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Sovereign Asset and Liability Management: An E-Learning Training Course |
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Rationale The government has been given a mandate to provide an expected level of services for a specified amount of taxation while also remaining solvent. Sovereign risk within this context is the risk of having to raise taxes to continue to provide the same level of services, reducing services at the current level of taxation, and default risk which could ultimately lead to insolvency. “The general notion that consumers become used to the level of consumption enjoyed in previous periods, including the consumption of public goods and services is important in the context of fiscal policy design because it directly links the social, political, and institutional constraints to the speed of fiscal adjustment” (Leigh and Olters, 2006). As sovereign risk is comprised by threats to assets and liabilities, management of sovereign assets and liabilities in a combined manner is more effective. While deadweight losses arising from variable taxation threatens long-term economic growth and must be mitigated, failing to manage risk in a holistic manner could most importantly, lead to catastrophic losses. If assets and liabilities are correlated in such a way that the movement of one economic variable can simultaneously devalue assets while increasing liabilities, any sovereign will be exposed to significant losses. For example, if assets are denominated in the domestic currency but liabilities are held in foreign currency instruments, a devaluation of the domestic currency will reduce the value of assets while at the same time increase liabilities. By managing asset and liabilities in a concurrent manner, these types of worst-case scenarios can be greatly reduced. “Fiscal outturns often differ substantially from budget or other fiscal projections, owing to shocks such as deviations of economic growth from expectations, terms of trade shocks, natural disasters, calls on government guarantees, or unexpected legal claims on the state…even in countries where debts and deficits have been reduced, policymakers’ attention is turning toward risks—especially from contingent liabilities and off-balance seet items” (Cebotari, et al. 2009). “Developed nations are not immune to risks such as structural imbalances in health and pension systems, aging populations, and contingent liabilities that have often not been quantified. Threats often unmeasured are those coming from the financial sector and corporate firms which pose systemic risk if these firms should fail. For example, a financial crisis or bailout can turn overnight a country with low public debt into one with a severe debt overhang” (Everaert et al., 2009). State owned enterprises and subnational units also pose risks to sovereigns if there is an implicit expectation by these entities and the public at large that the central government will intervene whenever necessary to provide resources that ensure their viability. Fiscal risks arise out of market conditions and cannot be completely eliminated. By developing a strategy and framework to address fiscal risks, the adverse impact of these risks can be reduced. An effective strategy for mitigating fiscal risks requires a comprehensive understanding of both external shocks (i.e. commodity prices, exchange rates, natural disasters) and domestic obligations in the form of contingent liabilities (i.e. housing market collapses, banking crisis, underfunded public pensions). Increased disclosure and transparency are also essential in addressing fiscal risks. The institutions, culture, and attributes of the specific sovereign will dictate what is disclosed and what is omitted. Generally speaking, increased disclosure should be an objective. “There is empirical evidence to suggest there is a link between greater fiscal risk disclosure and better sovereign credit ratings. However, disclosure of certain implicit contingent liabilitiescould create the perception the government will intervene to cover losses and create moral hazard. Information that could harm the government’s position in litigation should also not be disclosed. Fiscal policy should take into account all fiscal risks, including those that are not disclosed or specifically quantified” (Everaert et al., 2009). For more, see IMF reports “Fiscal Risks: Sources, Disclosure, and Management” and "Disclosing Risks in the Post-Crisis World". For more on tax smoothing and default risk see Box I:
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