Contingent Liabilities of the Government are like insurance obligations, which are contingent or conditional upon the occurrence of certain events, requiring payments by the Government, who had promised or agreed in the past to make good such liabilities, regardless of its financial health. It is a possible obligation and not a present obligation. It arises from some past events and its existence will be confirmed only by the occurrence of some future events. Its time of payment or the quantum of payment or both are uncertain.
Contingent liabilities arise mainly because of sovereign guarantees. However, it goes beyond that.
Types of Contingent Liabilities
A contingent liability may arise due to either explicit legal obligation or an implicit constructive obligation.
A legal obligation relates to specific government obligation defined by law or contract, e.g., guarantees given against third party, crop insurance, tax refunds under litigation, indemnities, etc.
A constructive or implicit obligation is an obligation that may arise when a government indicates to other parties that it accepts certain responsibilities and has created certain valid expectation on the part of those parties that it will discharge the responsibilities. eg. Letter of comfort issued by governments (Union and States), bailing out public sector insurance, banking and other entities, etc. This also represents a moral obligation or expected burden for the government not in the legal sense, but based on public expectations and political pressures. These liabilities arise out of the fact that Government is always perceived as the "last resort".
On the basis of the provisions made for meeting such contingent liabilities, it can be classified as either funded or unfunded liabilities. eg. the liability is funded in case of sovereign guarantees (guarantee is given in return for a fee and the collected fee is kept in a guarantee redemption fund). An unfunded Contingent Liability can arise due to some natural / manmade calamity say Bhopal Tragedy related payments, obligations on account of legislative changes with retrospective effect etc.
Need for Management of Contingent Liability
Report of the Internal Working Group on Debt Management (October 2008), chaired by Shri. Jahangir Aziz and the report of the Financial Sector Legislative Reforms Commission (FSLRC) (2013) which studied the issue of public debt management had highlighted the importance of managing contingent liabilities in India. This is because, there are close interconnections between contingent liabilities and debt issuance. For instance, the invoking of guarantees can have a substantial impact on the risk assessment of the public debt structure of the Central Government.
The Internal Working Group of Ministry of Finance for setting up an independent debt management office, chaired by Shri. Jahangir Aziz, in its Report (October 2008) had highlighted the following issues of contingent liabilities.
- Explicit contingent liabilities are a cost-effective manner for states to incentivise the private provision of public goods. However, proper pricing and valuation of these guarantees is very important for efficient risk management by the State. There could be significant negative fiscal repercussions for the State if contingent liabilities mature in large numbers at the same point in time.
- By their very nature, contingent liabilities are most likely to be called in during an economic downturn. These fiscal payments are counter-cyclical in nature. But, this is also the time when the state is least able to afford to fulfil such obligations due to reduced revenue collection. Hence, risk management of these liabilities would allow states to lessen the risk of default on these liabilities.
- Making the nature and volume of these liabilities public will increase both transparency and accountability in budgetary transactions.
- Further, guarantee-risk is conceptually the same as the risk taken in borrowing and on-lending funds, which is a risk that a debt management office will have to deal with on a day-to-day basis.
Hence the Aziz Committee had suggested the creation of a "National Treasury Management Agency" to deal with such contingency liability management issues.
Following up on these recommendations, the Financial Sector Legislative Reforms Commission (FSLRC) which submitted its report in 2013 suggested creating a Public Debt Management Agency (PDMA) and was of the view that PDMA must manage and execute implicit and explicit contingent liabilities of the Government. Further, PDMA must evaluate the potential risk of these contingent liabilities and advise the Central Government on charging appropriate fees. In addition, FSLRC advised that the Government should be required to seek the public debt management agency’s advice before issuing any fresh guarantees since this has implications for the overall stability of the public debt portfolio. Given this, FSLRC felt that the PDMA should advise the Central Government on making provisions for contingent credit lines with bilateral and multi-lateral agreements and establish similar credit lines with international agencies. FSLRC felt that the management of contingent liabilities is a specialised function that involves undertaking the risk assessment of clients. Therefore, it felt that the public debt management agency should be allowed to contract out in part or in entirety the management of contingent liabilities to outside agencies if it so chooses.
In short, Contingent liabilities management include:
- Assessing and pricing credit risk.
- Implementing policies and guidelines for the issue of Government guarantees and on-lending of borrowed funds.
- Advise on recapitalization of public sector enterprises given a risk management policy framework.
- Record and report government guarantees and other contingent liabilities.
The RBI Group to Assess Fiscal Risk of State Government Guarantees (2002) had also analysed fiscal exposure of States to guarantees and made similar recommendations regarding monitoring and pricing of guarantees.
Operational management of Contingent Liabilities in India
The FRBM Act 2003 mandates the Central Government to specify the annual target for assuming contingent liabilities which are in the form of guarantees. Accordingly, the FRBM Rules prescribe a cap of 0.5% of GDP in any financial year on the quantum of guarantees that the Central Government can assume in the particular financial year. In order to ensure greater transparency in its fiscal operation in public interest, the FRBM rules require the Central Government, at the time of presenting the annual financial statement and demand for grants, to make certain disclosure statements of receivables and payables as detailed below:
- Tax Revenues raised but not realised
- Arrears of Non Tax Revenue
- Guarantees given by the government
Further, Government Accounting Standards Advisory Board (GASAB) constituted by Comptroller and Auditor General of India (CAG) has issued Indian Government Financial Reporting Standard (IGFRS) -5 on Contingent Liabilities (other than guarantees) and Contingent Assets. This Standardprovide for disclosure requirements of contingent liabilities (other than guarantees) and contingent assets of Union and State Governments in their financial statements.
Based on the recommendations of FSLRC and Jahangir Aziz Committee, Union Budget 2015-16 has announced the creation of a Public Debt Management Agency which amongst other things would also manage Contingent liabilities of the Central Government including developing ways for its measurement, reduction in quantum and cost of such liabilities. PDMA would also be advising central Government on its contingent liabilities