## howtonote1706

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### Definition and scope of government guarantees
- Government guarantees are legally binding undertakings given by a government to assume responsibility for servicing a debt or the performance of an obligation on behalf of another entity under certain specified conditions—typically a default by that entity.
- Guarantees are usually extended to public entities—subnational governments and public financial and nonfinancial corporations—with objectives including access to cheaper credit or improving project viability with significant social and economic benefits.
- Governments may provide guarantees to fulfil preconditions for concessional loans from bilateral/multilateral agencies to subsovereign borrowers.
- Governments also provide guarantees to private entities, including individuals.
- Implicit guarantees arise from expectations that governments are “morally obliged” to provide financial support in the event of a crisis or disaster; they are not legally enforceable but create substantial fiscal risks.
- Guarantees do not involve any upfront cash outflow from the budget at issuance but expose governments to the risk of future cash outflows whose timing and quantum are often difficult to estimate.
- Figure 1: Stock of Government Guarantees in European Countries (2015).

### Fiscal risks, usage, and efficiency concerns
- Countries with substantial accumulation of guarantees face the risk of a fiscal shock if governments lack adequate budgetary provisions to service invoked guarantees; these risks are exacerbated during crises because of their correlated nature (IMF 2016a).
- Guarantees have been used to achieve financial stability during crises (for example, blanket guarantees to manage banking sector risks and restore creditor confidence).
- Inefficiencies and governance concerns:
  - Guarantees may be used to subsidize beneficiaries and projects in a nontransparent manner.
  - Because guarantees do not involve upfront cash outflow, governments may prefer them over direct expenditure to circumvent budgetary constraints and may perceive them as “free of cost.”
  - Guarantees are often off-budget and may escape usual scrutiny, including legislative scrutiny.
  - There is often no systematic assessment of risks or upfront recognition of potential losses.
  - Many governments do not maintain a complete and verifiable record of guarantees; few produce comprehensive reports covering different types of guarantees and consolidated risk exposure.
  - Institutional arrangements for guarantee management, including authorization and accountability, are often not well defined.

### Types of guarantees (classification highlights)
- One-off guarantees:
  - Loan (and other debt instrument) guarantees: commitments to bear the risk of nonpayment (default risk); government undertakes to assume debt service obligations (entirely or in part) of the borrower in case of default. Loan guarantees are the most common form and typically one of the largest components.
  - Exchange rate guarantees: promises to compensate a borrower—typically a public corporation or financial institution—for losses on foreign currency borrowings due to exchange rate fluctuations.
  - Guarantees related to PPP contracts: issued to private partner(s) as part of risk-sharing arrangements (for example, minimum revenue guarantees, exchange rate guarantees, transfer price guarantees).
  - Other one-off guarantees: lines of credit, loan commitments, contingent credit availability, letters of credit—become effective upon actual withdrawal of funds.
- Standardized guarantees:
  - Issued to a large number of beneficiaries, usually for fairly small amounts, with standard terms and repeated transactions and pooling of risks.
  - Include umbrella guarantees to financial institutions (mortgage loans, student loans, SME loans, agriculture loans, export credits) and government insurance schemes (deposit insurance, crop insurance, natural disaster insurance).
- Pension guarantees:
  - Government guarantees a minimum (annual) return on a defined-contribution pension plan or guarantees a minimum pension irrespective of the fund balance.
- Guarantees may be issued by public corporations and subnational governments that carry explicit or implicit national government counterguarantees, exposing the national government to the same risks.
- Standardized and pension guarantees are often provided and managed by specialized institutions outside the core government.

### Steps to strengthen guarantee management (Box 1)
- Ascertain the size of the guarantee exposure – Conduct an inventory of guarantees to be updated routinely.
- Ensure that guarantees are properly recorded and disclosed – For each class of guarantees, record and disclose the maximum amount guaranteed, in nominal terms, and the possible reimbursement, recovery, or counterclaim by the government.
- Ensure adequate budget provisions to meet claims – At a minimum, the budget should include a guarantee (or contingency) reserve; payments that are more or less certain should be distinctly provided for.
- If guarantees are sizable, create a guarantee reserve fund – Funds can be built by setting aside resources when issuing guarantees and by crediting guarantee fees. Notional funds are preferred for ease of management.
- Regulate issuance through a policy framework – Specify a ceiling, guidance on when guarantees can be considered, fees, and risk containment measures.
- Develop capacity to evaluate guarantee proposals and assess associated risks.
- Develop measures to mitigate risks – Examples include risk-based fees, partial guarantees, deductibles, reinsurance, and reserves.

### Evaluating a guarantee proposal — decision criteria
- Decisions on new guarantees or extensions should be made within a policy framework and based on clear analysis of rationale, associated risks, costs, benefits, and affordability.
- Key analytical questions:
  - Objectives and consistency with government policy; alternative delivery (conventional expenditure instrument).
  - Term of the guarantee and necessity of the term.
  - Risks, justification for government to assume risks, risk mitigation, and management of residual risks.
  - Financial position and creditworthiness of the guarantee seeker.
  - Fiscal costs: most likely and maximum exposure to the government.
  - Impact on government debt level and consistency with medium-term debt strategy (MTDS) and debt limits or rules.
- Rule of thumb for consideration:
  1) economic benefits exceed cost,
  2) project expected to generate positive returns,
  3) beneficiary is creditworthy,
  4) project cannot be financed without a government guarantee.
- Projects serving social objectives unlikely to generate positive returns, or undertaken by general government entities, are better served by direct support (subsidy or on-lending).

### Assessing and quantifying risks — valuation and techniques
- Credit-risk evaluation techniques focus on default probability and loss given default.
- Principal approaches (The World Bank 2016):
  - Credit rating:
    - Used by Australia, Colombia, Indonesia, Sweden to assess risks via beneficiary credit ratings.
    - Advantages: standardized, access to third-party resources; internal rating requires higher technical capacity.
  - Statistical models:
    - Example: Turkey computes a financial distress index from weighted profitability and balance sheet ratios; requires ample historical data; predictability good only over a very short horizon (one to two years).
  - Scenario analysis:
    - Stochastic simulations for revenues, traffic flows, exchange rates; used by Chile, Colombia, Sweden for PPP-related guarantees; captures project-specific risks but is complex.
- Structural model–based approach:
  - Option-valuation techniques where default occurs when asset value falls below liabilities (Merton 1977); used by Chile for exchange rate guarantees to concessionaires.
- Measures of guarantee cost and exposure:
  - Expected payment (probability-weighted payment, present value terms).
  - Maximum exposure (maximum possible loss).
  - Exposure at default (EAD).
  - Loss-given-default (EAD adjusted for recoveries, expressed as percentage of EAD).
  - Value at risk (maximum loss at a given confidence interval within a stipulated time).

### Country practices and policy frameworks (illustrative examples)
- Netherlands (policy adopted 2015):
  - Policy of “no, unless” for new contingent liabilities.
  - A ceiling sets a maximum limit for overall contingent liabilities; sunset clauses with standard end date five years for new programs; ex ante review by council of ministers and results submitted to parliament; independent expert opinion for large and complex risks; departmental budgets required to describe guarantees, loans, and financial interventions.
- United Kingdom Treasury process:
  - Departments initiating a high-value contingent liability (a maximum exposure of £3 million or more) must complete a standard checklist with 19 questions grouped around five aspects: rationale; exposure; risk and return; risk management and mitigation; affordability.

### United Kingdom’s checklist and risk-quantification guidance (Box 3)
- Risk quantification methods:
  - Use market price differential between a guaranteed and similar nonguaranteed debt as proxy for bottom-up risk quantification.
  - Use market price of equivalent derivative as proxy for exchange rate guarantee value.
  - For standardized guarantees, estimate expected loss based on historical default rate for the entire pool.
  - Simpler approaches for low-capacity environments: assess creditworthiness via simple financial analysis; introduce more quantitative techniques over time.
  - Reassess risk estimates annually.
  - Choice of discount rate: use risk-free rate adjusted for market risk in principle; simplified approach uses unadjusted risk-free rate (government borrowing rate), acknowledging likely undervaluation.
  - Tools: IMF/World Bank MTDS analytical tool for modeling realization of guarantees and evaluating cost and risk.
- Country practices and model examples:
  - Colombia:
    - Law empowers government to guarantee payment obligations of public entities; concurrence of National Council for Economic and Social Policy and approval of Congressional Commission on Public Credit required.
    - MHCP conducts credit risk assessment; externally assigned credit ratings determine default probability and loss given default.
    - Portfolio value computed by summing expected loss and unexpected loss at a 99.9 percent confidence interval.
    - Expected loss = exposure at time of default × default probability × loss given default factor.
    - Beneficiaries pay an annual risk-based fee equivalent to the expected loss for the year; fees payable for the entire duration of the guarantee and credited to a contingency fund.
    - Beneficiaries must post sufficiently liquid collateral of up to 120 percent of the guaranteed credit.
    - Legal limit: law imposes a limit of US$4.5 billion or equivalent (about 1.6 percent of GDP) on the stock of guarantees; second limit of 0.4 percent of GDP caps annual obligations arising from PPP projects, including annuity payments and called guarantees.
  - Turkey:
    - Turkish Treasury uses a logit regression model with financial ratios and past track record to estimate default probabilities; beneficiaries classified into six predefined risk categories.
    - Expected loss computed using default probability, recovery rate, treasury funding curve, and cash flow projections.
    - Model informs guarantee/on-lending limits, partial guarantee ratios, fees, and expected flows from the reserve (the risk account); Turkey maintains a “risk account” at the central bank.
  - Other practice examples and parameters:
    - India: in case of a default of a debt guarantee, government pays 70 percent to 90 percent of the amount in default; the balance is paid by the borrower.
    - Turkey: except for certain credits, government guarantees cover up to 95 percent of the agreed credit.
    - Vietnam: guarantees cannot exceed 80 percent of the project cost.
    - Iceland: guarantees limited to 75 percent of credit financing needs, with at least 20 percent equity financed—effectively limiting government guarantees to 60 percent of project cost.
    - Brazil: central government can retain taxes to be transferred to subnational governments in case of a default; guarantees are required to be reported publicly every four months; federal law examples include limits for state guarantees of 22 percent of net recurrent revenue.
    - Australia (New South Wales): public corporations with total guaranteed debt exceeding AU$10 million required to obtain a credit rating annually; guarantee fee rate equals difference between market interest rate for similar credit rating and cost of debt obtained from the treasury; fee applied to outstanding capital value and calculated monthly.
    - Sweden and United States periodically revalue guarantees during their term and adjust pricing; Sweden charges a premium for administrative expenses over risk-based fee; Sweden’s parliament can waive guarantee fee in full or part, and waived amount is appropriated in the budget as subsidy.

### Comparing guarantees with alternative instruments
- Conceptual equivalence: value of a loan with credit risk = value of identical risk-free loan minus a loan guarantee.
- On-lending versus issuing a guarantee is often a difference of form rather than economic substance.
- OECD 2005: if purpose is solely to finance an activity, credit guarantees will typically be inferior to direct lending by the government.
- Regular budgetary funds (subsidies, equity injections) may be more appropriate and transparent than guarantees or on-lending for quasi-fiscal activities or balance sheet support to financially distressed public corporations.

### Mitigating risks and containment tools
- Capping the size:
  - Limits on maximum exposure or on quantum of new guarantees are commonly applied; examples include Colombia limit of US$4.5 billion (about 1.6 percent of GDP) on stock; India annual cap on central government guarantees of 0.5 percent of GDP; Turkey prescribes two annual limits in budget laws.
  - South Africa and Thailand count guarantees within the debt limit.
  - Limits should be consistent with affordability and guided by the medium-term fiscal framework and debt-sustainability analysis incorporating contingent scenarios.
- Risk-based guarantee fees:
  - Risk-based fees moderate demand and address adverse selection; full risk-based fee equals expected losses plus a risk premium; fee below full price represents a hidden subsidy.
  - Countries levying risk-based fees include Australia, Chile, Colombia, Israel, Peru, Sweden, United States.
  - Fees should be charged annually for the entire term of the guarantee to allow revaluation.
- Guarantee reserve funds:
  - Can be actual (invested, e.g., Colombia) or notional (India, Sweden, United States); notional funds avoid affecting borrowing requirements and gross debt.
  - Fund size should consider overall risk exposure and volatility; reserves typically funded from guarantee fees and interest income; initial budget transfers may be required.
  - If government charges less than full price, differential should be appropriated and transferred to reserve as subsidy compensation.
- Other measures:
  - Time- and value-limiting guarantees; avoid open-ended “continuing” guarantees.
  - Partial guarantees and deductibles to leave risk with lenders and mitigate moral hazard.
  - Collaterals: mandatory in some countries (Colombia requires up to 120 percent collateral; Iceland rules above).
  - Reinsurance used as deterrent and cost-measure (Belgium, Estonia, France, Moldova, Peru, Switzerland).

### Budgeting for guarantees
- Objectives:
  - Make explicit the cost of guarantees at issuance.
  - Ensure adequate budgetary provision exists for payments when guarantees are called.
- Two main budgeting approaches:
  - Cash-based budgeting:
    - Make budget provisions for losses expected during the year or over the medium term because of guarantees issued in the past.
    - Estimate and appropriate payments expected during the budget year; include in contingency reserve or separate budget line.
    - For near-certain payments, obtain specific appropriations.
    - Cash-based budgeting is the minimum practice but does not reveal true cost of guarantees.
  - Cost-based (accrual) budgeting:
    - Example: United States federal credit reforms require agencies to include present value of expected costs of loans and guarantees in budgets.
    - Expected costs are discounted cash outflows adjusted for inflows (origination fees, repayments, interest receipts, recoveries); present value calculated using the government’s borrowing rate for similar maturity; part of cost not covered by fees treated as subsidy and appropriated.
    - Subsidy costs included in total budget expenditure and surplus/deficit; reestimated annually with automatic appropriation for overruns.
- Country practices by budgeting approach:
  - Cost-based budgeting: Australia, Denmark, New Zealand, United Kingdom.
  - Cost-based in cash-based budget countries: Canada, Colombia, Netherlands, United States.
  - Budget provisions for expected payments: Chile, Hungary, Indonesia, South Africa, Russia.

### Budgeting, accounting, disclosure, and statistical reporting (Box 7 — United States example)
- Budgeting approaches and rationale:
  - Cost-based budgeting requires upfront recognition of guarantee costs in present value at issuance; actual payments on called guarantees treated below the line as financing transactions.
  - Upfront recognition improves transparency, aligns guarantees with fiscal frameworks, sets aside resources, and corrects instrument-choice bias.
  - Selective application of accrual concepts to guarantees is possible without full accrual budgeting, but it requires higher technical capacity.
- Accounting and reporting for guarantees:
  - Accrual-based approach (preferred):
    - IPSAS 19: if >50 percent probability that a guarantee will require future payment(s) and amount can be reasonably estimated, recognize a provision (liability) in financial statements.
    - Record expense and equivalent liability; review provisions annually and adjust or reverse as needed.
    - For standardized guarantees, provisions based on expected loss estimated from historical default rate for the pool minus expected recoveries.
  - Cash-based approach:
    - Guarantees not recognized until called; payments recognized as expenditure when called; guarantee fees recorded as (non-tax) revenues.
    - Where a financial balance sheet exists, assumption of a guaranteed loan may be recognized as a liability; no upfront provisioning otherwise.
  - Practical implication: accrual supports upfront recognition and disclosure but may not be realistic in low-capacity environments short-to-medium term; where accrual not feasible, enhance disclosure.
- Disclosure expectations (IMF guidance):
  - IMF Fiscal Transparency Code introduces three levels:
    - Basic rating: annually publish all government guarantees, beneficiaries, and gross exposure.
    - Good rating: basic plus legal authorization of maximum value of new guarantees or stock.
    - Advanced rating: publish information on probability of call on guarantees.
  - Recommended disclosures:
    - Description, purpose, beneficiaries, expected duration.
    - Government’s gross financial exposure (maximum amount guaranteed, nominal).
    - Possibility of reimbursement/recovery/counterclaim.
    - Where possible, estimate likely fiscal cost (net present value of expected payments) and timing.
    - Payments made in settlement, claims established, recoveries, fees charged, receivables from guarantees.
  - Presentation and timing: disclose guarantees individually or by class; separate existing and new guarantees; classify per GFSM 2014, Table 4.6; report consistently and timely to legislature and public; include guarantees by all public entities.
- Statistical reporting treatment (GFSM, IMF 2014):
  - Contingent liabilities not recognized in macroeconomic statistics unless triggering event occurs.
  - Liabilities on account of loan and other one-off guarantees are attributed to the debtor, not guarantor, until guarantee is called.
  - One-off guarantee granted to a financially distressed corporation with very high likelihood of being called is treated as if called at inception and assumed as public debt.
  - If beneficiary will not be able to repay, a debt assumption of the outstanding principal should be recorded.
  - Economic substance, not legal form, guides statistical treatment.
  - Potential government claims on beneficiaries recognized as assets only when reasonable expectation of realization exists.
  - GFSM (IMF 2014) requires disclosing publicly guaranteed debt and one-off guarantees (if significant) at nominal value as memorandum item to government balance sheet.
  - Provisions for calls for standardized schemes treated as liability and included in public sector debt.
- Country practice example (New Zealand):
  - Contingent liabilities over NZ$20 million disclosed separately; quantifiable contingencies less than NZ$20 million included in “other quantifiable” total.
  - Guarantees and indemnities disclosed as separate class with nominal value, beneficiaries, and purpose.
  - Unquantifiable contingent liabilities disclosed where expected to be material but not remote; financial statements include table of unquantifiable indemnities by party, instrument, and actions indemnified.

### Monitoring requirements and institutional strengthening
- Monitoring:
  - Routinely monitor financial performance of beneficiaries via annual financial statements to detect creditworthiness deterioration and early signs of default.
  - Monitor compliance with guarantee agreements, proper use of funds, timeliness of repayments, balance of guaranteed amount, payment of guarantee fees, and recoveries in case of a called guarantee.
  - Legal safeguards to allow early government action when beneficiary fails to comply or financial condition deteriorates.
- Country practice example (Iceland):
  - State Guarantee Fund (SGF) collects quarterly information on outstanding guaranteed debt and accrued interest; two largest beneficiaries report monthly; beneficiaries must submit annual financial reports and other information by law; penal provisions for noncompliance.
  - SGF informs finance ministry of breaches and likely defaults and submits an annual report assessing prospects and estimating potential loss to the treasury.
- Strengthening institutional arrangements — key elements:
  - Regulatory framework:
    - Put ceiling on overall exposure (flow limits and/or stock limits); include limits in fiscal rules where possible.
    - Clearly specify approval authority in legislation or financial regulations (centralized controls with finance minister authority often better).
    - Specify disclosure requirements in legislation: responsibilities, required information, periodicity, timeliness, and mandates for collection, recording, monitoring, and reporting.
    - Specify general terms for extending guarantees: risk mitigation approach, guarantee fees, procedures for calls, recoveries, monitoring requirements, and penalties.
  - Institutional mechanisms:
    - Develop a policy framework specifying when and for what purposes guarantees can be considered.
    - Integrate guarantee decisions with the budget process; require consultation with ministry of finance.
    - Develop capacity to evaluate guarantees: measure exposure precisely; adopt accounting, reporting, and budgeting approaches; cost guarantees and determine fees; provide methodological guidance.
    - Locate risk management appropriately—government debt managers often better equipped for credit risk assessment and monitoring; debt management units can handle recording and monitoring.
    - Establish budgetary mechanisms for payment obligations: at minimum estimate likely payments and provide in budget; sizable exposures could consider a guarantee reserve fund.
    - Strengthen link between guarantee management and oversight of state-owned corporations and subnational governments.
    - Centralize recording and monitoring via a centralized database with secure information systems.
    - Ensure regular disclosure: routinely submit information on government exposure to legislature and publish at least annually.

*Source: Box 7, “Budgeting for Loans and Guarantees in the United States,” How to Strengthen the Management of Government Guarantees, Fiscal Affairs Department, International Monetary Fund, October 2017.*

### Introduction

### Introduction

### Definition and scope of government guarantees
- Government guarantees are legally binding undertakings given by a government to assume responsibility for servicing a debt or the performance of an obligation on behalf of another entity under certain specified conditions—typically a default by that entity.
- Guarantees are usually extended to public entities—subnational governments and public financial and nonfinancial corporations—with objectives including access to cheaper credit or improving project viability with significant social and economic benefits.
- Governments may provide guarantees to fulfil preconditions for concessional loans from bilateral/multilateral agencies to subsovereign borrowers.
- Governments also provide guarantees to private entities, including individuals.
- Implicit guarantees arise from expectations that governments are “morally obliged” to provide financial support in the event of a crisis or disaster; they are not legally enforceable but create substantial fiscal risks.
- Guarantees do not involve any upfront cash outflow from the budget at issuance but expose governments to the risk of future cash outflows whose timing and quantum are often difficult to estimate.
- Figure 1: Stock of Government Guarantees in European Countries (2015).

### Fiscal risks, usage, and efficiency concerns
- Countries with substantial accumulation of guarantees face the risk of a fiscal shock if governments lack adequate budgetary provisions to service invoked guarantees; these risks are exacerbated during crises because of their correlated nature (IMF 2016a).
- Guarantees have been used to achieve financial stability during crises (for example, blanket guarantees to manage banking sector risks and restore creditor confidence).
- Use of guarantees is not always economically efficient:
  - Guarantees may be used to subsidize beneficiaries and projects in a nontransparent manner.
  - Because guarantees do not involve upfront cash outflow, governments may prefer them over direct expenditure to circumvent budgetary constraints and may perceive them as “free of cost.”
  - Guarantees are often off-budget and may escape usual scrutiny, including legislative scrutiny.
  - There is often no systematic assessment of risks or upfront recognition of potential losses.
- Many governments do not maintain a complete and verifiable record of guarantees; few produce comprehensive reports covering different types of guarantees and consolidated risk exposure.
- Institutional arrangements for guarantee management, including authorization and accountability, are often not well defined.

### Types of guarantees (classification highlights)
- One-off guarantees:
  - Loan (and other debt instrument) guarantees: commitments to bear the risk of nonpayment (default risk); government undertakes to assume debt service obligations (entirely or in part) of the borrower in case of default. Loan guarantees are the most common form and typically one of the largest components.
  - Exchange rate guarantees: promises to compensate a borrower—typically a public corporation or financial institution—for losses on foreign currency borrowings due to exchange rate fluctuations.
  - Guarantees related to PPP contracts: issued to private partner(s) as part of risk-sharing arrangements (for example, minimum revenue guarantees, exchange rate guarantees, transfer price guarantees).
  - Other one-off guarantees: lines of credit, loan commitments, contingent credit availability, letters of credit—become effective upon actual withdrawal of funds.
- Standardized guarantees:
  - Issued to a large number of beneficiaries, usually for fairly small amounts, with standard terms and repeated transactions and pooling of risks.
  - Include umbrella guarantees to financial institutions (mortgage loans, student loans, SME loans, agriculture loans, export credits) and government insurance schemes (deposit insurance, crop insurance, natural disaster insurance).
- Pension guarantees:
  - Government guarantees a minimum (annual) return on a defined-contribution pension plan or guarantees a minimum pension irrespective of the fund balance.
- Guarantees may be issued by public corporations and subnational governments that carry explicit or implicit national government counterguarantees, exposing the national government to the same risks.
- Standardized and pension guarantees are often provided and managed by specialized institutions outside the core government.

### Box 1 — Steps to Strengthen the Management of Guarantees
1. Ascertain the size of the guarantee exposure – Conduct an inventory of guarantees to be updated routinely.
2. Ensure that guarantees are properly recorded and disclosed – Regardless of the accounting base, at a minimum for each class of guarantees, record and disclose in the annual budget documents or in a separate fiscal risk statement the maximum amount guaranteed, in nominal terms, and the possible reimbursement, recovery, or counterclaim by the government.
3. Ensure adequate budget provisions to meet claims – At a minimum, the budget should include a guarantee (or contingency) reserve. The size of the reserve should be estimated with consideration to likely payments from the call of guarantees. Payments that are more or less certain should be distinctly provided for, rather than being paid for from the reserve.
4. If guarantees are sizable, create a guarantee reserve fund – The need for a reserve fund should be judged on a consideration of country-specific circumstances. Funds can be built by setting aside resources when issuing guarantees and by crediting guarantee fees. Notional funds are preferred for ease of management.
5. Regulate the issuance of new guarantees through a policy framework – The framework should specify a ceiling and provide guidance on when guarantees can be considered, what fees will be charged, and which risk containment measures will be used.
6. Develop capacity to evaluate guarantee proposals and assess associated risks.
7. Develop measures to mitigate risks – Examples include risk-based fees, partial guarantees, deductibles, reinsurance, and reserves.

### Evaluating a guarantee proposal — decision criteria
- Decisions on new guarantees or extensions should be made within a policy framework and based on clear analysis of rationale, associated risks, costs, benefits, and affordability.
- Key analytical questions include:
  - What objectives is the guarantee seeking to serve, and are they consistent with government policy on guarantees? Could the same benefits be provided more efficiently using a conventional expenditure instrument?
  - What is the term of the guarantee, and why is this term necessary?
  - What are the risks associated with the guarantee? Is there adequate justification for the government to assume those risks? What risk mitigation measures will be used, and how will residual risks be managed?
  - What is the financial position and creditworthiness of the guarantee seeker? Does it have the potential to generate sufficient resources to service its obligations?
  - What will the fiscal costs of the guarantee be? What will be the most likely and maximum exposure to the government?
  - What impact would the proposed guarantees have on the government’s debt level? Would it be consistent with the medium-term debt strategy (MTDS) and any debt limits or rules?
- As a rule of thumb, guarantees can be considered for projects by public or private entities outside general government where:
  1) the economic benefits from the project exceed its cost,
  2) the project is expected to generate positive returns,
  3) the beneficiary is creditworthy, and
  4) the project cannot be financed without a government guarantee.
- Projects designed to serve social objectives unlikely to generate positive returns, or those undertaken by general government entities, are more efficiently served by direct support (subsidy or on-lending).

### Assessing and quantifying risks — valuation and techniques
- Risks associated with a guarantee can be assessed using standard credit-risk evaluation techniques focusing on default probability and loss given default.
- Principal approaches (The World Bank 2016):
  - Credit rating:
    - Used by countries such as Australia, Colombia, Indonesia, and Sweden to assess risks via beneficiary credit ratings.
    - Advantages: standardized approach, access to third-party resources (credit rating agencies), generally cost-efficient.
    - Internal government rating requires higher technical capacity and industry-specific risk understanding.
  - Statistical models:
    - Compute a financial distress index from weighted profitability and balance sheet ratios (example: Turkey).
    - Weights obtained via discriminant analysis and can be adapted to entity type.
    - Easier to use but requires ample historical data for calibration; predictability is good only over a very short horizon (one to two years).
  - Scenario analysis:
    - Stochastic simulations for risky variables (revenues, traffic flows, exchange rates), used by Chile, Colombia, Sweden for PPP-related guarantees.
    - Captures project- or context-specific risks but is complex and technically demanding.
- Structural model–based approach:
  - Uses option-valuation techniques where default is when asset value falls below liabilities (Merton 1977).
  - Chile uses this technique for valuation of exchange rate guarantees to concessionaires for infrastructure projects.
  - Limited application for guarantees to individuals or government-owned entities.
- Measures of guarantee cost and exposure include:
  - Expected payment (probability-weighted payment, present value terms).
  - Maximum exposure (maximum possible loss).
  - Exposure at default (EAD).
  - Loss-given-default (EAD adjusted for recoveries, expressed as percentage of EAD).
  - Value at risk (maximum loss at a given confidence interval within a stipulated time).

### Country practices and policy frameworks (illustrative examples)
- The Netherlands’ policy framework for contingent liabilities (adopted 2015) main features:
  - The government would not take on new contingent liabilities unless there is an overriding reason (policy of “no, unless”).
  - A ceiling sets a maximum limit for the overall level of contingent liabilities and contains the government’s risk exposure.
  - All new programs carrying government guarantee and modifications of existing programs are required to have a sunset clause; the standard end date is five years.
  - New policy measures carrying a government guarantee, or changes to an existing measure, require ex ante review by the council of ministers with results submitted to parliament.
  - Independent expert opinion is obtained on large and complex risks, including fees to be charged.
  - Departmental budgets are required to contain a separate section describing guarantees, loans, and financial interventions.
  - The government aims to improve reporting of contingent liabilities both in the budget and in annual reports.
- The U.K. Treasury process for contingent liabilities:
  - Departments initiating a high-value contingent liability (a maximum exposure of £3 million or more) must complete a standard checklist to facilitate treasury evaluation.
  - The checklist contains 19 questions grouped around five aspects:
    1) Rationale — justification and market failure; alternatives considered.
    2) Exposure — maximum size, maturity, exit strategy.
    3) Risk and return — triggers for crystallization, expected loss, distribution of possible losses.
    4) Risk management and mitigation — governance, risk mitigation tools, exchequer compensation for bearing risk, guarding against residual risk.
    5) Affordability — capacity to meet payment from existing budget, ratio of expected loss to available resources, effect on public sector net borrowing and public sector net debt.

*Source: Introduction section of howtonote1706 (howtonote1706 - Introduction).*

### Box 3 United Kingdom’s Checklist for Evaluating Proposals for Contracting Contingent Liabilities

### Box 3 United Kingdom’s Checklist for Evaluating Proposals for Contracting Contingent Liabilities

### Risk quantification methods
- Use market price differential between a guaranteed and a similar nonguaranteed debt as a proxy for bottom-up risk quantification of a debt guarantee.
- Use market price of an equivalent derivative contract as a proxy for the value of an exchange rate guarantee.
- For standardized guarantees (for example, guarantees on mortgage loans or deposit insurance), estimate expected loss based on historical default rate for the entire pool of similar guarantees.
- Simpler approaches for low-capacity environments:
  - Assess creditworthiness of guarantee seekers through simple financial analysis using balance sheet and cash flow projections to identify potential stress and ability to service obligations.
  - Introduce more quantitative techniques over time as capacity increases.
- Reassess risk estimates annually, because risk assessment depends on assumptions that can change.
- Choice of discount rate is a key issue; in principle use the risk-free rate adjusted for market risk (the undiversifiable risk).
  - A simplified approach is to use the unadjusted risk-free rate (that is, the rate at which the government borrows). This approach is likely to lead to undervaluation but may be less harmful than choosing incorrect models or assumptions.
- Tools:
  - The IMF/World Bank MTDS analytical tool can model realization of guarantees and evaluate cost and risk of the government debt portfolio with and without guaranteed debt; the tool is of particular use to developing countries where simplicity and feasibility are important.

### Country practices and model examples
- Colombia:
  - Law empowers government to guarantee payment obligations of public entities; guarantees issued with concurrence of the National Council for Economic and Social Policy and approval of the Congressional Commission on Public Credit.
  - Ministry of Finance and Public Credit (MHCP) routinely conducts credit risk assessment of its guarantee portfolio.
  - Externally assigned credit ratings determine default probability and loss given default.
  - Portfolio value computed by summing expected loss and unexpected loss at a 99.9 percent confidence interval.
  - Expected loss = exposure at time of default × default probability × loss given default factor.
  - Unexpected loss computed using weighted average life and an asset correlation factor.
  - Each beneficiary required to pay an annual risk-based fee equivalent to the expected loss for the year; fees payable for the entire duration of the guarantee and credited to a contingency fund.
  - Beneficiaries must post sufficiently liquid collateral of up to 120 percent of the guaranteed credit.
  - Legal limit: law imposes a limit of US$4.5 billion or equivalent (about 1.6 percent of GDP) on the stock of guarantees; second limit of 0.4 percent of GDP caps annual obligations arising from PPP projects, including annuity payments and called guarantees.
- Turkey:
  - Turkish Treasury uses a logit regression model to measure risks; model uses financial ratios and past track record to estimate default probabilities and is calibrated for each major beneficiary category.
  - Beneficiaries are placed in one of six predefined risk categories based on default probability.
  - Recovery rate estimated from nonrestructured and restructured cash flows.
  - Expected loss computed using default probability, recovery rate, treasury funding curve, and cash flow projections.
  - Model informs guarantee/on-lending limits, partial guarantee ratios, guarantee/on-lending fees, and expected flows from the reserve (the risk account), including required budget transfers into the reserve.
  - Turkey maintains a “risk account” at the central bank.
- India, Iceland, Vietnam, Brazil, Sweden, United States, Australia examples cited for specific practices:
  - India: in case of a default of a debt guarantee, government pays 70 percent to 90 percent of the amount in default; the balance is paid by the borrower.
  - Turkey: except for certain credits, government guarantees cover up to 95 percent of the agreed credit.
  - Vietnam: guarantees cannot exceed 80 percent of the project cost.
  - Iceland: guarantees limited to 75 percent of credit financing needs, with at least 20 percent equity financed—effectively limiting government guarantees to 60 percent of project cost.
  - Brazil: central government can retain taxes to be transferred to subnational governments in case of a default; guarantees are required to be reported publicly every four months; federal law examples include limits for state guarantees of 22 percent of net recurrent revenue.
  - Australia (New South Wales): all public corporations with total guaranteed debt exceeding AU$10 million required to obtain a credit rating annually; guarantee fee rate equals difference between market interest rate for similar credit rating and cost of debt obtained from the treasury; rates calculated from observed monthly average market bond rates or imputed by straight-line projection; single rate charged to all debt irrespective of term; fee applied to outstanding capital value and calculated monthly.
  - Sweden and United States periodically revalue guarantee during its term and adjust pricing; Sweden charges a premium for administrative expenses over and above risk-based fee; Sweden’s parliament can waive guarantee fee in full or part, and waived amount is appropriated in the budget as subsidy.

### Comparing guarantees with alternative instruments
- Conceptual equivalence: value of a loan with credit risk = value of identical risk-free loan minus a loan guarantee.
- On-lending versus issuing a guarantee is often a difference of form rather than economic substance.
- OECD 2005 conclusion: if purpose is solely to finance an activity, credit guarantees will typically be inferior to direct lending by the government.
- In some cases, regular budgetary funds (subsidies, equity injections) may be more appropriate and transparent than guarantees or on-lending—for example, compensating a public corporation for quasi-fiscal activities or providing balance sheet support to a financially distressed public corporation.

### Mitigating risks
- Capping the size:
  - Limits normally applied on maximum exposure or on quantum of new guarantees; often easier to apply and monitor than expected payments-based limits.
  - Limits specified in fiscal responsibility legislation, organic budget laws, public debt management laws, or annual budgets; can be standing or reset annually.
  - Examples: Colombia limit of US$4.5 billion (about 1.6 percent of GDP) on stock; India annual cap on central government guarantees of 0.5 percent of GDP; Turkey prescribes two annual limits each year in budget laws (a single limit covering credit guarantees and on-lent external debt, and a limit on on-lent domestic debt).
  - Counting guarantees within debt limits: South Africa and Thailand count guarantees within the debt limit.
  - Limits should be consistent with affordability in short, medium, and long term and guided by the medium-term fiscal framework and debt-sustainability analysis that incorporates contingent expenditure and debt scenarios.
- Risk-based guarantee fees:
  - Risk-based fees moderate demand, enforce discipline, and address adverse selection.
  - A fully risk-based fee equals expected losses plus a risk premium for uncertainty; a fee below this price represents a hidden subsidy.
  - Countries levying risk-based fees include Australia, Chile, Colombia, Israel, Peru, Sweden, and the United States.
  - Variants:
    - Full model-based fees with periodic revaluation during term (Colombia, Sweden, United States).
    - Flat fee proportional to face value adjusted for risk premium with predefined risk categories and standard predetermined proportional fees.
  - Fees should be charged annually during the entire term of the guarantee; annual charging allows revaluation and appropriate adjustments.
- Guarantee reserve funds:
  - Funds can be actual (invested in financial assets, e.g., Colombia) or notional with no underlying cash (India, Sweden, United States).
  - Notional funds pooled in the treasury single account provide tracking without underlying cash and avoid affecting borrowing requirements and gross debt.
  - Decisions on fund size should consider overall risk exposure and volatility in annual payments; build a margin or buffer over expected payments to absorb shocks.
  - Reserves typically funded from guarantee fees and interest income; budgetary transfers may be required during initial years to cover deficits; over time funds should become self-sufficient.
  - If government charges less than full price of a guarantee, the differential amount should be appropriated and transferred to the reserve as subsidy compensation.
- Other measures:
  - Time- and value-limiting guarantees: all guarantees should be limited in time and value; avoid open-ended “continuing” guarantees.
  - Partial guarantees and deductibles: partial guarantee leaves part of risk with lender to mitigate adverse selection and moral hazard; deductibles require borrower to absorb first losses.
  - Collaterals: mandatory collateral in some countries (for example, Colombia and Iceland); Colombia requires collateral up to 120 percent of guaranteed credit.
  - Reinsurance: use of reinsurance as cost measure and deterrent for high-risk transactions (Belgium, Estonia, France, Moldova, Peru, Switzerland).

### Budgeting for guarantees
- Integrate issuance of new guarantees into the national budget plan so conventional and contingent expenditures are evaluated comparably.
- Two main issues:
  - Make explicit the cost of guarantees at time of issuance.
  - Ensure adequate budgetary provision exists for payments when guarantees are called.
- Two main approaches to budgeting for guarantees and contingent liabilities:
  - Cash-based budgeting:
    - Make budget provisions for losses expected during the year or over the medium term because of guarantees issued in the past.
    - Estimate and appropriate payments expected during the budget year from calls of guarantees; include in a general contingency reserve or a separate budget line for payments toward guarantees.
    - For near-certain payments, obtain specific appropriations rather than relying on contingency reserves.
    - Identify guarantees expected to be called in budget documents and explain basis for appropriation.
    - Cash-based budgeting is the minimum practice but does not reveal the true cost of guarantees and does not, by itself, address full cost recognition.
  - Cost-based (accrual) budgeting:
    - Example: United States federal credit reforms require agencies to include present value of expected costs of loans and guarantees in their budgets.
    - Expected costs are discounted cash outflows (disbursements and payments on default) adjusted for inflows (origination fees, repayments, interest receipts, recoveries).
    - Present value calculated using a discount rate equal to the rate the government pays on its borrowings of similar maturity; part of cost not covered by fees treated as subsidy and appropriated.
    - Subsidy costs included in total budget expenditure and surplus/deficit; reestimated annually; automatic appropriation covers overruns.
- Country examples by budgeting practice (from Table 1):
  - Cost-based budgeting: Australia, Denmark, New Zealand, United Kingdom.
  - Cost-based budgeting in cash-based budget countries: Canada, Colombia, Netherlands, United States.
  - Budget provisions for expected payments: Chile, Hungary, Indonesia, South Africa, Russia.

*Source: Government of Colombia 1993 and 2015; Cangoz and Balibek 2013; Government of Brazil 2015; Government of the United States of America 2004; New South Wales Government 2014; Irwin 2007; OECD 2005, 2013, 2017b.*

### Box 7 Budgeting for Loans and Guarantees in the United States

### Box 7 Budgeting for Loans and Guarantees in the United States

### Budgeting approaches and rationale
- Cost-based budgeting: estimate and make provisions for the cost (in present value terms) of a guarantee at the time of its issuance.
  - Actual payments on called guarantees are treated below the line as financing transactions.
  - Upfront recognition of provisions:
    - Makes the cost of guarantees—and the element of subsidy—involved more transparent.
    - Brings guarantees under overall fiscal and budget frameworks.
    - Sets aside resources for meeting any future obligations.
    - Corrects bias in instrument choice by putting guarantees on par with direct lending and grants/subsidies.
  - Does not require adopting accrual budgeting in its entirety; selectively applied to guarantees.
  - Requires higher technical capacity and may not be suitable for low-capacity environments.

### Accounting and reporting for guarantees
- Two broad accounting approaches:
  - Accrual-based approach (preferred):
    - Requires upfront recognition of liabilities likely to arise from issuance of guarantees.
    - IPSAS 19: if there is more than a 50 percent probability that a guarantee will require future payment(s), and the payment(s) amount can be reasonably estimated, then a provision (liability) should be recognized in the financial statement.
    - Record an expense in the operating statement and an equivalent liability in the balance sheet.
    - For existing guarantees previously disclosed as contingent liabilities, recognize provisions in the accounting period in which the change in probability occurs.
    - Payments made in settlement of guarantee claims are set off against the liability.
    - Likely reimbursement is recognized as an asset only when it is virtually certain to be received.
    - The provision amount should be the best estimate of the payments required (in present value terms) to settle the obligation at the reporting date.
    - Provisions should be reviewed at the end of every year and adjusted or reversed as needed.
    - For standardized guarantees, provisions are based on expected loss estimated from the historical default rate for the entire pool of similar guarantees, minus any expected recoveries.
  - Cash-based approach (commonly used):
    - Does not recognize guarantees until they are called.
    - When called, payments made in settlement of a guarantee claim are recognized as expenditure.
    - Guarantee fees charged at origination are recorded as (non-tax) revenues.
    - Countries that maintain a financial balance sheet recognize the assumption of a guaranteed loan as a liability; subsequent payments are set off against that liability.
    - No upfront provisioning for likely payments.
- Practical implication:
  - Accrual-based approach supports upfront recognition and disclosure but is technically more demanding and may not be realistic in low-capacity environments in the short-to-medium term.
  - Where accrual is not feasible, enhance disclosure of information on guarantees.

### Disclosure expectations (IMF guidance)
- The IMF’s Fiscal Transparency Code requires that a government’s exposure from guarantees is regularly disclosed and authorized by law and introduces three levels:
  - Basic rating: annually publish all government guarantees, their beneficiaries, and the gross exposure created by them.
  - Good rating: basic requirements plus authorization by law of the maximum value of new guarantees or their stock.
  - Advanced rating: publish information on the probability of call on guarantees.
- Countries should be encouraged to disclose the following (IMF 2008):
  - A brief description of their nature, intended purpose, beneficiaries, and expected duration
  - The government’s gross financial exposure—that is, the maximum amount guaranteed, in nominal terms
  - The possibility of any reimbursement, recovery, or counterclaim by the government
  - Where possible, an estimate of the likely fiscal cost (the net present value of expected payments) and likely timing of flows
  - Payments made during and up to the year in settlement of called guarantees, claims established on defaulters, and payments received in recovery from defaulters
  - Any fees charged for guarantees
  - Receivables from guarantees
- Presentation and timing:
  - Information should be disclosed for all guarantees individually, or as a class where amounts are relatively small.
  - Reports should separate existing and new guarantees issued during the year and show changes to existing guarantees.
  - Encourage classification along lines suggested in GFSM 2014, Table 4.6.
  - Aim to report guarantees consistently throughout the fiscal cycle and make information complete, timely to the legislature, and publicly available.
  - Reports should include guarantees issued by all public entities, including subnational governments and public corporations.

### Statistical reporting treatment
- GFSM (IMF 2014) principles:
  - Contingent liabilities are not recognized in macroeconomic statistics unless the triggering event is deemed to have occurred.
  - Liabilities on account of loan and other one-off guarantees are attributed to the debtor, not the guarantor, until the guarantee is called.
  - A one-off guarantee granted by government to a financially distressed corporation, with a very high likelihood of being called, is treated as if the guarantee is called at inception and is assumed as public debt; rationale applies throughout the term of a guarantee.
  - If it becomes evident that the beneficiary will not be able to repay outstanding obligations, a debt assumption of the outstanding principal amount should be recorded.
  - Economic substance—not legal form—guides statistical treatment of guarantees.
  - Potential government claims on beneficiaries are recognized as assets only when there is a reasonable expectation of their realization.
  - GFSM (IMF 2014) requires disclosing publicly guaranteed debt and other one-off guarantees (if significant), at nominal value, as a memorandum item to the government balance sheet.
  - Provisions for calls for standardized guarantee schemes are treated as a liability and included in public sector debt.

- Country practice example (New Zealand):
  - Reports guarantees in notes to annual financial statements.
  - Contingent liabilities over NZ$20 million are disclosed separately; quantifiable contingencies less than NZ$20 million are included in the “other quantifiable” total.
  - Guarantees and indemnities disclosed as a separate class with nominal value, beneficiaries, and purpose.
  - Unquantifiable contingent liabilities disclosed at year-end where expected to be material but not remote.
  - Financial statements include a table of unquantifiable indemnities by party, instrument, and actions indemnified; other unquantifiable contingent liabilities briefly explained item by item.

### Monitoring requirements
- Governments should routinely monitor financial performance of beneficiaries:
  - At minimum, analyze annual financial statements of institutions receiving guarantees to assess continued creditworthiness and financial solvency and detect early signs of default.
  - Monitor compliance with guarantee agreements, proper use of guaranteed funds, timeliness of repayment of guaranteed debt and other obligations, balance of guaranteed amount, timely payment of guarantee fees, and recoveries in case of a called guarantee.
  - Legal safeguards can allow the government to take early action when a beneficiary fails to comply, does not meet disclosure requirements, or its financial condition deteriorates.

- Country practice example (Iceland):
  - State Guarantee Fund (SGF) responsible for management and monitoring of government guarantees under the State Guarantees Law.
  - SGF collects quarterly information on outstanding guaranteed debt and accrued interest from each beneficiary; two largest beneficiaries required to submit monthly.
  - Beneficiaries must submit annual financial reports and other requested information by law; penal provisions for noncompliance.
  - SGF informs the finance ministry of breaches and likely defaults and submits an annual report assessing prospects of each beneficiary, a risk assessment, and estimate of potential loss to the treasury.

### Strengthening institutional arrangements — key elements
- Strengthen the regulatory framework:
  - Put a ceiling on overall exposure from guarantees (flow limits on new issuance and/or stock limits on total size); where possible, include limits in fiscal rules.
  - Specify who can approve guarantees; authority should be clearly defined in legislation or financial regulations (centralized controls with finance minister authority often work better).
  - Specify disclosure requirements in legislation: responsibilities, required information, periodicity, timeliness, and mandates for collecting, recording, monitoring, and reporting.
  - Specify general terms for extending guarantees: risk mitigation approach, guarantee fees to be charged, procedures for a call on guarantee including recoveries, and monitoring requirements and penalties for noncompliance.

- Develop institutional mechanisms:
  - Develop a policy framework specifying when and for what purposes guarantees can be considered.
  - Integrate guarantee decisions with the budget process; require mandatory consultation with the ministry of finance to assess appropriateness, cost-effectiveness, and fiscal impact.
  - Develop capacity to evaluate guarantees: measure exposure precisely; adopt accounting, reporting, and budgeting approaches that reflect exposure; cost guarantees and determine guarantee fees; develop guidance on methodologies and assumptions.
    - Appropriately locate the risk management function—government debt managers are typically better equipped for credit risk assessment and monitoring overall creditworthiness; debt management units often handle recording and monitoring as back-office functions.
  - Establish adequate budgetary mechanisms for meeting payment obligations when they arise:
    - While cost-based budgeting is ideal, at minimum estimate likely payments and provide for them in the budget.
    - Countries with sizable exposure could consider building a guarantee reserve fund.
  - Strengthen link between guarantees management and oversight of state-owned corporations and subnational governments—typical main beneficiaries.
  - Centralize recording and monitoring of guarantee data via a centralized database supported by an information system ensuring data security and traceability.
  - Ensure regular disclosure: routinely submit information on government exposure from guarantees and other contingent liabilities to the legislature and publish at least annually.

*Source: Box 7, “Budgeting for Loans and Guarantees in the United States,” How to Strengthen the Management of Government Guarantees, Fiscal Affairs Department, International Monetary Fund, October 2017.*

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_Source: https://www.imf.org/-/media/files/publications/howtonotes/howtonote1706.pdf_