Finance, Technology and Macroeconomics

Contingent Liabilities

Direct liabilities are obligations whose outcome is predictable, while contingent liabilities are obligations that may or may not come due, depending on whether particular events occur. The probability of their occurrence may be exogenous to government policies (for example, if they are related to natural disasters) or endogenous (for example, if government programs create moral hazard).

Explicit liabilities are specific obligations, created by law or contract, that governments must settle.

Implicit liabilities represent moral obligations or burdens that, although not legally binding, are likely to be borne by governments because of public expectations or political pressures. Conventional fiscal analysis tends to concentrate on governments' direct explicit liabilities. These include repayments of sovereign debt, budget expenditures for the current fiscal year, and longer-term expenditures for legally mandated obligations (such as civil service salaries and pensions and, in some countries, the overall social security system).

Direct implicit liabilities are often a presumed, longer-term consequence of public expenditure policies and are not captured in government balance sheets. In countries with pay-as-you-go pension schemes, for example, future pensions constitute direct implicit liabilities. Their magnitude is determined by how generous pension benefits are, how many people are eligible to receive them, and at what age pensioners become eligible, as well as by future demographic and economic developments.

Contingent explicit liabilities are legal obligations for governments to make payments only if particular events occur. Because their fiscal cost is invisible until they come due, they represent a hidden subsidy and a drain on future government finances, and complicate fiscal analysis. State guarantees and financing through state-guaranteed institutions may, in the short run, be more attractive than outright budgetary support because of their hidden nature. Such contingent explicit liabilities, however, may well turn out to be more expensive in the long run. Moreover, they may create moral hazard in the markets, particularly if governments guarantee all, rather than a part of, underlying assets (such as a credit to an enterprise) and all risks, rather than selected political and commercial risks. State insurance schemes, for example, often cover uninsurable risks of infrequent but potentially enormous losses; these schemes redistribute wealth because they tend not to be self-financed, through fees, but rely on government financing.

Contingent implicit liabilities are not officially recognized until after a failure occurs. The triggering event, the value at risk, and the amount of the government outlay that could eventually be required are all uncertain. In most countries, the financial system represents the most serious contingent implicit liability. Experience has shown that, when the stability of a country's financial system is at risk, markets usuallyexpect the government to provide financial support that far exceeds its legal obligation.

posted by JD @ 4:39 PM