Contingent Liabilities for Philippines, by Tarun Das

8/14/2019 Contingent Liabilities for Philippines, by Tarun Das

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Management of Contingent Liabilities in Philippines-Policies, 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 personalviews 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 Philippines-

Policies, 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 andFinancial Management Review (PEPFMR) for the Philippines being prepared by theWorld Bank. The objective of the PEPFMR exercise is to examine selected issues inthe allocation and management of public resources, which are of interest to theGovernment of Philippines and the World Bank. In particular, the objectives of theWorld 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 topromote economic growth, improve delivery of basic social services, and reducepoverty; and

(ii) To fulfill the World Banks fiduciary responsibility and serve as the core background analytical framework for future operations in Philippines. ThePEPFMR findings and recommendations will constitute part of the core analyticalwork for a proposed Public Finance Strengthening Loan (PFSL), and attendantprograms and adjustment loans.

2. A key focus area of the PEPFMR is the identification and management of publiccontingent liabilities, which pose threats to fiscal stability and overall macro-economic stability and, therefore, require better monitoring and management. Theseliabilities include exposures under obligations such as government guarantees onloans; performance guarantees to BOT projects, guarantees on guarantee institutionsand deposit insurance, and fiduciary guarantees to public pension, provident andinsurance institutions. Certain other categories of government's contingent liabilitiesinclude forward contracts for foreign exchange, various implicit obligationsassociated 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 asexposures under government guarantees on loans, BOT projects, guarantees onguarantee institutions, public pension institutions, deposit insurance, un-fundedliabilities of pension institutions and the increasing debt of the National PowerCorporation (Napocor). The report suggests systems for monitoring and

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dissemination of information on outstanding guarantees of the government guaranteeinstitutions that are explicitly or implicitly backed by the national government.

4. The report examines the legal framework, policies, processes and institutionalarrangements for monitoring public contingent liabilities in the Philippine

government with special emphasis on state guarantees to Government FinancialInstitutions (GFIs) and Government Owned and Controlled Corporations (GOCCs).The report identifies the key issues and concerns, and describes, analyzes andassesses the steps already taken by the authorities. In addition, it provides country-specific recommendations in the short-, medium- and long term for the improvementas per international sound practices.

5. The findings are based on examination of available reports on the subjects anddiscussions with the concerned entities involved in receiving, issuing, approving,managing and recording state contingent liabilities (focusing for the present onexplicit ones which are recognized under legal laws and contracts for both domesticand external liabilities) during a mission to Manila during 17 February to 2 March2002.

6. The consultant has worked under the continual guidance of the PEPFMR task teamleader (TTL) Mr. Amitabha Mukherjee who specified the broad objectives and scopeof the study and also indicated the key technical officials and policy makers in thePhilippines who are responsible for the approval, issue, recording, monitoring andmanagement of contingent liabilities.

7. During visit to Manila, the Consultant maintained close interactions with Mr. LloydMcKay, Lead Economist, World Bank Office at Manila (WBOM), Ms. LauraPascua, Under-Secretary, Department of Budget and Management (DBM) and the

Chairperson of the counterpart team (PER Working Group) established by theGovernment of Philippines; Ms. Nieves Osorio, Undersecretary, Department ofFinance (DOF), Government of Philippines (GoPh), Ms. Soledad Emilia J. Cruz,Director, Corporate Affairs Group, DOF, GoPh., and Ms. Xuelin Liu, CountryEconomist, Philippines Country Office, Asian Development Bank.

8. The Consultant has also benefited greatly from detailed discussions with variousofficials of the government of Philippines and GOCCs, who are responsible forissuing, approval, monitoring and auditing of contingent liabilities and formulation ofpolicies. A list of key officials with whom detailed discussions were held in Manila isgiven at Annexure-D.

3. Contingent liabilities- definitions and measurement

Contingent liabilities are defined by the System of National Accounts 1993 as contractualfinancial arrangements that give rise to conditional requirements either to make paymentsor to provide objects of value. A key characteristic of such financial arrangements, asdistinguished from the current financial liabilities, is that one or more conditions orevents 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 areuncertain.

Contingent liabilities represent potential claims against the government, which have notyet materialized, but which could trigger a firm financial obligation or liability under

certain circumstances. Several studies have shown that contingent liabilities, oncematerialized, can be a major factor in the build up of public sector debt and can posesignificant risks to the governments balance sheet.

Contingent liabilities are of two main types- explicit and implicit. Explicit contingentliabilities are based upon legal and contractual commitment or formal acknowledgementof a potential claim, which can be realised in particular situations. Explicit contingentliabilities include bonds or other liabilities contracted by the government with put optionsfor lenders, credit-related guarantees, performance guarantees, various types ofgovernment insurance schemes (e.g., against banking deposits, crop failure, naturaldisasters, 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 nothave a contractual obligation to provide financial support, but society expects thegovernment to provide assistance because of moral considerations. Implicit contingentliabilities arise when the cost of not assuming them are considered to be very high interms of social and economic disruptions. For example, bailing out weak banks or failedfinancial institutions or meeting the obligations of the subnational (state and local)governments or the Central Bank in the event of default following systematic crisis maybe 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 state-owned enterprises or government obligations under a fixed exchange rate regime todefend its currency peg. These risks can be particularly significant in emerging marketcountries undergoing financial sector and capital convertibility reforms and where theregulatory and disclosure standards may be weak.

As for example of contingent liabilities, in the case of Philippines, the nationalgovernment assumed about US$7.5 billion (or P152 billion) of liabilities from thePhilippine National Bank (PNB) and the Development Bank of the Philippines (DBP) inthe process of rehabilitation of these GFIs. Most of these liabilities were due to thedefault 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 theseexternal loans, it was constrained to assume these liabilities because of automaticgovernment guarantees provided for in these bank charters and to avoid adverse impacton the credit rating of sovereign debt. Again in 1993, the Philippine government assumedliability of US$8.1 billion or P331 billion of cumulative losses of the Central Bank ofPhilippine (CBP). The losses of CBP was primarily due to mismatch between its assetsand 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 andrehabilitation of weak banks.

Contingent liabilities are complex and not easy to quantify. A single and uniformframework for their measurement may not be appropriate. The choice of a technique

depends on the type of contingent liability being measured and the availability ofrequisite 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 formanaging contingent liabilities. Only the accrual based accounting systems can capturecontingent liabilities as they are created. Within such systems, contingent liabilities canbe recorded at full face value or maximum potential loss as well as expected value andexpected present value of contracts.

Following Polackova (1998), contingent liabilities can be best described in terms of aFiscal Risk Matrixcross-classifying sources of potential risks on government finance bytwo 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 Direct: Obligation in

Any event

Contingent: Obligation if a

Particular event occurs

Explicit:

Governmentliability by lawor by a contract

Sovereign debt (domestic and

external)

Budgeted expenditures of

different departments

Expenditures non-

discretionary and legally

binding in the long term (civilservice salaries and pensions)

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

Implicit:

A moralobligation of thegovernmentwhich reflectspublic andinterest grouppressures

Future recurrent costs of

public investment projects

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 sub-

national governments

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4. Practices of Managing Contingent Liabilities in Philippines

At present, the government of Philippines does not have a comprehensive Act to monitorall contingent liabilities. It has only one tool to manage its contingent liabilities related toexternal sector. Republic Act 4860 (Foreign Borrowings Act), as amended from time totime, sets a ceiling of $7.5 million on outstanding government guarantees for foreignloans of the government-owned and controlled corporations (GOCCs). Items, which arerequired to be charged against this ceiling, are the guaranteed principal amounts (i.e.,disbursements less repayments, excluding interest payments and other bank fees) of loansincurred and bonds issued. The national government charges a fixed 1 per cent annualguarantee fee regardless of the risk profile of the guaranteed loan or institution.

The Department of Finance (DoF) reviews and approves requests of GOCCs fornational 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 totaloutstanding 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 chargedagainst this ceiling. These exemptions render the ceiling a less effective controlmechanism, especially since some of the exempted corporations are the giant GOCCswith large outstanding loan balances.

A study by AGILE (Accelerating Growth Investment and Liberalisation with Equity- aConsortium of the Development Alternatives Inc., Harvard Institute for internationalDevelopment, Cesar Virasta & Associates Inc. and PricewaterhouseCoopers) made an

analysis of contingent liabilities of the Philippines government for 30 GOCCs. TheAGILE study identified 15 GOCCs with automatic guarantees in their charters. However,a more comprehensive study made by Bernardo and Tang (2001) indicates that 22GOCCs, out of 32 GOCCs, enjoy automatic guarantees in their charters (Annexure-A).

Except guaranteed GOCC loans; other types of government contingent liabilitiesare largely unmonitored. There are efforts in the DoF and BTr to monitor governmentguarantees for various types of risks under BOT contracts but these are still in the initialstages. The government also does not monitor exposures related to foreign exchangecover for loans of government financial institutions secured by the Land Bank and theDevelopment Bank of the Philippines from official creditors in foreign exchange andrelent to accredited private financial institutions in pesos. Likewise, the unfundedliabilities of the pension institutions (Social Security System, Government ServiceInsurance System, Home Development Mutual Fund), also guaranteed by thegovernment, are not monitored and managed. In addition, there is currently no systemfor bringing together information on outstanding guarantees of government guaranteeinstitutions 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 ofgovernment's general revenues and are not kept in a separate account to fund futureguarantee calls. Given government's cash-based accounting and budgeting frameworks,government does not presently provide reserves for expected guarantee calls. Thecorporations are also not required to conform to standard prudential norms in

provisioning and reserve policy for contingent liabilities. The GOCCs donot estimate anddisclose their off-balance sheet contingent liabilities in their annual reports. Only when aguarantee is called does the government set up the needed budget to fund payments andonly for that portion due in the current year.

As in most countries, government budgets in the Philippines are done on a cash basis andnot on accrual basis. Non-cash expenditures such as depreciation of assets, taxes owedbut not yet paid, donot appear in the budget. Consequently, guarantees and other off-budget arrangements are made liberally and there is no hard budget constraint. Althoughit is possible to note guarantees and other non-cash items as memorandum items in thecash-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 guaranteeson loans, BOT projects, guarantees on guarantee institutions, public pension institutionsand deposit insurance are estimated to be Pesos 3.4 trillion, which is equivalent to 111 percent of public debt and 95 per cent of GDP. The most dominant component involvesexposures in unfunded liabilities of pension institutions, amounting to P1.8 trillion or 55per 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 totalcontingent liabilities, equivalent to around 15 per cent of GDP and 17 per cent of nationalgovernment debt), closely followed by government guarantees BOT projects (whichaccount for about 14 per cent of total contingent liabilities, equivalent to around 14 percent of GDP and 16 per cent of national government debt). Deposit insurance has also asignificant share (11 per cent) in total contingent liabilities, equivalent to 11 per cent ofGDP and 12 per cent of public debt. However, these contingent liabilities do not includegovernment's contingent liabilities under forward contracts for foreign exchange andvarious implicit obligations associated with bank failures and possible recapitalization offailing corporations.

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Table-2: Summary of government contingent liabilities

Maximum exposure for each type as in October 2001

Type of contingentliability Amount(P billions) Share in totalcontingent

liability (%)

As % ofGDP As % ofpublic

debt

Guarantees on loansBOT ProjectsGuarantee institutionsPublic pension institutionsDeposit insurance

Total

49145540

1,828352

3,166

15.514.31.357.711.1

100

14.813.71.255.010.6

95.2

17.216.01.464.212.4

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 inContingentLiabilities

% of GDP % of totalNG debt

Domestic debt 15.3 3.1 0.5 0.5Guaranteed 15.1 3.1 0.5 0.5Assumed 0.2 0.0 0.0 0.0

External debt 476.1 96.9 14.3 16.7Guaranteed 458.7 93.3 13.8 16.1Assumed 17.4 3.5 0.5 0.6

Total CLs 491.4 100.0 14.8 17.2Memo items

NG total debt

Domestic

External

2844.01239.41604.6

85.637.348.3

100.043.656.4

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, totalcontingent 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 nationalgovernment debt. This includes P17.6 billion in assumed guarantees of formerlyrehabilitated GOCCs (mainly Philippine National Bank and Development Bank ofPhilippines). The bulk (97 per cent) of the contingent liabilities consist of guarantees onforeign debts of GOCCs, including borrowings of GOCCs whose charters exempt themfrom the ceiling provided under RA 4860. Domestic debts guaranteed include bondissuances of the Home Development Mutual Fund and the National DevelopmentCompany as well as agrarian reform bonds of the Land Bank.

A breakdown of the above data by GOCCs is not readily available. Instead, informationculled from 1999 Commission on Audit reports indicate that National Power Corporation,

which enjoys automatic government guarantee on its bonds, has the largest share (42 percent) 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 toservice their loans is very high. A review of the financial performance on the basis ofAudit Reports indicate that LRTA and PNR had negative networth for the past threeyears, and four others (NEA, NFA, NIA, NPC) had been registering losses leading todeclining networth.

Guarantees to GOCCs need to be more tightly managed and monitored. Decisions toproviding guarantees should be subject to the same process of appraisal as that forproviding loans. The recent decision of the DOF to make a provisioning in the budget byone percentage of guarantees is a positive move. But, these charges are modest and theuniform provisioning does not reflect an assessment of the differing risk characteristics ofthe projects or loans being guaranteed.

In the short run, government should systematically assess the financial health of each ofGOCCs to ascertain their creditworthiness and the government's risk in guaranteeing theirdebts. 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 beforeguaranteeing loans and adjust guarantee fees depending on credit rating of theinstitutions.

In the medium term, the government should review and amend the charters of GOCCs asnecessary to ensure that the guarantee limits apply to all GOCCs. Where desirable andpossible, GOCCs could be privatised to avoid the risk. Weak GOCCs either need to bestrengthened with feasible capital and manpower restructuring or closed with legalcompensations 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 thenational 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 itcomplete an inventory of all contingent liabilities, review the sources of contingentliabilities, develop means for minimizing and sharing risks across government and quasi-governmental organizations, monitor projects guarantees, and build institutional capacityfor effective management of contingent liabilities. The government has recognized thecomplexity of issues relating to continent liabilities and is devoting resources to thedifficult task of measuring them.

(b) BOT Projects

In order to attract private sector participation and financing for critical infrastructureprojects in power, road, rail transport and water supply, the government of Philippinesissued guarantees for BOT projects for mitigating some of the risks posed by the politicaland economic environment in the Philippines. Some of the risks assumed by thegovernment include currency, market, political and regulatory risks as well as forcemajeure 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 nationalgovernment exposure to BOT project-related risks for 40 power projects, six transport projects and five other projects (on water supply, housing, tourism, informationtechnology, thermal coating and printing plant). The study assessed risks in the BOTprojects and computed the expected losses of the government from these projects usingMonte Carlo or stochastic simulation methods. The study estimated that the indicativeexposure in these projects amounted to P1412 billion and explicit exposure at P455billion. The explicit exposure represents the maximum contractual obligation of thenational government that arises if all the contingencies, including force majeure, aretriggered in all the contracts. However, it may be mentioned here that the likelihood ofsuch happening is remote and the expected loss from some of these exposures (e.g., forcemajeure) is zero.

The results indicate that the Sual and Pagbilao power projects and the MRT-III light railtransit project have the highest risks for losses, and the main risk factors arise fromcurrency and demand risks and time-overruns in implementation of projects. However, itmay be noted that in the case of the power projects, neither the NPC nor the nationalgovernment assumes the costs of these risks as these costs are actually passed on toconsumers. For MRT-III on the other hand, the government already provided US$76million in subsidy in 2000.

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Table 4: Indicative and Explicit NG Exposures

under BOT Projects* (In P billion)

Indicative* Explicit*

PowerTransportWaterOthers

Total

1,210167431

1,412

253167431

455

Indicative exposures refer to the present value of future

payments by the national government to BOT operators andtheir 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 theagriculture, small enterprise, housing and export sectors. The biggest among these is theHome Guaranty Corporation (HGC). HGC is particularly noteworthy because it has anauthorized capital of P50 billion and an allowable guarantee limit of 20 times itsnetworth. Since all of HGC's obligations and loan guarantees are backed automaticallyby 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 slumpfollowing the Asian crisis, guarantee calls on HGC have risen substantially and havestrained HGC's cash position. Reorienting HGC's guarantee scheme towards cashflowguarantee may be needed to help HGC manage the guarantee calls. A further point ofconcern would be pressure for it to do "formula lending" for low-income housing similarto what NHMFC was doing (i.e., with no credit evaluation).

Aside from HGC, there are a host of much smaller government guarantee institutionswhich include the Trade and Investment Development Corporation of the Philippines(TIDCORP), the Guarantee Fund for Small and Medium Enterprises (GFSME), the SmallBusiness Guarantee Fund Corporation (SBGFC) and the Quedan and Rural CreditGuarantee Corporation (Quedancor). Except for the SBGFC (which will be merged withthe GFSME), guarantees of the TIDCORP, Quedancor and GFSME are backed by thenational government.

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A 1998 study on the Quedancor, SBGFC and GFSME noted substantial losses in theseprograms, with all three-guarantee institutions suffering negative net operating incomefrom 1992 to 1997. The study, moreover, observed that the number of loans guaranteedby the programs is small and the additional number of loans that were stimulated by theguarantee 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 ofP170.4 billion comprising Pension Reserve Fund of P151.8 billion, Employeescompensation 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, itmanaged to overcome the gap by its earnings from investment. However, this may not befeasible for all the years to come. According to estimates made by the Secretariat of thePresidential Retirement Income Commission (PRIC) on the basis of the World BankPROST model, the implicit public debt in the case of termination of the program in 1999would have amounted to P1.48 trillion or about 50% of GDP. The program's unfundedliabilities were estimated at P1.3 trillion. The PRIC Secretariat further estimated that cashflow 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. Officeof 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 socialsecurity system and fund ratio due to the following factors:

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

The SSS has been experiencing contributions-to-benefits as well as contributions-to-expenditures imbalances for the past several years, especially since 1993. The majorproblem with the SSS is that for many years, benefits have been increasing withoutcorresponding increase in contributions. The last increase in the contribution rate from7.4 per cent to 8.4 per cent was done in 1979. Since then the benefits had been enhanced23 times due to political reasons, but there had been no commensurate increase in thecontribution rates.

This deficiency is largely accounted for by the basic mismatch between the benefit rateand 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 beneficiariesof the minimum pension, the benefit ratio is estimated at 7.93.

Table-5 below indicates that by international comparisons, the SSS contribution rate islow 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 theemployee and 5.1 percent by the employer) is much smaller compared to that of GSISand similar funded and aged social security programs in other countries. It comparesunfavorably with the GSIS with a contribution rate of 21 per cent. The SSS contributionrate is also one of the lowest among the similar pension systems for other countries suchas Malaysia with a contribution rate of 23 per cent, Singapore 32 per cent, China 30 percent, 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 Retirementage

(Years)

Length ofService required

for pension(years)

Combinedcontribution

Rate(%)

Averageretirement

Rate

Real rate ofreturn on

investments

Administration 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 EastAsia 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 anddevelopment loans, which constitute about 50 per cent of total investments. At the end ofOctober 2001, housing loans comprised 26 per cent of total investments, member loans15 per cent, development loans 8 per cent, government sector loans 17 per cent, equitiesin private sector 29 per cent, and real estate 4 per cent. Moreover, because of politicalconsiderations, the SSS is not allowed to diversify its investments by investing in foreignassets. The result is that the SSS has become actuarially unsound.

Demographic transition in Philippines has also exacerbated the SSSs financial plight.

Due to an increase in expectation of life, more people are living longer and the pensionbenefits 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 privateemployees are the members of SSS. The most current audited balance sheet (2000) of theGSIS shows a total reserve fund of P166 billion comprising Social Insurance Fund pf

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P154 billion, Optional Life Insurance Fund P6.8 billion, General Insurance Fund P4.8billion, and Employees Compensation Insurance Fund P0.5 billion. However, this doesnot accurately represent the unfunded liabilities of the institution. The PRIC Secretariatestimated that the implicit public debt of GSIS at the end of 1999 stood at P538 billioncompared 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 pensiondebt for the Philippine is estimated to be 107 per cent of GDP. It may, however, be notedhere that the Philippines is not the only country having problem with contingent liabilitiesrelating to pension and provident funds. Governments all over the world face similarproblems, many of which are yet to explicitly recognize that the problem exists. Table-6belowhighlights 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 emergingmarkets.

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 131Source: Holzmann, Robert, Ian W. Mac Artjir and Yvonne Sin Pension Systems in EastAsia and the Pacific: Challenges and Opportunities, Social Protection Unit, The WorldBank, June 2000.

Although the financial position of GSIS is better than that of the SSS, it is estimated thatthe current benefits of GSIS at the existing rates would exceed the current contributionsin 1924, and there would be serious liquidity problem in 2041 and the reserves would beexhausted 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 thelowest income member. The contribution rate at 21 percent is almost two and half timesof that of SSS. Although there is little scope for enhancing the contribution rate, which isreasonable at 21 per cent, there is scope for improving the compliance rate and torationalize the benefits among the members in different income brackets. There is alsoscope for enhancing the qualifying period for getting pension and to increase theretirement 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 governmentguarantee in the case of financial problem faced by GSIS or SSS. However, both thesystems 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 suchas administration of benefits, limiting direct lending operations to salary and housingloans to its members, and phased out peripheral programs, which can be more efficientlyhandled 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. Whilegovernment can provide some subsidies for life insurance for targeted groups of peopledue 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. orPag-IBIG is a mandatory savings program where accumulated contributionsfrom employees and employers are used primarily for housing finance. Forty-fourpercent (P42.5 billion) of Pag-IBIG's assets at the end of 1999 are in the form ofmortgage loans to members. Members are allowed to withdraw their account balancesafter 20 years of contributions (or upon retirement, death or disability) with an option towithdraw partially after 10 years. For a large number of the early contributors, Pag-IBIG'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 in2000.

While Pag-IBIG appears in better shape financially than the pension institutions, thequality of its portfolio is a point of concern. It is reported that the institution's non-performing mortgage loans comprise 30% of its mortgage portfolio, which under theworst case scenario (no recoveries) translates into a potential loss of P12 billion based onmortgages 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 externalshocks, the banking system continued to hold its ground in 2000 with growing deposits,manageable asset quality, and desirable capital adequacy ratio. Deposits of commercialbanks grew by 7.5 per cent in 2000. While savings deposits accounted for 60.7 per cent oftotal deposits, time and demand deposits comprised 28.4 per cent and 10.9 per centrespectively.

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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 mandatoryfor all banks to disclose the off balance sheet (i.e. contingent) liabilities in their balancesheet. 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-standardassets. Commission on Audit is responsible for auditing all GOCCs including governmentbanks and BSP.

Philippines banks, particularly the government banks, at present are beset with theproblems of high levels of non-performing assets and low rate of return, although theyhave reasonable capital adequacy ratios. Moreover, both the capital and the non-performing assets are unevenly distributed among the banks.

The asset quality of the banking system exhibited steady worsening since 1997. The non-

performing loan (NPL) ratio of the banking system increased to 17.3 per cent at the endof 2001 compared to only 2.8 per cent at the end of 1996 (Table-7). The NPL ratio for thenon-expanded commercial banks (NEKBs) was the highest at 22.8 per cent, and that forforeign banks was the lowest at 4.8 per cent, while the NPL ratio for government banksstood at 17.8 per cent at the end of 2001. Restructured loans of commercial banksincreased 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 TotalCommercial

Banks (KBs)

ExpandedCommercial

Banks (EKBs)

Non-ExpandedCommercial

banks (NEKBs)

Governmentbanks

Foreignbanks

1996 2.8 2.4 3.7 4.4 3.3

1997 4.7 4.2 7.2 6.1 4.4

1998 10.4 10.4 13.7 10.1 7.8

1999 12.3 13.0 16.4 12.6 3.5

2000 15.1 16.8 17.6 15.0 3.8

2001 17.3 19.4 22.8 17.8 4.8

However, the banking system remained adequately capitalized. The average capitaladequacy 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 ratioremained well above the BSP statutory floor rate of 10 per cent and the Bank forInternational Settlements (BIS) standard of 8 per cent. Meanwhile, bank provisions forpossible loan defaults improved to 6.5 per cent of total loans at end-December 2000 from5.8 per cent in 1999. On the other hand, the proportion of banks reserves for probablelosses to total NPLs declined to 43.5 per cent at the end of December 2000 from 45.2 percent at the end of 1999.

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The ratio of real estate loans to total loans (inclusive of inter bank loans) of commercialbanks dropped marginally to 11.3 per cent at the end of 2000 from 11.6 per cent at theend of 1999. The current ratio continued to remain well below the BSPs norm of 20 percent ceiling on bank lending to the real estate sector.

Banks profits continued to fall with the average return on equity (ROE) declining from3.3 per cent in 1999 to 2.6 per cent in 2000. Return on assets (ROA) also declined from0.5 per cent in 1999 to 0.4 per cent in 2000. The rural banks posted the highest ROE at 7per cent followed by the commercial banks at 2.9 per cent. The ROE of the thrift banksdeteriorated to (-) 1.7 per centin 2000 from the positive ROE of 7.4 per cent in 1999.

With outstanding guarantees at PhP40.4 billion the government commercial banksaccount for almost two-thirds (63.6 per cent) of total outstanding guarantees of PhP63.5billion 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 fromthe 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 inanticipation of a bank failure, the maximum exposure faced by the system is aboutPhP352 billion (amounting to 10 per cent of GDP). In contrast, the deposit insurance fundhas reserves on only PhP20 billion so the failure of any of the countrys large bankswould probably exhaust the reserve.

There is also an implicit risk from the possibility of a too big to fail bank facing a bankrun or imminent failure. While it is difficult to estimate the probability for the occurrenceof such an event, there are troubled banks in the Philippines. In a study on the basis of1999 data, Standard and Poors has estimated that in the event of a worst case scenariothe gross non-performing assets of the Philippines banking system would be in the rangeof 15 to 30 per cent of all banking system assets. This would lead to a fiscal cost to thegovernment amounting to 7 to 15 per cent of GDP in the event of a systematic crisis. Thisis roughly the magnitude of the Mexicos crisis in 1994-95 and much larger thanestimates 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 non-

guaranteed 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 automaticgovernment guarantee on its bonds, has the largest share (42%) of outstanding foreignloans of GOCCs. Government financial institutions, including the BSP, also have largeoutstanding foreign loans.

Forward cover for foreign exchange risks

Government financial institutions (GFIs), such as the Land Bank (LBP) and theDevelopment Bank of the Philippines (DBP), are allowed to incur foreign loans frommultilateral funding agencies and re-lend funds to private sector entities for industrial,agricultural and other development projects. While the concerned GFI generally takes onthe credit risk, it also seeks national government guarantee to cover the foreign exchangerisk. The national government provides the service, in the absence of hedging facilities inthe private market, to take advantage of concessional loans from the multilateral fundingagencies. In exchange, it charges guarantee fees based on the difference in peso T-billand the interest rate on the foreign loan. These fees are generally adequate to coverexchange rate risk over time, since the expectations on peso depreciation are factored inthe T-bill rates. Unfortunately, the BTr does not monitor these loans with foreignexchange cover separately.

External Debt

As per the World Banks classification, Philippines is categorised as aModeratelyindebted country with the present value of debt to GNP ratio at 66 per cent and thepresent 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 debtindicators are quite favourable. Its debt service ratio is 14 per cent, concessional debtconstitute 26 per cent of total debt (second highest after India among the top 15 debtorcountries) 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

Total

external

debt

(US$ bn)

Share of

concessio

nal debt

in total

debt (%)

External

debt to

GNP ratio

(percent)

Ratio of

short-

term debt

to total

debt (%)

Ratio of

short-

term debt

to foreign

exchange

Ratio of

debt

services to

exports of

goods andservices

1. Brazil2. Russian Federation3. Mexico4. China5. Indonesia6. Argentina7. Korea, Republic8. Turkey9. Thailand10. India11. Poland

12. Philippines13. Malaysia14. Chile15. Venezuela

244.7173.9167.0154.2150.1147.9129.8101.896.394.454.352.0

45.937.835.9

0.70.20.819.220.81.40.65.510.147.313.425.7

5.41.10.2

33.546.335.515.9113.353.732.354.379.921.335.664.8

62.555.935.6

12.19.114.411.513.321.326.823.124.34.311.011.0

16.414.66.3

84.8186.275.711.275.7120.047.0100.668.712.424.243.4

24.738.118.5

110.913.525.19.030.375.824.626.222.015.020.414.3

4.825.423.2

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

Present value

(PV) of Total

external debt

(US$ billion)

PV to GNP ratio

(per cent)

PV to exports of

goods and

services

(per cent)

Indebtedness

classification

1. Brazil2. Mexico3. Argentina4. Indonesia5. China6. Russian federation7. Korea, Republic8. Turkey9. Thailand10. India

11. Philippines12. Poland13. Malaysia

14. Venezuela, RB15. Chile

242.7172.0154.4149.7134.5130.9124.397.594.370.551.9

51.247.1

37.835.9

324054

10314373149751666

3459

4051

38011942924661

14173

168128114111

11850

155172

SevereLess

SevereSevereLess

ModerateLess

ModerateModerate

LessModerate

LessModerate

ModerateModerate

Source: Global Development Finance, 2001, Analysis and Summary Tables, The World Bank.

Note: For Severely Indebted countries, either PV/XGS > 220 or PV/GNP > 80For 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 endof 1999 to US$51.1 billion at the end of 2000. Public sector accounted for 66 per cent oftotal debt stock at the end of 2000 and around 66 per cent of the public debt consisted ofliabilities of the National government.

By creditor type, bilateral and multilateral creditors combined accounted for the bulk (48per cent) of the countrys sources of external financing. Foreign holders of bonds andnotes represented 25.8 per cent of total external debt while banks and other financialinstitutions 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 percent) 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 14.3per cent in 1999 to 12.3 per cent in 2000.

The maturity profile of the countrys external debt remained concentrated in

medium- and long term (MLT) loans constituting 88.6 per cent of total debt at theend 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 haveappropriate policies to deal with exchange rate fluctuations. It is desirable that the

government fixes benchmarks for the interest rate, maturity and currency mix of thefuture external loans. It may also like to put a limit on external debt and the nationalgovernment 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 isto 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. Thecritical aspect is the more effective management of contingent liabilities so that theassociated risks are minimised and the costs are not unlimited. Further, since the originof problem was the need to manage country risks on private investment flows, suchliabilities need to be seen in the overall risk management framework in the emergingeconomy. Such a framework should cover the management of both the existing liabilitiesand the future issue of such liabilities, and both the explicit and implicit contingentliabilities. The broader framework should also include the direct liabilities of thegovernment as in the case of many developed countries like Australia, Canada, NewZealand, UK and USA.

Provision of government guarantees per see is not bad. But, problems of contingentliabilities arise when the risks inherent in such contingent liabilities are not properlyassessed and quantified, and adequate provisionis not made in the event of default by theborrower. As a result, when guarantees are invoked, it leads to heavy budgetary burdenon the issuing Governments. Contingent liability, therefore, became a badword.

The conventional budgeting system on the basis of cash accounting followed by mostGovernments also contributed to the growth of contingent liabilities. In such a budgetingframework, guarantees appeared as an off balance-sheetitem or a memorandum item inthe Budget. Since they did not appear as part of the overall balance sheet and resourceutilisation statements, they were often viewed as a free resource, which encouragedGovernments to issue guarantees liberally for attracting private sector investment,

Even in cases where the risks were understood, very often the Governments did notbother because the implications of such contingent risks was to be felt in the long runonly and there was no immediate budgetary implications.

The problem of moral hazard also surfaced. With Governments willing to extend allsupport to foreign investment, investors sometimes insisted on blanket guarantees. Oncethey could get commitmentforassured returns as in the case of many BOT projects onpower, the investors sometimes did not make serious appraisal of the projects and theirrisk/return profile. As a result, unviable and uneconomic projects were also taken up forinvestment, which led to situations where Governments often ended up paying theminimum assured returns to the investors from its own budgetary resources.

However, there is no fundamental difference between the risks associated with directloans taken by the Government and those associated with Government guarantees. Ifthere is a shortfall of demand or income of a project funded by direct loans, theGovernment has less revenues than expected, and it must use general taxes to pay backlenders. 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 thefacility, 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 explicitand 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 agovernment and are a potential source of future tax rate variability. However, unlike mostgovernment financial obligations, contingent liabilities have a degree of uncertainty. Theyare exercised only if certain events occur or do not occur and the size of the actual fiscaloutgo depends on the structure of the undertaking.

Sound public policy requires that a government needs to carefully manage and control therisks of their contingent liabilities. The most important aspect of this is to establish clearcriteria as to when contingent liabilities will be used and to use them sparingly. In a well-managed program, the government debt office may be called on to assist in evaluating the

governments cost and risks under the contingent liabilities, and to recommend policiesfor managing these risks.

For a government seeking to manage risks for contingent liabilities the first step shouldbe to determine its degree of risk aversion in the area of contingent liabilities and theextent of the balance sheet risk it wishes to be accountable for. It also needs to decidewhether it wishes to manage its own balance sheet solely, or whether to be accountablefor risks generated in other parts of the public sector or in the private sector.

Experience in the industrialised countries suggests that more complete disclosure, betterrisk sharing arrangements, improved governance structures for state-owned entities andsound economic policies can lead to very substantial reductions in the governmentsexposure 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 contingentliabilities. The choice of countries was based on the advanced nature of the considerationof the problem of contingent liabilities and the ready availability of such information.Individual country practices differ in dealing with contingent liabilities, but all countriesshare a common set of principles to capture maximum contingent liabilities affectinggovernment budget.

In all the countries surveyed, the consideration of contingent liabilities was an integral part of improving transparency in government operations in general and fiscaltransparency in particular. Indeed it is tied to a process of bringing open government sothat citizens and outsiders (foreign investors, commercial banks, credit ratingorganisations, multilateral financial institutes etc.) can more accurately assess thegovernments financial position.

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All countries adopted the Government fiscal framework in line with the IMFs Guidelineson Fiscal Transparency. In addition, these countries also publish information of theInternational Investment Position and report information on the new foreign exchangereserves template introduced by the IMF under the SDDS.

Cross-country experiences with respect to various aspects of management of contingentliabilities 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 theTreasury is in charge of approval and issue of government guarantees except in theUnited Kingdom where the respective Ministries/ Departments are empowered toapprove 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 orthe Treasury is in charge of monitoring of guarantees. However, in the countries such asthe United Kingdom, Columbia, Hungary and New Zealand where a full-fledged PublicDebt Office (PDO) exists, the PDO monitors guarantees as a part of overall riskmanagement for the government in ALM framework.

(iii) Automatic guarantee:

In general the USA and New Zealand avoid automatic guarantee and makes properevaluation of risks before providing any kind of guarantee. However, other countriesprovide automatic guarantees, particularly fiduciary guarantees for insurance or certainitems for social reasons. Government of India provides automatic guarantee to SmallSavings Scheme, Public Provident Funds and Life Insurance, Australia to certainliabilities of government controlled financial institutions, Canada to Crown Corporationson insurance, Hungary to reinsurance of priority lending, Philippines to some of theGOCCs 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, aremade 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 generaluse. However, some countries may not reveal certain information in national interest orfor 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 areimportant 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 enactingparticular 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) 1998Canada: Financial Administration ActColumbia: Law 448 enacted on 21-07-98Czech Republic: Law of Budgetary RulesHungary: Public Finance Act 1992New 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 countriesdepending 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 InsuranceAustralia, Canada, New Zealand: Guarantees, indemnities, uncalled capitalColumbia- Contingent Liabilities of state entitiesCzech Rep- Guarantees, hidden debtHungary- Guarantees, reinsurancePhilippines- 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 andNew Zealand indicate ceilings on contingent liabilities as percentage of GDP. In Hungaryalso there is limit on contingent liabilities as percentage of revenue. In the USA there isautomatic limit through appropriation of subsidies relating to contingent liabilities in theirannual budget. Other countries viz. India, Australia, Columbia, Czech Republic,Philippines, UK donot have any statutory limits on contingent liabilities. However, Indiais 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 contingentliabilities.

(iv) Audit by Independent Auditors:

In all the countries, there are independent audit organizations, which audit not only theannual balance sheet but also the contingent liabilities. The details of the Audit Offices indifferent countries are indicated below:India: Comptroller General of AccountsAustralia: National audit OfficeCanada, Columbia, Czech Rep: YesHungary- State Audit Office

New Zealand: Yes, applies Generally Accepted Auditing Principles (GAAP)Philippines- Yes by Commission on AuditUK: National Audit OfficeUSA: 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 outlookand projections. But the governments of India, Columbia, and Czech Rep donot providesuch policy framework and outlook. However, Indias proposed Fiscal Responsibility andBudget 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 designatedContingency Redemption Fund, which can be used in the case of recall of guarantees. Butthe 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 accountingmethodology for measuring risk relating to contingent liabilities. InAustralia, Canada, Hungary, New Zealand, and U.S.A., budgeting is done on the basis ofaccrual accounting. But the countries ofIndia, Columbia, Czech Rep, Philippines, andU.K. still use mainly cash accounting, although accrual accounting may be used forcertain 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 astatement on fiscal risk in their budget, while so such statements are given in the budgetsof 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-fledgedPublic Debt Office (PDO) exists. The PDO is in charge of managing overall risk of bothloans and guarantees in the framework of Asset Liability Management (ALM). But, nosuch 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 programsvisible ex-ante. Accrual-based budgeting and accounting systems help fiscal discipline but are neither sufficient nor necessary in their entirety. Disclosure of full fiscalinformation is most critical. Disclosure of face values of contingent liabilities as in thecase of the USA enables the markets to analyse and measure the complete fiscal risks andthus indirectly assist the government in its risk assessment. Formulation of efficient rulesand regulations on the use of government guarantees, pension funds and insuranceprograms, 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 withrisks on program-by-program basis. As evidenced by the comparative country experiencesdiscussed above, the existing rules for guarantees, government-guaranteed agencies and otheroff-budget obligations in Philippines are not effective in limiting the total face value ofcontingent government liabilities. The system is weak to minimize the likelihood ofcontingent government liabilities being called and the size of public outlays required whenthey are called. Specifically, before the government adopts a program of contingent support, itneeds to have a systematic and comprehensive analysis on the attributes of the underlyingrisks, factors influencing the size of these risks, and the incentive mechanisms of the partiesunder the program. The Government should avoid providing blanket guarantees too manyGOCCs. All these activities require the establishment of a full-fledged risk analysis officeequipped with up to date methodology and expertise.

On the basis of effective risk analysis, the government can design the appropriateprograms that would still deliver the desired outcomes but minimise the governmentsrisk exposure. The objective would be particularly to expose the government only tothose risks that are beyond control of the parties under the program and that would spreadthe potential cost of the program between the government and the beneficiaries. Under astate guarantee, for instance, the government would identify and cover in the guaranteecontract only selected risks, which may be shared by it, while other risks may be left tobe assumed by other stakeholders or beneficiaries. With respect to the autonomous publicsector agencies, the government should strengthen the financial and managerialaccountability of their staffs by remunerating sound risk analysis and early warningsignals 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 contingentliabilities. For this purpose, it is necessary to set up a Middle Office for management ofContingent Liabilities in the DOF with sanction of sufficient budget and recruitment oftechnical experts. The main reason for locating it in the Department of Finance is thatthere are strong links between budgeting and sovereign liability management functions.At the same time, it would help to mitigate conflicts in objectives between fiscalmanagement and monetary policy, through active co-ordination between the middleoffice and the BSP.

The middle office is usually an entity, which serves as the risk manager, formulates andadvises on the sovereign liability management strategy and develops benchmarks for

assessing the risk-cost trade-off of the contingent liabilities. The role of the middleoffice is to identify, quantify and monitor contingent liabilities, make analysis of risk, provide advice and management information system (MIS) inputs for formulation ofappropriate policies in the overall framework of the public debt and contingent liabilitymanagement, keeping into perspective the long-term financial requirements for economicdevelopment 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 implicitcontingent liabilities and could gradually be expanded to include management of bothinternal and external debt. The Middle Office should immediately deal with fixation ofceiling on contingent liabilities, their allocation between domestic and external sectorsand among competing sectors (such as agriculture and allied sectors, industry, transport,

communications, power, banking and other financial services, real estate etc.). It shouldalso develop benchmarks for currency composition of external loans, maturity, interestrates, composition of loans under floating and fixed interest rates etc. for whichguarantees may be considered.

The middle office can also review the contractual obligations for BOT projects, estimatemonetary obligations of the national government, suggest inputs for feasible unbundlingof risks and for possible renegotiating of contracts, specify early warning systems fordefaults, provide advice to improve the legal, institutional and regulatory frameworkaffecting 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 agenciesto the middle office. The middle office should ensure that it develops a completelycomputerised data recording system, which is amenable to modern risk managementanalysis and can be easily retrieved and cross-classified by various characteristics such assector, currency, interest rate, and maturity.

The middle office would be responsible for bringing out an annual status report oncontingent liabilities, which should enhance the transparency and accountability of theliability position of the government. The report should clearly define and disclose themain objectives of contingent liability management, the strategic benchmarks of theliability portfolio and performance of portfolio management by the relevant agencies asmeasured 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 Officewould be expected to determine strategic benchmarks for the contingent liability portfolio. The strategic benchmarks could be the proportion of domestic and foreigncurrency debt; the currency composition, average duration, mix of floating-fixed interestrate debt and maturity structure of foreign currency debt portfolio; and maturity structureand duration for the domestic debt portfolio, for which government guarantees can beprovided.

Strategic benchmarks, designed by the Middle Office, should have the approval of theSecretary of Finance. For this purpose, the Contingent Liability Advisory Committeeshould advice the Finance Secretary periodically on the appropriateness of the frameworkand the strategic benchmarks.

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Once, the strategic benchmarks are approved, the Middle Office should regularlydisseminate the relevant benchmarks to the concerned agencies involved for contractingor issuing government guarantees. This would enable them to determine their liabilitymanagement 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 AdvisoryCommittee comprising of senior executives from the DOF, DBM, NEDA, BSP, COA,SSS, GSIS and some other government departments and GOCCs. This would ensure thatadvisory role of the Middle Office would be respectedby different entities involved formanagement of contingent liabilities.

The middle office should be staffed with officials with the necessary expertise from theDOF, 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 liabilityand overall debt management.

2. To prepare standardised Manual and Guidelines

In order to have uniformity in measurement and reporting necessary information, theDOF in consultation with other departments and BSP and COA should prepare standardized manuals on the following items for all GOCCs, and particularly for theNon-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 aninitial 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 shoulddisclose in their Budget documentation the main central government contingentliabilities, provide a brief indication of their nature and extent and indicate the potentialbeneficiaries. The Code suggests that best practice in the area would involve providingan estimate of the expected cost of each contingent liability wherever possible and thebasis for estimating expected cost.

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Best management practice for contingent liabilities is to make adequate provision forexpected losses and to hold additional assets against the risk of unexpected losses. Incases where it not possible to derive reliable cost estimates, the available information onthe cost and risk of contingent liabilities should be summarised in the notes to the Budget

tables or the governments financial accounts.

Before a full-fledged accrual accounting system is in place, it may be desirable to presenta 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 organisationalchallenges have been addressed, all the GOCCs must be directed to disclose theircontingent liabilities in their Annual Reports and to have appropriate policies forcontingent liability management1. .

4. Reporting to DOF

All government departments and GOCCs may be required to submit half yearly reportsto 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 soundgovernance arrangements for managing sub-national entities and state-owned enterprises,and making them accountable for managing their own risks. It is necessary to strengthenthe 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 boundprogram for capacity building within government and GOCCs for management of CLs. Itis also necessary to improve infrastructure and hardware and software capacities forinformation systems, central databases networks and interface with all organisationsdealing with CLs.

7. Limit on Guarantees

DOF may issue an Executive Order for removing all automatic guarantees on someGOCCs and to put a limit on guarantees. Future requests for guarantees may be examinedon 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 explicitand implicit contingent liabilities of the government, and reduction of risk arising fromunfunded 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 toreduce the current gap between contributions and benefits. Management of the

investment portfolio of the reserve funds for both SSS and GSIS needs to be fullyprofessionalised and insulated from political interference.

To provide a truly equitable, universal and meaningful social security protection, the SSSmust align its benefits and hence its contributions to that of similar programs both locallyand internationally. There is an urgent need to enhance the SSS contribution rate to atleast 12 per cent in the current year and to double the present rate of 8.4 per cent, if not tothe level of GSIS rate, in a phased manner in three years. It is estimated that the gradualincrease in the SSS contribution rate from 8.4 per cent to 20 per cent will increase theactuarial life of the social security fund by at least 20 years.

While increases in social security contributions are always politically sensitive, the taskfaced by the Philippine policy makers may not be difficult on considering the fact that theGSIS members are already contributing 21 per cent. Therefore, actions to bring benefitsand contribution in line with each other are urgently required for fiscal sustainability ofthe social security system.

Although there is little scope for enhancing the contribution rate of GSIS, which isreasonable at 21 per cent, there is scope for improving the compliance rate and torationalize the benefits among the members in different income brackets. There is alsoscope for enhancing the qualifying period for getting pension and to increase theretirement age commensurate with the increase in expectation of life.

It may not be politically feasible to amend the Act for removal of automatic governmentguarantee in the case of financial problem faced by GSIS or SSS. However, both thesystems should move from defined benefits system to defined contribution system.

There is also need for strengthening the Asset Liability Management (ALM) system inboth 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 suchas administration of benefits, limiting direct lending operations to salary and housing

loans to its members, and phased out peripheral programs, which can be more efficientlyhandled 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. Whilegovernment can provide some subsidies for life insurance for targeted groups of peopledue to social reasons, there should be no subsidies for non-life insurance, which can befully funded and better managed by the private sector.

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(b) The banking sector urgently needs strengthening. Cross-country evidence suggeststhat timely rehabilitation is one of the key factors in determining the success of bankrehabilitation efforts. The current level of asset performance, the system could facesevere difficulty if another major external shock such as that of 1997 occurred or if the

economys growth rate slowed significantly. The government is currently attempting toencourage private sector driven measures to restructure banks. But the effectiveness ofprivately led asset management companies is subject to question. In the meantime, thegovernment 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 andinsurance system and capital markets, including the use of such instruments as mandatoryrisk limits and minimum capital adequacy norms. Stronger accounting and disclosurerequirements for private corporations are important mechanisms for limiting thelikelihood that a systemic crisis might occur, and will limit the government's exposure ifit does.

The Philippine banks have been entertaining sales of their non-performing loans to theU.S. opportunity funds for the past several months. Several banks are presently innegotiations with U.S. investment banks and opportunity funds. But these negotiationshave not resulted in significant transactions, as most of the banks do not have the capitaladequacy to sustain large write-offs in their NPLs without adversely affecting theircapital base.

The government has currently circulated a very comprehensive draft of proposedregulatory changes to reduce the "friction costs" of investing in NPLs and makes it easierfor foreign investors to establish Special Purpose Asset Vehicles to acquire and managethe NPL resolution process. In addition to proposed tax relief and a reduction ormoratorium on real estate transfer taxes, the legislation will make it easier for foreigninvestors to own Philippine real estate assets.

These measures are in the right directions and need to strengthened and brought to theirlogical ends on time bound schedule.

(c) GOCCS: Auditing and accounting of the GOCCs need to be strengthened. It mayalso be desirable to institute performance contacts and sign Memorandum ofUnderstanding (MOUs) with major GOCCs and GFIs (as being done in India) indicatingtheir medium term corporate objectives and planning and annual targets on both physicaland 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 ofaccounting as required under theRevised Government Statistics (GFS 2000) the IMF. TheGovernment accounts in the Philippines, as in the case of many countries, are currently

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maintained on mainly cash basis, and not on complete accrual basis. It is generallyrecognised that cash-based systems are not suitable for measuring, recording andmonitoring 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 toassess inter-generational or inter

Contingent Liabilities for Philippines, by Tarun Das

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