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Sovereign Asset and Liability Management: An E-Learning Training Course
II. Rationale
III. The Conceptual Balance Sheet
IV. Contingent Liabilities




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:

The Ricardian Equivalence Theorem (Barro,1974) states the conditions under which the choice between financing government expenditure by taxes or by issuing debt has no impact on the real economy.  The equivalence result holds only under restrictive assumptions about citizen’s altruism and rationality, completeness and efficiency of financial markets and lump-sum taxes.  Closely related to Ricardian Equivalence is the Neutrality Theorem of Debt Management (Missale,1999) which states under similar conditions that ‘public debt management’ has no impact on the real economy.  Public debt management includes the choice of denomination and maturity of securities to issue, indexation features, changes in the relative supply of existing securities, and innovations in the menu of public assets” (Hansen, 2003).  If taxes are on income or consumption, i.e. are not lump sum, then the Ricardian Equivalence Theorem does not hold, and the amount and/or type of debt matters because it determines the distribution of tax rates over time and across states of nature.  As income taxes are distortionary in that they reduce incentives for work and production, one objective of debt management is to choose the amount and characteristics of debt so as to support the least distortive allocation of tax rates thus contributing to reduce the loss in economic efficiency that results from distortionary taxes, and maximize production. Under realistic assumptions about the elasticity of labor supply and other tax bases, optimal taxation calls for ‘tax smoothing’, that is, a relatively constant tax rate over time and across states of nature” (Chari, Christiano and Kehoe 1994).  

“The tax-smoothing literature suggests that higher long-term growth is more likely to be achieved if tax variability is minimal, since tax smoothing reduces tax distortions and uncertainty.  Taxes, other than lump sum, create inefficiencies as they distort economic decision-making and volatile tax rates create significant losses inasmuch as they complicate long-term investment decisions, depress consumption and possibly channel excess savings into short-term financial instruments” (Currie and Velandia, 2002). 

“As SALM incorporates the net present value of government revenues and expenditures (net of debt service costs) into the existing public debt management framework that only considers the value of debt, SALM is naturally conducive to tax smoothing in that the debt, by providing a hedge against shocks to government revenues (i.e. output shocks) and expenditures, allows to minimize changes in tax rates. Finally, it is worth noting that the insurance that the debt structure can provide against macroeconomic shocks to the government’s budget is not only valuable for tax smoothing; it helps achieve other important objectives of fiscal policy. For instance, by stabilizing the debt-to-GDP ratio, fiscal insurance enhances debt sustainability” (Lloyd-Ellis and Zhu 2001, Borenzstein and Mauro 2004, Giavazzi and Missale 2005). “The immunizing debt structure also works as an automatic stabilizer: it avoids higher tax rates in bad times, thus preventing taxation from being pro-cyclical, consistent with the Keynesian view of fiscal policy. Finally, as insurance is provided by debt holders to taxpayers, the debt-tax scheme implements an allocation of risk that appears desirable in that debt holders are in a better position to withstand risk, if anything because taxes are compulsory while debt holdings are voluntary” (Missale,1999).



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