beneficiaries. With respect to the autonomous public sector agencies, the government should strengthen the financial and managerial accountability of their staffs by remunerating sound risk analysis and early warning signals rather than short-term profits of these agencies.

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The following specific tasks are required to be completed in the near term: 1. Setting up a Centralised Middle Office in the DOF First, to create a full fledged institutional structure in the DoF to manage contingent liabilities. For this purpose, it is necessary to set up a Middle Office for management of Contingent Liabilities in the DOF with sanction of sufficient budget and recruitment of technical experts. The main reason for locating it in the Department of Finance is that there are strong links between budgeting and sovereign liability management functions. At the same time, it would help to mitigate conflicts in objectives between fiscal management and monetary policy, through active co-ordination between the middle office and the BSP. The middle office is usually an entity, which serves as the risk manager, formulates and advises on the sovereign liability management strategy and develops benchmarks for assessing the risk-cost trade-off of the contingent liabilities. The role of the “middle office” is to identify, quantify and monitor contingent liabilities, make analysis of risk, provide advice and management information system (MIS) inputs for formulation of appropriate policies in the overall framework of the public debt and contingent liability management, keeping into perspective the long-term financial requirements for economic development and maintaining fiscal sustainability. The Middle Office will advise the government on the following tasks:           

Identification, measurement, monitoring and management of CLs To complete the inventory of all existing explicit and implicit CLs Review charter of all GOCCs regarding exposures of CLs Quantification of exposures and real contingent liabilities for the NG To produce status reports on CLs and present to Congress and for general dissemination of information Evaluation and recommendations for the issue of future CLs Designing appropriate guarantee instruments for BOTs Reviewing, restructuring of the existing ones for BOTs Formulation or review of policies, guidelines and regulations for contingent liabilities Determination of risk based guarantee fees, Evaluation and monitoring of risks for all CLs

 

To organise training, seminars and workshops on capacity building etc.

Role of the Middle Office

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The scope of the middle office at the initial stage should include both explicit and implicit contingent liabilities and could gradually be expanded to include management of both internal and external debt. The Middle Office should immediately deal with fixation of ceiling on contingent liabilities, their allocation between domestic and external sectors and among competing sectors (such as agriculture and allied sectors, industry, transport, communications, power, banking and other financial services, real estate etc.). It should also develop benchmarks for currency composition of external loans, maturity, interest rates, composition of loans under floating and fixed interest rates etc. for which guarantees may be considered. The middle office can also review the contractual obligations for BOT projects, estimate monetary obligations of the national government, suggest inputs for feasible unbundling of risks and for possible renegotiating of contracts, specify early warning systems for defaults, provide advice to improve the legal, institutional and regulatory framework affecting BOT/ PSP projects. The middle office should also act as the apex monitoring unit for all contingent liabilities. Thus, data on contingent liabilities should be regularly transferred by different agencies to the middle office. The middle office should ensure that it develops a completely computerised data recording system, which is amenable to modern risk management analysis and can be easily retrieved and cross-classified by various characteristics such as sector, currency, interest rate, and maturity. The middle office would be responsible for bringing out an annual status report on contingent liabilities, which should enhance the transparency and accountability of the liability position of the government. The report should clearly define and disclose the main objectives of contingent liability management, the strategic benchmarks of the liability portfolio and performance of portfolio management by the relevant agencies as measured by the cost of the actual liability portfolio relative to the benchmark portfolio. Strategic Benchmarks and Risk Management Based on the risk-management framework and cost-risk trade-off, the Middle Office would be expected to determine strategic benchmarks for the contingent liability portfolio. The strategic benchmarks could be the proportion of domestic and foreign currency debt; the currency composition, average duration, mix of floating-fixed interest rate debt and maturity structure of foreign currency debt portfolio; and maturity structure and duration for the domestic debt portfolio, for which government guarantees can be provided. Strategic benchmarks, designed by the Middle Office, should have the approval of the Secretary of Finance. For this purpose, the Contingent Liability Advisory Committee should advice the Finance Secretary periodically on the appropriateness of the framework and the strategic benchmarks.

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Once, the strategic benchmarks are approved, the Middle Office should regularly disseminate the relevant benchmarks to the concerned agencies involved for contracting or issuing government guarantees. This would enable them to determine their liability management strategy so as to be consistent with the strategic benchmarks. Advisory Committee for the Middle Office: Operations of the Middle Office could be supervised by a Contingent Liability Advisory Committee comprising of senior executives from the DOF, DBM, NEDA, BSP, COA, SSS, GSIS and some other government departments and GOCCs. This would ensure that advisory role of the Middle Office would be respected by different entities involved for management of contingent liabilities. The middle office should be staffed with officials with the necessary expertise from the DOF, and on a deputation basis from the other organisations mentioned above. Investment in infrastructure and human resource development should be an area of priority for the government to promote professional approach towards contingent liability and overall debt management. 2. To prepare standardised Manual and Guidelines In order to have uniformity in measurement and reporting necessary information, the DOF in consultation with other departments and BSP and COA should prepare standardized manuals on the following items for all GOCCs, and particularly for the Non-Banking Financial Corporations (NBFCs): (a) Manual for measurement of all contingent liabilities- explicit and implicit (b) Manual on prudential norms for income recognition, asset classification and provisioning for advances and investment portfolio. (c) Guidelines for risk management and Asset and Liability Management (ALM) framework. (f) 3. Disclosure and Accountability As an initial step towards risk management, it is necessary to promote disclosure and accountability with regard to at least explicit contingent liabilities. In its Code of Good Practices on Fiscal Transparency, the IMF also recommends that countries should disclose in their Budget documentation the main central government contingent liabilities, provide a brief indication of their nature and extent and indicate the potential beneficiaries. The Code suggests that best practice in the area would involve providing an estimate of the expected cost of each contingent liability wherever possible and the basis for estimating expected cost.

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Best management practice for contingent liabilities is to make adequate provision for expected losses and to hold additional assets against the risk of unexpected losses. In cases where it not possible to derive reliable cost estimates, the available information on the cost and risk of contingent liabilities should be summarised in the notes to the Budget tables or the government’s financial accounts. Before a full-fledged accrual accounting system is in place, it may be desirable to present a separate budget for contingent liabilities (as was done in the USA before 1990). GOCCs also should estimate and disclose their contingent liabilities. Once the concepts, definitions, methodology and data problems have been resolved and key organisational challenges have been addressed, all the GOCCs must be directed to disclose their contingent liabilities in their Annual Reports and to have appropriate policies for contingent liability management 1. . 4. Reporting to DOF All government departments and GOCCs may be required to submit half yearly reports to the Middle Office in DOF on their contingent liabilities and risk mitigation measures. 5. Good Corporate Governance Risks associated with contingent liabilities can be reduced by promoting sound governance arrangements for managing sub-national entities and state-owned enterprises, and making them accountable for managing their own risks. It is necessary to strengthen the corporate governance and risk management capability in all GOCCs and local bodies. 6. Capacity Building As the co-ordinating organisation and nodal office, DOF may formulate time bound program for capacity building within government and GOCCs for management of CLs. It is also necessary to improve infrastructure and hardware and software capacities for information systems, central databases networks and interface with all organisations dealing with CLs. 7. Limit on Guarantees DOF may issue an Executive Order for removing all automatic guarantees on some GOCCs and to put a limit on guarantees. Future requests for guarantees may be examined on the basis of normal appraisal procedures for providing either loans or grants. 8. Sector Specific Policies

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(a) Pension Funds and Social Security: SSS and GSIS are the major sources of explicit and implicit contingent liabilities of the government, and reduction of risk arising from unfunded or underfunded pension liabilities is needs to be given urgent attention. Contribution rates for SSS are much lower than the benefits and need to be increased to reduce the current gap between contributions and benefits. Management of the investment portfolio of the reserve funds for both SSS and GSIS needs to be fully professionalised and insulated from political interference. To provide a truly equitable, universal and meaningful social security protection, the SSS must align its benefits and hence its contributions to that of similar programs both locally and internationally. There is an urgent need to enhance the SSS contribution rate to at least 12 per cent in the current year and to double the present rate of 8.4 per cent, if not to the level of GSIS rate, in a phased manner in three years. It is estimated that the gradual increase in the SSS contribution rate from 8.4 per cent to 20 per cent will increase the actuarial life of the social security fund by at least 20 years. While increases in social security contributions are always politically sensitive, the task faced by the Philippine policy makers may not be difficult on considering the fact that the GSIS members are already contributing 21 per cent. Therefore, actions to bring benefits and contribution in line with each other are urgently required for fiscal sustainability of the social security system. Although there is little scope for enhancing the contribution rate of GSIS, which is reasonable at 21 per cent, there is scope for improving the compliance rate and to rationalize the benefits among the members in different income brackets. There is also scope for enhancing the qualifying period for getting pension and to increase the retirement age commensurate with the increase in expectation of life. It may not be politically feasible to amend the Act for removal of automatic government guarantee in the case of financial problem faced by GSIS or SSS. However, both the systems should move from defined benefits system to defined contribution system. There is also need for strengthening the Asset Liability Management (ALM) system in both these organizations to minimize the risks given defined contributions. The present thrust of the GSIS on the “Back to Basics Policy” is in the right direction. Under the policy, the GSIS concentrated on essential activities where it is efficient such as administration of benefits, limiting direct lending operations to salary and housing loans to its members, and phased out peripheral programs, which can be more efficiently handled by the private sector. The SSS can learn from these experiences of GSIS. There is also a need to separate life and non-life components of insurance. While government can provide some subsidies for life insurance for targeted groups of people due to social reasons, there should be no subsidies for non-life insurance, which can be fully funded and better managed by the private sector.

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(b) The banking sector urgently needs strengthening. Cross-country evidence suggests that timely rehabilitation is one of the key factors in determining the success of bank rehabilitation efforts. The current level of asset performance, the system could face severe difficulty if another major external shock such as that of 1997 occurred or if the economy’s growth rate slowed significantly. The government is currently attempting to encourage private sector driven measures to restructure banks. But the effectiveness of privately led asset management companies is subject to question. In the meantime, the government should also continue its efforts to improve capital standards and supervision. It is also equally important to improve the supervision and regulation of the banking and insurance system and capital markets, including the use of such instruments as mandatory risk limits and minimum capital adequacy norms. Stronger accounting and disclosure requirements for private corporations are important mechanisms for limiting the likelihood that a systemic crisis might occur, and will limit the government's exposure if it does. The Philippine banks have been entertaining sales of their non-performing loans to the U.S. opportunity funds for the past several months. Several banks are presently in negotiations with U.S. investment banks and opportunity funds. But these negotiations have not resulted in significant transactions, as most of the banks do not have the capital adequacy to sustain large write-offs in their NPLs without adversely affecting their capital base. The government has currently circulated a very comprehensive draft of proposed regulatory changes to reduce the "friction costs" of investing in NPLs and makes it easier for foreign investors to establish Special Purpose Asset Vehicles to acquire and manage the NPL resolution process. In addition to proposed tax relief and a reduction or moratorium on real estate transfer taxes, the legislation will make it easier for foreign investors to own Philippine real estate assets. These measures are in the right directions and need to strengthened and brought to their logical ends on time bound schedule. (c) GOCCS: Auditing and accounting of the GOCCs need to be strengthened. It may also be desirable to institute performance contacts and sign Memorandum of Understanding (MOUs) with major GOCCs and GFIs (as being done in India) indicating their medium term corporate objectives and planning and annual targets on both physical and financial achievements. In the medium and long term the following tasks may be completed: 1. Cash and Accrual Basis of Accounting One important task for the medium term is to move towards the full accrual system of accounting as required under the Revised Government Statistics (GFS 2000) the IMF. The Government accounts in the Philippines, as in the case of many countries, are currently 34

maintained on mainly cash basis, and not on complete accrual basis. It is generally recognised that cash-based systems are not suitable for measuring, recording and monitoring contingent liabilities, which can be captured by only accrual accounting. The accrual accounting model is widely used in business financial reporting where it provides a measure of profitability of the business. In government, it can be used to assess inter-generational or inter-temporal equity, which implies that one generation or one period should not be made to pay for the benefits extended to and enjoyed by another generation or period. A simple measure of inter-generational equity is what is called Net Asset/Equity, which is defined as the balance of assets and liabilities. If Net Asset/Equity is negative, it implies that the future generations will have to bear the burden of additional taxation if the Government has to honour its commitments. There is an increasing awareness on this issue and many governments are switching over to accrual based accounting. The Philippine government has already decided to proceed towards accrual accounting for bringing more transparency in reporting. The decision needs to be implemented on priority basis. In order to achieve accrual accounting, it is important to change the accounting system in both the government, GOCCs and private entities as there are close inter-linkages among them and the systems need to be comparable and standardized. It is understood that Philippines adopts the Generally Accepted Accounting Practices (GAAP), which is suitable for adopting the accrual system. For uniformity and comparability of the annual balance sheets, the Commission on Audit in consultation with the government needs to prescribe a set of accounting rules for the various types of contingent liabilities. Given the lack of common accounting standards for government non-bank financial institutions, a necessary step would be to have some sort of accounting manual for these institutions. The manual would prescribe acceptable practices for income recognition or interest accrual, and set standards on provisioning and treatment of past due accounts. 2. Improvement in Audit It is necessary to strengthen both the internal and external audit teams to deal with accrual system of accounting and to measure and report properly the explicit and implicit contingent liabilities. A full audit of the non-bank financial institutions may be called for. Equally important, a broader role for resident auditors in reviewing the financial statement of GOCCs would ensure that not only are transactions properly booked in the balance sheet but also profit and loss statements are reflective of the true financial positions of the corporations. It should be made mandatory for all GOCCs, particularly for SSS, GSIS, RSBS, HGC and Pag-ibig, to disclose contingent liabilities in their annual reports and balance sheets. It is also necessary to introduce performance auditing and corporate governance auditing for all GOCCs. Indian Banks and financial institutions have already adopted corporate governance auditing as a part of their annual statutory auditing as required by the regulatory authority i.e. the Reserve Bank of India (RBI).

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In India there is also a system of signing a Memorandum of Understanding (MOU) between a public sector undertaking (PSU) and the concerned administrative ministry of the department on the annual targets on various aspects of physical and financial performance. The achievement of the PSU in terms of the targets under MOU is audited as per performance auditing by the statutory auditors and the specific grades are awarded to the PSUs. The similar system of signing MOUs with GOCCs and their performance auditing may be introduced by the government of Philippines for better monitoring the overall performance of the GOCCs. 3. US System of Provisioning In the long run, budgeting for contingent liabilities would ideally follow the U.S. example where both direct and contingent liabilities are integrated in the budget based on their subsidy costs, i.e., for loans, the present value of amounts not repaid and the difference between the interest rate charged from borrowers and government’s cost of funds; for guarantees, the present value of the difference between cash payments for defaults and cash received from fees and recoveries. The main advantage of adopting this approach is that government becomes indifferent as to choosing between cash subsidy, a loan or a guarantee on loans. The US system of budgeting and management of contingent liabilities are discussed in details in Annexure-3. 4. Setting up of a contingency fund or contingent liability redemption fund The system of charging a uniform flat rate of guarantee fee is not good for effective management of contingent liabilities. The guarantee fee charged needs to be based on the cost of borrowing, plus the cost of provisioning and the cost of building-up reserves for unanticipated losses. Guarantee fees collected should not be taken as general revenues; rather be kept in a separate contingency fund or contingent liability redemption fund. Where sophisticated risk adjusted pricing is possible, the revenue from the guarantee fee as risk premium will enable adequate reserves to be built up over time. The government still may have to allocate some initial capital from general revenues into the Reserve Fund in the event that the contingent liability is called prior to the build up of sufficient reserves through fee income. The amount of capital allocated would reflect the governments risk preferences. 5. Setting up of a full fledged Public Debt Office In the long run, the Philippines government may move towards setting up a full-fledged Public Debt Office under the overall charge of DOF. Major functions of public debt managers as regards management of contingent liabilities of the government may include valuing contingent exposures, discussing with the sovereign credit rating agencies the extent of the government's exposure and its policy response, restructuring contingent claims and analysing their possible effects on the governments future financing needs.

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In the long run, the middle office for the contingent liability management may be converted into a middle office for the overall public dent management. The need for a middle office, however, cannot be viewed in isolation. It should be analysed in the context of total structure of liability management comprising the Head Office (i.e. the office responsible for final approval of guarantees), Front Office (responsible for appraisal of guarantee requests and making negotiations with the lenders), Middle Office (responsible for measurement, monitoring, policy formulation and risk management) and Back Office (responsible for auditing, accounting, data consolidation, and functions of the dealing office). The institutional character assumes significance in view of the need for an active risk management framework, professional approach and expertise required for management of debt and contingent liabilities. The role of a public debt manager in managing contingent liabilities of the government owned and controlled corporations (GOCCs) depends on the degree to which management of GOCCs is decentralized, the quality of the corporate governance in these corporations and their technical capability for risk management. For example, in a well board managed and completely decentralized public sector structure, the GOCCs may be responsible for designing their own guarantees and underwriting instruments, for implementing the necessary provisioning and reserving and for managing any subsequent restructuring in their assets and liabilities. Within this framework the government may wish to have a central agency such as the Department of Finance, the Treasury or the Public Debt Office to be responsible for evaluating risk-covering instruments in order to standardize budgetary procedures and to control their fiscal impact. International Experience International experiences and practices of management of contingent liabilities by leading public debt offices bear many valuable lessons for countries in the process of strengthening their debt management capacity. Many countries - mainly advanced and some emerging market economies - have set up integrated public debt offices and are successfully managing their sovereign debts. In most countries where debt offices have been set up, there is clear evidence of moving towards fiscal consolidation. There has also been a significant change since late 1980s in the institutional structure, the role and style of functions of public debt management towards risk management. This has been enabled by institutionalisation of the debt office with an in-house risk management culture, as a specialised institution, staffed with professionals and market specialists. The role of such debt offices, in many instances, gradually transformed into treasury operations on the lines of those performed by investment banks, corporates and foreign exchange management by central banks. Within the debt office, middle office emerges as the risk manager, which formulates and advises on the debt management strategy and also develops benchmarks for assessing the risk-cost trade off of the portfolio. Annex 3 summarises the key sound practices in sovereign debt management. The primary requirement for a debt office is to bring the size of public debt at sustainable levels. Without sustainability of debt, risk management would not have much impact towards insulating the debt portfolio from systemic risks. The main risks that needs to be

37

managed for the sovereign debt portfolio are foreign currency risk, interest rate risk, credit risk, liquidity risk, refinancing risk, operational risk and payments and settlement risk. Many debt offices have addressed management of market risks like currency and interest rate risk by establishing a risk management framework for the sovereign debt in an asset-liability management framework. A prudential risk management framework is essential for reducing uncertainty among sovereign debt managers as to the government’s tolerance for risk, its willingness to trade off cost and risk objectives. Once the risks are identified, risks and costs for alternative debt strategies are measured in a scenario-based model under a base case scenario and different market rate scenarios; or in a simulation-based model under value-at-risk, costat-risk or budget-at-risk approach. The government then chooses the strategy that best represents the government’s preferences for managing the risk/cost trade-off and generally tend to choose it along an efficient frontier, which entails minimum risk. The debt managers may also use various derivatives such as buyback operations, currency and interest swaps and other hedging activities. The institutional structure for public debt management, world wide, could be broadly characterised into two categories – setting up of a centralised public debt office and scattered debt management responsibilities. The former category of a centralised debt office, which has been the showcase for countries currently strengthening their debt management capacity, is mainly found in advanced countries and a few emerging market economies. For these countries, there has been a preference to locate the debt office as a separate entity under the Ministry of Finance or within the mainstream Ministry. There are also some instances of locating the debt office outside the Ministry as an autonomous agency, but with a Memorandum of Understanding (MOU) signed between the Ministry of Finance and the Public Debt Office. This institutional mechanism is usually, safeguarded, by public debt legislation or legal statutes. The second category of institutional structure reflects dispersed debt management responsibility, either within the Ministry of Finance (for most emerging market economies) or scattered between the Ministry of Finance (responsible for external public debt management) and the central bank (responsible for the internal public debt management). A World Bank survey of about 50 developing economies showed that in around 11 per cent of these countries, central bank manages domestic debt. Some of the emerging market economies, with dispersed debt management responsibilities between the Ministry of Finance and the central bank (Hungary, Colombia, South Africa) have already separated debt management responsibility from their central banks. Moreover, some emerging market economies with debt management responsibility within the Ministry of Finance (China, India, Thailand, South Korea, Brazil, and Mexico) have started to set up a middle office under the Ministry of Finance as a first step towards strengthening their debt management capacity. Although, independent set-up for the Public Debt Office and the Ministry of Finance are regarded as somewhat separate watertight compartments for locating the debt office, in reality, however, there is a very thin dividing line between the two. The Ministry of

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Finance always exercises some measure of control over the operations of the debt office, irrespective of its location. This is unavoidable because it is the liability of the Government that is to be managed by the debt office. Therefore, even among the most independent set-ups like National Treasury Management Agency of Ireland and the Swedish National Debt Office which are entrusted with day-to-day management responsibilities, the Ministry of Finance determines the policy, sets the operational guidelines and the benchmarks under which the debt office is required to operate. Governance issues promoting sound and professional approach towards debt management, required debt offices to clearly define and disclose its objectives for debt management, establishing an organisational structure that ensures clear accountability and transparency of responsibilities with appropriate internal controls, and establishment of a legal framework wherever possible. For enabling sound risk management practices, most debt offices established prudent risk management strategy and policy, strengthened middle office analytical capability, and defined a framework for risk management ensuring consistency with other macroeconomic policies and objectives. Debt offices also accorded priority to recruitment of trained staff, and selection and implementation of effective management information systems. 6. Capability Building for Contingent Liability Management Continual upgrading the professionalism for management of public debt and contingent liabilities is essential for maintaining debt sustainability over time. Once the public debt management responsibility is centralised and a computerised debt recording system functions efficiently, the main challenge is to develop a risk management office (or middle office). Building a sound risk management capability within a sovereign debt management operation can take several years given the experiences of Belgium, Colombia, Ireland, New Zealand and Sweden. However, there is no uniform model for this and it needs to be country-specific. Given that risk management skills are a scarce resource and training staff in this area is very expensive, a strategy needs to be developed to hire new staff with these skills and to have an intensive training program for existing staff. Appropriate policies also need to be formulated to retain these staff given their obvious marketability. The manager or the head of the middle office should also have strong technical and public policy skills. A decision on whether to introduce specialist risk management software should be deferred until risk management skills and a sound technical knowledge have been built up within the office. Rushing into these decisions may lead to the establishment of a risk management framework without a full understanding of the alternative strategies or an understanding of how the designated software actually works. There is also the question of compatibility of this software with the management information systems. 7. Privatisation of some of the GOCCs

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Government may examine the feasibility of privatising some of the weak GOCCs. Privatisation does not imply outright sale of the public enterprises but a combination of various measures to reduce the control of government in the equity holding, management and policy formulation relating to the public enterprises. 8. Innovative Systems for BOT projects It is important to design contingent liabilities in such a way that they have risk sharing mechanisms embodied in them, and ensuring that all the risks are not under control of the beneficiary given that this creates moral hazard risks for the government. Sound risk sharing arrangements would include providing termination dates for the contingent claims, pricing the contingent liability on a risk adjusted basis and charging the beneficiaries accordingly. It also requires beneficiaries to post collateral securities and to strip down blanket risk guarantees into different risk dimensions so that risk can be more evenly distributed between the government and the potential beneficiaries. All new commitments should be scrutinised thoroughly and, whenever possible, must embody risk sharing arrangements and sunset or termination clause. Given the substantial support that public-private infrastructure partnerships are likely to receive from the government, government may work toward establishing capabilities to audit the award of these projects. The goal would be to assure the public that the government had achieved value for its money. In the United Kingdom, the National Audit Office supplements its own skills with those of professional advisors, including lawyers, investment bankers, and accountants. Skills within government units in India could be augmented through a similar system. Government risk sharing should only be considered as a last resort. To prevent excessive government exposure, decisions should be transparent and based on explicit cost-benefit analysis for the project to be guaranteed, including an assessment of the likely cost to taxpayers and the impact of alternative forms of government support. Guarantees of "policy risks" should support a credible reform program but not be regarded as a substitute for it. In the medium-term policy reforms for enabling private participation in infrastructure projects should obviate the need for a guarantee. All the stakeholders viz. Private operators, beneficiaries, banks and government should share a part of the risk. In structuring guarantees the government must ensure that the normal "performance incentives" for private investors are not undermined, essentially by not covering "normal business risk," including exchange rate and interest rate movements, and some other market risks which can be covered by the insurance companies and capital markets. If the amount of guarantees rises significantly in private infrastructure projects, it may be desirable to establish a "guarantee corporation", which would help develop standardised guarantee products, facilitate learning across projects, reduce the need for government and local bodies to issue guarantees, allow the employment of competent staff to do so and limit taxpayer exposure in a transparent way.

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9. Reforms in Pension Funds. As discussed earlier, in the medium term, the government should move towards defined contribution schemes or fully funded programs for SSS and GSIS to make them financially viable and more sustainable over time. 10 Continue with sound macroeconomic policies Sound macro economic system supported by strict fiscal and monetary discipline is the best defense against any economic and financial crisis leading to contingent liabilities. The odds for the occurrence of a financial crisis and so the risk of implicit contingent liabilities can be reduced by sound macro-economic policies, complemented by appropriate legal, regulatory and institutional set-up for effective prudential regulation, monitoring, surveillance and supervision of the financial system and improved corporate governance. However, these entail structural reforms with an unavoidably long-time scale.

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References AGILE (A Consortium of the Development Inc., Harvard Institute for International Development, Cesar Virata & Associates Inc., and Pricewaterhousecoopers) (2001) Analysis of Contingent Liabilities of the Philippine Government, May 2001. Australia Treasury, Annual Report, 1998-1999. Bernardo, R. L. and M.C.G. Tang (2001) A note on Philippine government contingent liabilities. Borensztein E, and G. Pennacchi (1990), ‘Valuation of Interest Payment Guarantees on Developing Country Debt’, IMF Staff Papers, Vol. 37(4), December. Brixi, Hana P., Hafez Ghanem and Roumeen Islam. "Fiscal adjustment and contingent government liabilities: case studies of the Czech Republic and Macedonia". Das, Tarun; Anil Bisen, M.R. Nair and Raj Kumar (2001) External sector related contingent liabilities- A case study for India, commonwealth Secretariat, London. Department of Finance, Canada, “Debt Management Report”, 1998, Ottawa. Finance Canada, “Annual Financial Report”, 1998-1999. International Monetary Fund, “Experimental IMF Report on Observance of Standards and Codes: Czech Republic”, August 1995. International Monetary Fund, “Code of Good Practices on Fiscal Transparency – Declaration on Principles”, April 1999. International Monetary Fund, “Report on the Observance of Standards and Codes – Czech Republic”, July 2000. Kopits, G and J Craig, “Transparency in Government Operations”, IMF Occasional Paper No. 158, Jan 1988, Washington. Kharas, Homi & Deepak Mishra ”Hidden Deficits and Currency Crisis”, World Bank draft paper, April 1999. Klein, Michael, “Risk, Taxpayers, and the Role of Government in Project Finance”, World Bank Policy Research Paper No. 1688, Dec 1996. Kumar, Raj “Debt Sustainability Issues – New Challenges for Liberalising Economies in External Debt Management” Reserve Bank of India, Mumbai, 1998.

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Lewis, Christopher & Ashoka Mody ”Contingent Liabilities for Infrastructure Project – Implementing a Risk Management Framework for Government”, World Bank, Aug 1998. Marcus, A.J. and Shaked, 1, (1984), The Valuation of FDIC Deposit Insurance Using Option Pricing Estimates, Journal of Money, Credit and Banking. Merton, R.C. (1990), ‘An Analytic Derivation of the Cost of Deposit Insurance and Loan Guarantees: Application of Modern Option Pricing Theory’, Continuous – Time Finance Mody, Ashoka and Dilip Patro, “Methods of Loan Guarantee Valuation and Accounting.” World Bank Discussion Paper No. 116, November 1995. Mody, Ashoka “Contingent Liabilities in Infrastructure: Lessons of the East Asian Crisis, World Bank, Washington, 2000. Mukherjee, A. (2001a) Philippines- Concept Paper, Public Expenditure, Procurement and Financial Management Review, World Bank, Washington DC Dec. 2001. Mukherjee, A. (2001b) Philippines- Aide Memoir, Public Expenditure, Procurement and Financial Management Review, World Bank, Washington DC Dec. 2001. New Zealand Government, “Financial Statements” (various years), Wellington. Polackova, Hana, H Ghanem, R Islam “Fiscal Adjustment and Contingent Government Liabilities – Case Studies of the Czech Republic and Macedonia”, World Bank Policy Research Working Paper, 2177 Sept 1999. Polackova, Hana, “Contingent Government Liabilities – A Hidden Fiscal Risk” Finance and Development, March 1999, Vol. 36, No 1. Schick, Allen, “Budgeting for Fiscal Risk”, World Bank Internal Draft, Sep 1999. Treasury Board of Canada Secretariat. TB Circular 1984-63: Policy on the contingent liabilities of the government of Canada and consequential policies with regard to the reporting of the financial position of, and insurance schemes operated, by Crown Corporation. Towe, C.M. (1991),'The Budgetary Control and Fiscal Impact of Government Contingent Liabilities', IMF Staff Papers Vol. 38 (1) U.K. Finance Act, 1998. U.K. H M Treasury, “Fiscal Policy: Public Finances and The Cycle”, 1997.

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United States General Accounting Office. Budgeting for Federal Insurance Programs. GAO/AIMD-97-16, September 1997. World Bank, “Dealing with Public Risk in Private Infrastructure.” Edited by T Irwin, M Klein, G.E. Perry and M Thobani, Washington DC.

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Annexure-A: National Government Guarantees to GOCCs Name of GOCC

Absolute guarantee to both principal and interest

Nature of guarantee Automatic Solidary

Employees' Compensation Commission Government Service Insurance System Home Development Mutual Funds

Guarantees the benefits prescribed under this Title

Automatic Subsidiary

Guarantees the fulfillment of the obligations of the GSIS to its members as and when they fall due

Automatic Subsidiary

Guarantees the payment of employees' and employers' contributions and dividends to the members when they are due

Automatic

5.

Home Guarantee Corporation

Guaranties the payment by the Corporation both of the principal sums and interest of the bonds, debentures, collateral, notes, or other such obligations of the Corporation,

Automatic Subsidiary

6.

Human Settlement Development Corporation Laguna Lake Development Authority Land Bank of the Philippines

Guarantees both the principal and interest by the Government of the Republic of the Philippines

Automatic Subsidiary

Guarantees both the principal and the interest of the bonds, debentures, collaterals, notes and such other obligations Loans from both local and foreign sources

Automatic Subsidiary

1. 2. 3.

4.

7. 8.

Cultural Center of the Philippines

Government Guarantees

Special Guaranty Fund. In the event that the Bank shall be unable to pay the bonds, debentures, and11 other obligations issued by it, a fixed amount thereof shall be paid from a special guaranty fund to be set up by the Government 9.

Light Rail Transit Authority

10. Local Water Utilities Administration

Automatic

And bonds and other obligations Subsidiary subject to limits Automatic Subsidiary

Statutory limit on guarantee

20 times the capital and surplus of the Corporation

Up to an aggregate amount not exceeding, at any one time, five times its unimpaired capital and surplus

Funds borrowed from any source, private or public, foreign or domestic

Automatic Subsidiary

P300 million

Both the principal and interest

Automatic Subsidiary

Pesos 1,000 million for domestic loans and US$500 million for foreign loans

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Annexure-A. National Government Guarantees to GOCCs: Continued Name of GOCC

Government Guarantees

Nature of guarantee Subject to contract

Statutory limit on guarantee

11. Mactan-Cebu International Airport Authority 12. Manila International Airport Authority

Loans or other indebtedness of the Authority

Loans or other indebtedness of the Authority

Subject to contract

Total indebtedness shall not exceed the net worth of the Authority

13. Manila Waterworks and Sewerage System

Both principal and the interest of the bonds issued by said System by virtue of this Act, and shall pay such principal and interest in case of the System fails to do so.

Automatic Solidary

The total principal indebtedness of the System exclusive of interest, shall not exceed One Billion Pesos at any given time

14. National Development Company

The payment of all loans, credits and other indebtedness contracted by the Company

Automatic Solidary

Loans, credits convertible to foreign currencies, or other forms of indebtedness, from foreign governments or any international financial institution or fund source, including foreign private lenders.

Subject to contract, Solidary

The payment by the NEA of both the principal and the interest of the bonds or other evidences of indebtedness, and shall pay such principal and interest in case the NEA fails to do so;

Automatic Solidary

U.S. $500M

Subject to contract, Solidary

US$800 million

15. National Electrification Administration

Loans, credits convertible to foreign currencies, or other forms of indebtedness, from foreign governments or any international financial institution or fund source, including foreign private lenders. 16. National Food Authority

Both the principal and the interests of the bonds and other evidences of indebtedness and shall pay such principal and interests in case the Authority fails to do so

Automatic Subsidiary

Foreign indebtedness

Automatic

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US$500 million

Annexure-A National Government Guarantees to GOCCs: Continued Name of GOCC

Government Guarantees

Nature of guarantee Automatic Solidary

Statutory limit on guarantee

The total amount of the bonds or securities issued shall not exceed ten times its paid up capital and surplus. Total indebtedness with foreign countries not to exceed US$500M. Five hundred million pesos

17. National Home Mortgage and Finance Corporation 18. National Housing Authority

Both principal and interest by the government of the Republic of the Philippines Both the principal and the interest of the bonds, debentures, collateral, notes or other obligations

Automatic Subsidiary

19. National Irrigation Administration

Payment of the loans, credits and indebtedness up to the amount herein authorized

Subject to contract, Solidary

20. National Power Corporation

Both the principal and the interest of the bonds issued by said Corporation

Automatic Subsidiary

Foreign Loans

Subject to contract, Solidary

21. Philippine Aerospace Development Corporation 22. Philippine Health Insurance Corporation 23. Philippine National Oil Company

Loans, credits, indebtedness and bonds Subject to contract, issued

US$1 billion

Solidary

Government Guarantee. The Government of the Philippines guarantees the financial viability of the Program

Implicit

bonds or other securities and loans

Subject to contract, Solidary

24. Philippine National Railways

Foreign Loans.

Subject to contract, Solidary

25. Philippine Ports Authority

Loans or other indebtedness of the Authority

Subject to contract

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Total outstanding indebtedness shall not exceed the networth of the Authority.

Annexure-A National Government Guarantees to GOCCs: Completed Name of GOCC

Government Guarantees

Nature of guarantee Subject to contract

Statutory limit on guarantee Shall not exceed fifty per cent (50%) of its net worth.

26. Philippine Postal Authority

Domestic or foreign loans, credits and other indebtedness, and to issue bonds, notes, debentures, securities and other instruments of indebtedness

27. Philippine Tourism Authority

Principal and interest of domestic and foreign loans

Subject to contract

Total principal domestic debt not to exceed 200 million pesos while total foreign debt not to exceed US$200 million

28. Public Estates Authority

Bonds, credits, loans, transactions, undertakings or obligations of any kind which may be incurred by the Authority

Subject to contract

29. Quedan and Rural Credit Guarantee Corporation

Sovereign Guarantee. The Republic of the Philippines shall answer for the payment of guarantee obligations duly incurred by the Corporation

Automatic Subsidiary

30. Social Security System

The Government of the Republic of the Philippines accepts general responsibility of the solvency of the SSS.

Implicit, Subsidiary

31. Southern Philippines Development Administration

Both the principal and interests on bonds, debentures, collaterals, notes or such other obligations incurred by the Authority

Automatic Subsidiary

The bonds issued shall not exceed pesos 500 million

Foreign Loans.

Subject to contract, Solidiary

Exclusive of interest, shall not exceed US$200 million

Trade and The payment of obligations incurred by the Corporation under the provisions of this Decree is fully guaranteed by the Government of the Republic of the Philippines

Automatic Subsidiary

Shall not exceed fifteen (15) times its subscribed capital stock surplus

32. Investment Development Corporation (TIDCOR)

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Annexure-B International Experiences in Management of Contingent Liabilities This annexure surveys the experiences of ten countries – India, Australia, Canada, Columbia, Czech Republic, Hungary, New Zealand, Philippines the United Kingdom and United States with regard to the management of contingent liabilities. The choice of countries was based on the advanced nature of the consideration of the problem of contingent liabilities and the ready availability of such information. The situation in other countries such as Bulgaria and Thailand was also examined, but it was not possible, without further investigation, to clearly spell out the legal and accounting regime in place and how such liabilities are recorded and managed. Individual country practices differ in their dealing with contingent liabilities, but all countries share a common set of principles to capture maximum contingent liabilities as they affect the government budget. In all the countries surveyed, the consideration of contingent liabilities was an integral part of improving transparency in government operations in general and fiscal transparency in particular. Indeed it is tied to a process of bringing “open government” so that citizens and outsiders (foreign investors, commercial banks, credit rating organisations, multilateral financial institutes etc.) can more accurately assess the government’s financial position. In this survey it was not possible to ascertain the technical details and methodology for the measurement of contingent liabilities and associated risks. But countries such as New Zealand Treasury, the General Directorate of Public Credit in Columbia and the public debt offices in Canada, UK and USA monitor explicit contingent liabilities of the government as part of overall asset-liability management. In any case, the risks associated with contingent liabilities have to be considered as part of reducing balance sheet risk for the government. All frameworks tended to look at the issue as part of the Government fiscal framework, in line with the IMF’s Guidelines on Fiscal Transparency. In addition, these countries also publish information of the International Investment Position and report information on the new foreign exchange reserves template introduced by the IMF under the SDDS. (a) Definition of Contingent Liabilities While all frameworks generally define contingent liabilities as costs borne by the Government if a particular event occurs, the precise scope and the detailed items reported vary across countries. Nevertheless, in most frameworks there is provision to publish information in the form of quantifiable and non-quantifiable contingent liabilities. Some examples of quantifiable contingent liabilities are loan guarantees, non-loan guarantees, indemnities, warranties, promissory notes, callable share capital in international organisation and liabilities arising out of legal proceedings and disputes (though usually within maximum limits).

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Non-quantifiable liabilities include guaranteed benefits payable by national pension, provident and insurance schemes, environmental contingencies, exchange rate risks and in some cases (e.g. UK) liabilities relating to privatisation. There is also an implicit reason for the non-disclosure or partial disclosure of contingent liabilities for tactical reasons such as “moral hazard” (arising out of say, bank failures) or litigation claims against the Government (e.g. litigation involving health matters). (b) Legal Regime and Institutional Set Up Most Governments have in place Acts pertaining to powers to borrow, invest and enter into other financial obligations on behalf of its citizens, and the responsibilities to report major contingent liabilities to the parliament through budget documents and other financial reports. The legal framework usually sets out the maximum amount of new borrowing and guarantees that the Congress, Parliament or the Minister of Finance can approve over a specified period, usually the fiscal year. The authority to borrow and to issue guarantees is delegated to the Minister of Finance or the principal public debt manager under the Ministry of Finance or Treasury, and requires the Finance Minister to be accountable for these decisions to the Parliament. In all regimes, the need to report on contingent liabilities is also underpinned by fiscal legislation, the main Act and Regulations. The most comprehensive is the Federal Reform Act of USA, whose important objective is to neutralise budgetary incentives, making policy makers indifferent to whether they choose grants, direct loans or guarantees. The conditions for the recognition, measurement and disclosure of contingent liabilities are clearly spelt out. The legislative arrangements of the countries surveyed indicate that the regimes delegate powers to the Minister of Finance on the design and issue of guarantee instruments and other implementation aspects. Some countries, such as Colombia and Sweden, are passing this responsibility onto the government debt manager. In the case of Sweden, the Swedish National Debt Office is the only government agency that can issue government guarantees. The Office has developed a model for pricing guarantees in which clients are charged a risk based premium and all revenues and losses are met from a fund, which is separate from the Budget. In Colombia, the General Directorate of Public Credit is currently developing a methodology for valuing contingent liabilities based on Monte Carlo simulations. It will use this model to evaluate the risks associated with a wide range of government guarantees, and to establish clear budgetary procedures for disclosure and provisioning. (c) Accounting Among the ten countries surveyed, in five countries i.e. India, Czech Republic, Columbia, Philippines and the united Kingdom, conventional budget is prepared on the basis of cash accounting i.e. transactions and events are recognised when cash is received or paid. The financial results are measured in terms of inflows and outflows of cash and

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changes in the cash balance. The focus of such reporting is on budgetary compliance and maintaining liquidity solvency- two aspects of Government’s finances that are of prime concern to the Parliament and to the executives for current decision making. However, cash accounting has a number of serious drawbacks, such as the following: ♦ It fails to take account of future commitments, guarantees, or other contingent liabilities. A liability is not recognised until the cash is paid to settle the debt. The most significant omission being the pension liability of the Government, which is handled on pay as you go basis. ♦ It fails to accurately represent the amount of resource usage. For instance, a large capital acquisition will distort expenditure upward in the first year but the usage of that asset will not be recognised in following years. ♦ Recognition of cash payments alone sometimes results in an unnoticed deterioration in fixed assets. ♦ Perhaps the most significant deficiency in the system is the absence of a system of cost allocation. The focus of cash costs alone results in understatement of costs incurred by the Government departments in delivering goods and services. In the other countries surveyed i.e. Australia, Canada, Columbia, Hungary, New Zealand, and the United States of America, there is a clear preference for using the accrual accounting framework, although the degree of implementation of this method varies from country to country. Accrual accounts also show cash transactions but also record contingent liabilities when they are created. By measuring changes in assets and liability structure, it also provides invaluable information on the financial position of the Government. The Accrual and Consolidation Model requires that: ♦ A financial flow is to be reported at the time when an economic value is created, transformed, exchanged, transferred or extinguished, whether or not cash is exchanged at the time. ♦ All economic cost, cash or non-cash, be covered and matched with the revenue (measured in terms of economic benefits) of the period, ♦ Both short term and long term items be included in the financial statements and ♦ All sub-entities are aggregated for the entity. It is generally accepted that cash-based accounting systems are not well suited to record contingent liabilities, which are often treated as off-balance sheet items. The preferred method is certainly the accrual-based accounting systems, which can capture contingent liabilities as they are created. Within such systems, contingent liabilities are recorded at face value and expected present value of contracts. The Governments of Canada and the United States have formulated standards for accounting contingent liabilities. None of the frameworks actually sets out the valuation methods for estimating the contingent liabilities. Rather, greatest reliance is on the exposure method. This is to list the maximum exposure or the maximum potential amount than can be lost from

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contingent liabilities. Thus a guarantee covering the full amount of a loan outstanding would be recorded at the full nominal value of the underlying loan. Such lists are given by the UK, New Zealand and Australian regimes. The obvious limitation of the method is that there is no information on the likelihood of the contingency occurring. Further research is necessary to ascertain the valuation methodologies that underpin the calculation of the contingent liabilities. (d) Recording, Monitoring and Management In most of the regimes surveyed, the reporting of the contingent liabilities is set out as indicated in the following sections. Further work is required to ascertain at the countrylevel how each contingent liability is identified, measured, recorded, monitored and managed. Further, it is essential to evaluate vulnerabilities relating to the financial sector or the external sector. For this, additional information have to be ascertained from sources outside the fiscal sector, e.g. the reporting of international reserves, Central Bank Balance Sheets and private sector potential external liabilities. In other words, the frameworks for contingent liability disclosures only focus on potential government liability, and not on other sources of systemic risks, which the public and private sectors have to bear in special unforeseen circumstances. The conclusion is that in understanding the comprehensive range of contingent liabilities that the government faces, the fiscal frameworks governing them is only one source of information for monitoring and management. This has to be supplemented by a range of information and disclosure requirements for the early identification of external and financial sector vulnerability. It needs to be emphasised that there is no uniform system for reporting contingent liabilities. Standards and benchmarks need to be developed taking into account the diversity in country circumstance. While codes for data disclosures in a range of activities are being developed by the IMF, it will be left to individual countries to establish their own practical framework for the identification, measurement, disclosure and management of a whole range of contingent liabilities that confront the Government. Table-A.1 summaries the existing systems for data recording and monitoring, legal and institutional set up, policy framework and risk management in ten countries surveyed here. It may be observed that as judged by transparency, accountability, legal set up, policy framework and risk management Australia, Canada, Hungary, New Zealand and the USA provides international best practices for monitoring and management of contingent liabilities.

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Table-A.1 Management of contingent liabilities - Country experiences Items 1. Transparency- recording/ reporting (a) Types of contingent liabilities considered by government (b) Who approves and issues government guarantees? (c) Is there centralised unit to monitor and report contingent liabilities? (d) Are there ad-hoc or automatic government guarantees? (e) Types of contingent liabilities recorded and monitored regularly (f) Any contingent liability excluded or not reported regularly? (g) Does there exist up-to-date database for other liabilities? (h) Are all monitored contingent liabilities reported to public? 2. Accountability- Legal system (a) Are there legal requirements to report contingent liabilities? (b) Which of the contingent liabilities regulated by law? (c) Are their limits on contingent liabilities? (d) Is there any system of risk management by PSUs? (e) Is there Audit by independent auditors? 3. Policy framework (a) Is there policy framework for issue of guarantees? (b) Is there near term or medium term fiscal framework? (c) Is there designated contingent fund? If so, is it adequate? (d) Is there bail out of weak PSUs? 4. Risk Management (a) Is budgeting done on the basis of accrual accounting? (b) Is a Statement on Fiscal Risk included in the Budget? (c) Are the concerned organisations capable of evaluation and control of contingent liabilities? (d) General fiscal measures taken to prevent fiscal risk (e) Are the pension or provident systems fully funded? (f) Does there exist independent Public Debt Office, which also deals with contingent liabilities?

1. India

2. Australia

(a) Government guarantees, debt relief, bail outs (b) Ministry of Finance

(a) Guarantees, indemnities and uncalled capital (b) Department of Finance

(c) Yes, MOF/ RBI for only guarantees

(c) Yes, DoF

(d) Yes to small savings, pensions and PF (e) Only government guarantees (f) Liabilities for pension, provident funds, insurance (g) No

(d) Yes for certain liabilities under legislation (e) Quantifiable and unquantifiable (f) Insurance and pension

(h) Yes

(h) Yes

(a) For only guarantees, govt. plans to enact FRBM Act (b) Government guarantees, provident, insurance funds (c) No, Govt. plans to have limits under FRBM Act (d) Yes, ALM by banks and financial institutes (e) Yes, by the Comptroller General of Accounts

(a) Yes, the Charter of Budget Honesty Act (BHA) 1998 (b) Guarantees, indemnities and uncalled capital (c) No

(a) Yes

(a) Yes, the Charter of Budget Honesty Act (BHA) 1998 (b) No

(b) No, FRMA proposes such framework (c) Guarantee Redemption Fund for $2.5 bn (d) Yes

(g) Yes

(d) Yes, oversight by MOF and Cabinet under GBE (e) Yes, by Australian National Audit Office

(c) No (d) Yes

(a) No, govt. plans to adopt revised IMF GFS (b) No, FRMA proposes such statement in the Budget (c) Not fully

(a) Yes

(d) Strict prudential norms for banks and financial inst. (e) No, adopts "pay as you go" approach (f) No

(d) Sound fiscal management under the BHA 1998 (e) No, adopts "pay as you go" approach (f) Yes

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(b) Yes (c) Yes

Table-A.1 Management of contingent liabilities - Country experiences: Continued Items 1. Transparency- recording/ reporting (a) Types of contingent liabilities considered by government (b) Who approves and issues government guarantees? (c) Is there centralised unit to monitor and report contingent liabilities? (d) Are there ad-hoc or automatic government guarantees? (e) Types of contingent liabilities recorded and monitored regularly (f) Any contingent liability excluded or not reported regularly? (g) Does there exist up-to-date database for other liabilities? (h) Are all monitored contingent liabilities reported to public? 2. Accountability- Legal system (a) Are there legal requirements to report contingent liabilities? (b) Which of the contingent liabilities regulated by law? (c) Are their limits on contingent liabilities? (d) Is there any system of risk management by PSUs? (e) Is there Audit by independent auditors? 3. Policy framework (a) Is there policy framework for issue of guarantees? (b) Is there near term or medium term fiscal framework? (c) Is there designated contingent fund? If so, is it adequate? (d) Is their bail out of weak PSUs? 4. Risk Management (a) Is budgeting done on the basis of accrual accounting? (b) Is a Statement on Fiscal Risk included in the Budget? (c) Are the concerned organisations capable of evaluation and control of contingent liabilities? (d) General fiscal measures taken to prevent fiscal risk (e) Are the pension or provident systems fully funded? (f) Does there exist independent Public Debt Office, which also

3. Canada (a) Contingent and potential liabilities (b) Department of Finance

4. Columbia

(g) Yes

(a) Contingent liabilities of the Nation, entities (b) Ministry of Finance and Public Credit (MoF&PC) (c) General Directorate of Public Credit of the MoF&PC (d) Law 448 does not mention any (e) Possible contingent liabilities (f) Law 448 requires reporting of all possible (g) No

(h) Yes

(h) Yes

(a) Yes, under Financial Administration Act (b) Guarantees, callable share capital, land claims (c) No

(a) Yes, by Law 448 enacted on he 21st July 1998 (b) Contingent liabilities of the state entities (c) No

(d) Yes, except for those not dependent on govt.finance (e) Yes

(d) No

(a) Yes

(a) Law 448 requires such policy (b) No

(c) Yes, Treasury Board (d) Yes to Crown corporations (e) Guarantees, Aboriginal and comprehensive land claims, insurance (f) The Canada Pension Plan

(b) Yes (c) Not known

(e) Yes

(d) Yes

(c) Yes, State Entities Contingent Fund (d) Yes

(a) Yes

(a) No

(b) No

(b) No

(c) Yes

(c) No

(d) Strict fiscal discipline

(d) General fiscal policies

(e) No, adopts "pay as you go" approach

(e) No, adopts "pay as you go" approach

(f) Yes

(f) Yes

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deals with contingent liabilities Table A.1. Management of contingent liabilities - Country experiences: Continued Items 5. Czech Republic 6. Hungary 1. Transparency- recording/ reporting (a) Types of contingent liabilities (a) Government guarantees, (a) Guarantees, reinsurance considered by government subsidies (b) Who approves and issues (b) MOF (b) MOF government guarantees? (c) Is there centralised unit to (c) MOF, but there is (c) State Debt Management monitor and report contingent reporting of partial Office liabilities? contingencies (d) Are there ad-hoc or automatic government guarantees? (d) Yes (d) Yes, for reinsurance to (e) Types of contingent liabilities lending to priority sectors recorded and monitored regularly (e) So-called “hidden (e) Guarantees and state (f) Any contingent liability excluded liabilities” reinsurance or not reported regularly? (f) Pension and insurance (f) Pension funds (g) Does there exist up-to-date funds database for other liabilities? (g) No, only one attempt was (g) Yes, by State Debt (h) Are all monitored contingent done under the world Bank Management Office liabilities reported to public? (h) Yes (h) Yes 2. Accountability- Legal system (a) Are there legal requirements to (a) Yes, Law on Budgetary (a) Yes, by the public Finance report contingent liabilities? Rules Act of 1992 (b) Which of the contingent liabilities (b) Guarantees, hidden debt (b) Guarantees, reinsurance regulated by law? and priority lending (c) Are their limits on contingent (c) No (c) Yes as percentage of state liabilities? revenue receipts (d) Is there any system of risk (d) No (d) Yes, strict regulatory and management by PSUs? enforcement mechanism (e) Is there Audit by independent (e) Yes (e) Yes, by the State Audit auditors? Office 3. Policy framework (a) Is there policy framework for (a) Is under formulation (a) yes by MOF and state issue of guarantees? Debt Management Office (b) Is there near term or medium term (b) No (b) Yes, three-year Fiscal fiscal framework? Forecast made in Budget (c) Is there designated contingent (c) No (c) Yes, Budget makes fund? If so, is it adequate? provisions for CL (d) Is there bail out of weak PSUs? (d) Yes (d) Generally avoided 4. Risk Management (a) Is budgeting done on the basis of (a) No, attempts are being (a) Yes by both cash and accrual accounting? done accrual basis (b) Is a Statement on Fiscal Risk (b) No included in the Budget? (b) Yes, Budget shows (c) Are the concerned organisations (c) No probabilities of default capable of evaluation and control (c) Yes, ALM by concerned of contingent liabilities? agencies (d) General fiscal measures taken to (d) To consider hidden debt in (d) Strict monitoring of fiscal prevent fiscal risk the budget risks/ off-budget risks (e) Are the pension or provident (e) No, adopts "pay as you (e) No, adopts "pay as you systems fully funded? go" approach go" approach (f) Does there exist independent (f) No (f) Yes, the state Debt

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Public Debt Office, which also deals with contingent liabilities

Management Office

Table-A.1. Management of contingent liabilities - Country experiences: Continued Items 1. Transparency- recording/ reporting (a) Types of contingent liabilities considered by government (b) Who approves and issues government guarantees? (c) Is there centralised unit to monitor and report contingent liabilities? (d) Are there ad-hoc or automatic government guarantees? (e) Types of contingent liabilities recorded and monitored regularly (f) Any contingent liability excluded or not reported regularly? (g) Does there exist up-to-date database for other liabilities? (h) Are all monitored contingent liabilities reported to public? 2. Accountability- Legal system (a) Are there legal requirements to report contingent liabilities? (b) Which of the contingent liabilities regulated by law? (c) Are their limits on contingent liabilities? (d) Is there any system of risk management by PSUs? (e) Is there Audit by independent auditors? 3. Policy framework (a) Is there policy framework for issue of guarantees? (b) Is there near term or medium term fiscal framework? (c) Is there designated contingent fund? If so, is it adequate? (d) Is there bail out of weak PSUs? 4. Risk Management (a) Is budgeting done on the basis of accrual accounting? (b) Is a Statement on Fiscal Risk included in the Budget? (c) Are the concerned organisations capable of evaluation and control of contingent liabilities? (d) General fiscal measures taken to prevent fiscal risk (e) Are the pension or provident systems fully funded?

7. New Zealand

8.Philippines

(a) Guarantees, indemnities, uncalled capital, others (b) MOF

(a) Guarantees of foreign loans of GOCCs (b) Department of Finance

(c) Yes, Public Debt Office

(c) Bureau of Treasury

(d) Generally not

(d) Charters of many GOCCs allow automatic guarantee (e) Only guarantees given to GOCCs (f) Other types are largely unmonitored. (g) No

(e) Quantifiable and nonquantifiable CL (f) All possible CL are considered (g) Yes, six-monthly statements by all (h) Yes

(h) Yes

(a) Yes, By PF Act, LG Act, Fiscal Responsibility Act (b) Quantifiable and nonquantifiable CL (c) Yes, under Fiscal Responsibility Act (d) Yes, all PSUs use accrual accounting and report CLs (e) Yes, GAAP used for both public & private sectors

(a) Republic Act 4860 (Foreign Borrowing Act) (b) Only guarantees given to GOCCs (c) $7.5 million ceiling on govt. guarantees on foreign loans (d) Generally not (e) Yes by Commisson on Audit

(a) Yes, ALM and prudent risk management for all (b) Yes

(a) Yes issued by DOF

(c) Yes

(c) No, present Budget only allocated 1% of CLs. (d) Yes

(d) Very rare

(b) Yes reported in the Budget

(a) Yes, on both cash-basis and accrual basis (b) Yes, Fiscal Risk in ALM Framework (c) Yes

(a) No, only on cash basis with modified accrual (b) No

(d) Strict fiscal prudence and ALM (e) Yes

(d) No strict hard budget constraint (e) Not fully funded, adopts defined benefit system

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(c) Systems need strengthening

(f) Does there exist independent Public Debt Office, which also deals with contingent liabilities

(f) Yes

(f) No

Table- A.1 Management of contingent liabilities - Country experiences: Completed Items 9. United Kingdom 10. United States of America 1. Transparency- recording/ reporting (a) Types of contingent liabilities (a) Material contingent (a) Guarantees, pending considered by government liabilities litigation, claims (b) Who approves and issues (b) Respective Ministries/ (b) The Treasury government guarantees? Departments (c) Is there centralised unit to (c) Annual statement of CLs (c) President Office of Budget monitor and report contingent of the Consolidated Fund publishes General liabilities? given in the Budget financial reports (d) Are there ad-hoc or automatic (d) Yes, on grounds of (d) No government guarantees? national security (e) Types of contingent liabilities (e) Guarantees and other (e) Guarantees, pending recorded and monitored regularly material CLs litigation, claims (f) Any contingent liability excluded (f) CLs related to national (f) Contingencies classified as or not reported regularly? security & public interest remote, and insurance (g) Does there exist up-to-date (g) Information on CLs (g) Yes in Federal Financial database for other liabilities? disclosed with legal status Reports (h) Are all monitored contingent (h) Yes, except CLs for (h) Yes liabilities reported to public? national security & interest 2. Accountability- Legal system (a) Are there legal requirements to (a) Code of Fiscal Stability (a) Yes, Federal credit report contingent liabilities? under the Finance Act Reforms Act of 1990 (b) Which of the contingent (b) All material contingent (b) “Probable and liabilities regulated by law? liabilities Reasonably Probable” (c) Are their limits on contingent (c) No (c) Automatic limits through liabilities? appropriation (d) Is there any system of risk (d) Yes (d) Yes management by PSUs? (e) Yes, as per Federal (e) Is there Audit by independent (e) Yes, by National Audit Financial Accounting auditors? Office Standards 3. Policy framework (a) Is there policy framework for (a) Yes, each Ministry has to (a) Yes, on the basis of present issue of guarantees? publish legal status on CL value measurement (b) Is there near term or medium term (b) Yes, fiscal aggregates (b) Yes fiscal framework? projected for next 2 years (c) Is there designated contingent (c) No (c) Annual appropriations fund? If so, is it adequate? must be made for CLs (d) Is there bail out of weak PSUs? (d) Yes (d) Yes 4. Risk Management (a) Is budgeting done on the basis of (a) No (a) Yes accrual accounting? (b) Is a Statement on Fiscal Risk (b) Publishes an Economic (b) Yes included in the Budget? and Fiscal Strategy Report (c) Are the concerned organisations (c) Yes, each Department/ (c) Yes capable of evaluation and control Ministry has to list and of contingent liabilities? disclose CLs & legal status (d) Present value of cash (d) General fiscal measures taken to (d) Indicates long term outflows on CLs is taken prevent fiscal risk economic & fiscal strategy as cost in the budget (e) Are the pension or provident (e) No, adopts "pay as you (e) No systems fully funded? go" approach

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(f) Does there exist independent Public Debt Office, which also deals with contingent liabilities

(f) Yes, UK Debt Management Office

(f) Yes, President’s Office of Management and Budget

Annexure-C The Management of Contingent Liabilities in The United States of America With the introduction of the Federal Credit Reform Act of 1990 (effective since the fiscal year of 1992), the US Federal Government replaced a parallel budgeting system for contingent liabilities with new budgetary rules for direct and guaranteed loans. These provisions are designed to neutralise budgetary incentives, making policy makers indifferent to whether they choose grants, direct loans or guarantees. The primary interest is to ensure that subsidy costs of grants, direct loans and guarantees are taken into account in budgetary discussions. The standards for accounting for liabilities, including contingent liabilities are set out in the Statement of Federal Financial Accounting Standards, “Accounting for Liabilities of the Federal Government (September 1995)” published by the President Office of Management and Budget. These standards apply to general-purpose financial reports to US Government reporting entities. The Act has the following specific purposes: (a) (b) (c) (d)

Ensure a timely and accurate measure and presentation in the President’s budget of the costs of direct loan and loan guarantee programmes; Place the cost of credit programmes on a budgetary basis equivalent to other federal spending; Encourage the delivery of benefits in the form most appropriate to the needs of beneficiaries, and Improve the allocation of resources among credit programmes and between credit and other spending programmes.

The major provisions of the Act require that: •

• • •

For each fiscal year in which the direct loans or the guarantees are to be obligated, committed or disbursed, the President’s budget reflect the long-term cost to the government of the subsidies associated with the loans and guarantees. The subsidy cost is to be estimated as the present value of the projected cash outflows discounted at the average rate of marketable Treasury securities of similar maturity. Before direct loans are obligated or loan guarantees are committed, annual appropriations generally are enacted to cover these costs. However, mandatory programmes have permanent indefinite appropriations. Borrowing authority from Treasury covers the non-subsidy portion of direct loans. There are budgetary and financing controls for each credit programme.

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59

Contingencies A contingency is an existing condition, situation, or set of circumstances involving uncertainty as to possible gain or loss to an entity. The uncertainty will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm a gain, (i.e., acquisition of an asset or reduction of a liability) or a loss (i.e., loss or impairment of an asset or the incurrence of a liability). When a loss contingency (i.e., contingent liability) exists, it is classified in three probability categories depending on the likelihood of the future event to occur:

• Probable: The future confirming event or events are more likely than not to occur. • •

Reasonably possible: The chance of the future confirming event or events occurring is more than remote but less than probable. Remote: The chance of the future event or events occurring is slight.

Some examples of loss contingencies are collectibility of receivables; pending or threatened litigation; and possible claims and assessments. Criteria for Recognition of a Contingent Liability A contingent liability should be recognised when all of these three conditions are met. • • •

A past event or exchange transactions has occurred (e.g. a federal entity has breached a contract with a non-federal entity). A future outflow is probable (e.g. the non-federal entity has filed a legal claim against a federal entity for breach of contract and the federal entity believes that the claim is more likely to be settled in favour of the claimant). The future outflow or sacrifice of resources is measurable.

The estimated liability may be a specific amount or a range of amounts. If no amount within the range is a better estimate than any other amount, the minimum amount in the range is recognised and the range and a description of the nature of the contingency should be disclosed. Criteria for Disclosure of a Contingent Liability A contingent liability should be disclosed if any of the conditions for liability recognition is not met and there is at least a reasonable possibility that a loss may have been incurred. “Disclosure” is regarded as an integral part of the basic financial statements. Disclosure should include the nature of the contingency and an estimate or a range of the possible liability or a statement that such an estimate cannot be made. In some cases, contingencies may be identified but the degree of uncertainty is so great that no reporting is necessary in the federal financial reports. Specifically, contingencies

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classified as remote need not be reported in general purpose federal financial reports, though law may require such disclosures in special purpose reports. Implementation Conversion to the subsidy cost basis has entailed the maintenance of separate budgetary accounts for the subsidised and unsubsidised portions of loans and guarantees. Programme accounts receive appropriations for subsidy costs; financing accounts handle the cash flows associated with the non-subsidised portion. Programme accounts are included in the budget; financing accounts, however, are recorded as “means of financing” and their cash flows are not included in budget receipts or outlays. Future Legislation The subsidy cost basis is currently used only for direct and guaranteed loans, not for other contingent liabilities. However, legislation tabled in the United States Congress during 1999 shifts all US Government insurance programmes to this basis. The legislation provides that beginning with fiscal year 2006, insurance commitments could be made only to the extent that budget resources were appropriated to cover their “risk-assumed cost”. This cost is defined as “the net present value of the estimated cash flows to and from the Government resulting from an insurance commitment or modification thereof”. As the volume of insurance commitments is many times greater than that of loan guarantees, this legislation would have an enormous impact on the budgetary treatment of contingent liabilities.

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Annexure-D Partial List of Persons Met during visit to Manila: 17 February to 2 March 2002 1. 2.

3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29.

Mr. Lloyd McKay, Lead Economist, World Bank Office at Manila (WBOM). Ms. Hazel Malapit, Consultant, World Bank Office at Manila. Ms. Laura Pascua, Under-Secretary, Department of Budget and Management (DBM) and the Chairperson of the counterpart team (PER Working Group) established by the Government of Philippines; Mr. Romeo de Vera, Consultant, DBM. Ms. Estee Manglo, Division Chief, Planning, DBM. Mr. Jo Abundo, Director, DBM. Mr. Edgardo Jose L. Compos, Senior Strategy Adviser for Public Sector Reforms, DBM and Adviser to AGILE. Ms. Nieves Osorio, Undersecretary, Department of Finance (DOF), Government of Philippines (GoPh). Ms. Soledad Emilia J. Cruz, Director, Corporate Affairs Group, DOF, GoPh. Ms. Dolly Celam, Corporate Affairs Group, DOF. Ms Emelina Silao-Blanco, Corporate Affairs Group, DOF, GoPh Mr. Richard S. Ondrik, Chief Country Officer, Philippines Country Office (PhCO), ADB. Ms. Xuelin Liu, Country Economist, PhCO, ADB Mr. Romeo L. Bernardo, MD, Lazaro Bernardo Tiu & Associates Inc. Ms. Marie Christine G. Tang, Senior Associate, Lazaro Bernardo Tiu & Associates Inc. Ms. Patricia K. Buckles, Mission Director, United States Agency for International Development (USAID), Philippines. Mr. Francis A. Donovan, Deputy Mission Director, USAID. Mr. Joseph S. Ryan Jr., Chief, Economic Development and Governance, USAID. Mr. Karoly K. Okolicsanyi, Financial Markets Development Adviser, USAID. Mr. Tony Cintura, Deputy Director (Economic Research), Bangko Sentral ng Pilipinas. Mr. Guillermo Carague, Chairman, Commission on Audit. Ms. Emma Espina, Assistant Commissioner, Commission on Audit. Mr. Gilbert Llanto, Deputy Director General, National Economic & Development Authority (NEDA). Mr. Reynaldo P. Palmiery, Executive Vice President & COO, GSIS Ms. Enrigueta P. Disuanco, Senior Vice President (Corporate Services), GSIS. Ms. Maria Fe-Santos-Dayco, Vice President and Actuary, GSIS. Ms. Corazon S. De La Paz, President and CEO, SSS. Ms. Maribel D. Ortiz, Assistant Vice President (Research), SSS. Ms. Virgina E. Gallarde, Assistant Vice President (Actuary), SSS

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