## _wp08159

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---

### Introduction: nature and origins of large off-balance sheet liabilities
- Governments may confront very large contingent or off-balance sheet fiscal liabilities that are typically not being serviced.
- Typical origins (recent Eastern European experience):
  - War damage claims and frozen fx deposits (Bosnia).
  - Pension arrears (court decision) (Croatia).
  - Frozen domestic currency deposits (Lithuania, Ukraine).
  - Frozen fx deposits (Macedonia, Serbia).
  - Pension and expenditure arrears due to government liquidity (Moldova, Russia).
- Imperatives to address liabilities: accumulating court orders, past guarantees (e.g., of deposits), or political considerations.
- Representative case liabilities (country, timeframe, size of liability in percent of GDP):
  - Bosnia 1992-01 149 (in 2003): War damage claims + frozen fx deposits
  - Croatia 1993-98 6 (in 2005): Pension arrears (court decision)
  - Lithuania 1991 9 (in 1996): Frozen domestic currency deposits
  - Macedonia 1991 18 (in 1999): Frozen fx deposits
  - Moldova 1994-98 11 (in 1996): Pension and expend. arrears (gov't liquidity)
  - Russia 1994-98 7 (in 1998): Pension and expend. arrears (gov't liquidity)
  - Serbia 1991-01 29 (in 2001): Frozen fx deposits
  - Ukraine 1991 160 (in 1996): Frozen domestic currency deposits

### Design of a settlement: economic considerations and sustainable primary surplus
- Primary trade-off:
  - A well-designed settlement can eliminate uncertainty, lower risk premia and debt service costs, and remove budget risks from court-ordered awards.
  - An overly generous or poorly structured settlement can undermine fiscal plans and macroeconomic stability.
- Fiscal sustainability framework:
  - The present discounted value of expected primary surpluses (PS) must be large enough to pay off debt (B).
  - Debt dynamics depend on the relation between the real interest rate (R) and the growth rate (g), with GDP deflator growth (p) adjustments.
- Constraints on achieving higher PS:
  - Tax policy constraints:
    - Total tax burden limited by mobility of tax bases, evasion, and weak tax administration.
    - Taxation distorts incentives and can reduce supply and accumulation of factors of production.
  - Expenditure policy constraints:
    - Historical legacies (e.g., pensions), public investment needs, and equity/redistribution preferences limit scope for cuts.
- Iterative design approach:
  - Determine sustainable primary surplus given constraints.
  - Assess additional debt capacity given conservative growth and real interest rate assumptions.
  - Derive maximum NPV of a settlement to guide choices on face value, maturities, interest rates, or cash payment schedules.
  - Ensure maturity structure limits rollover risks; if settlement is too small, revisit primary surplus assumptions.
- Empirical pattern from Eastern Europe:
  - Primary surplus tended to rise even before a settlement; difference between pre- and post-settlement averages is about 1½ percent of GDP.
  - Small claims: extra debt service often covered via budget adjustments.
  - Large claims: relied more on significant write-downs in NPV terms.

### Settlement structures and country experience (selected observations)
- Settlement methods observed:
  - Cash payments (scheduled or discretionary).
  - Bonds (various maturities, grace periods, coupon structures).
  - Netting against tax arrears and tax payments; triangular netting with public enterprises.
  - In-kind payments; exchangeability of bonds for land or public assets; notes redeemable against tax payments.
- Representative country cases and selected magnitudes (size of liability; clearance procedure; illustrative NPV or Max/Min values in percent of GDP):
  - Bosnia (2003 & ongoing): 204.0 (in 2003); cash (small deposits and expenditure arrears), bonds (various maturities and interest rates); NPV examples: Cash: 4.0; Bonds-1: 6.0; Bonds-2: 5.3; Bonds-2: 0.9 / 0.1 (Max/Min)
  - Croatia (2005): 6.0 (in 2005); cash pre-established schedule; NPV: 3.4; Max/Min ~1.0
  - Lithuania (1997): 9.2 (in 1996); cash semi-discretionary schedule linked to privatization proceeds with annual cap; 10 years; NPV: 5.4; Max/Min 2.1 / 0.0
  - Macedonia (1999): 17.5 (in 1999); cash (small deposits) and bonds (10 yr maturity; 2 yr grace; 2 percent interest; exchangeable for land or public assets at face value); 12 years; NPV: 10.1; Max/Min 1.25 / 0.35
  - Moldova (1996-1998): Max 11.0 (in 1996); netting against tax arrears; triangular netting with public enterprises; NPV unclear; Max/Min 10.7 / 8.3
  - Russia (1996-1998): Max 6.9 (in 1998); netting against tax arrears; triangular netting; notes redeemable against tax payments; NPV 3.4 / 1.7
  - Serbia (2001): 29.2 (in 2001); cash for small deposits and bonds with 1-16 yr maturity, 3 yr grace, 2 percent interest; cash (4 yrs, 1998-2002) and bonds (16 yrs, 2001-16); NPV 11.5 (minimum); Max/Min 1.2 / 0.6
  - Ukraine (1996/ongoing): 161.1 (in 1996); discretionary annual cash payments; triangular netting with public enterprises; NPV 3.5 total (through 2007); netting sub-total 0.4 (through 2007); Max/Min 0.4 / 0.1
- Practical design insights:
  - Large settlements: NPV write-downs often necessary when fiscal space limited.
  - Netting and triangular netting reduced cash outlays in several cases but entail risks.
  - Example design target: limit debt service to no more than 1 percent of GDP in any one year (Armenia/Serbia illustration).

### Macroeconomic stability: channels, model illustration (GIMF) and simulation results
- Key channels:
  - Wealth effect: non-Ricardian behavior and liquidity constraints imply restitution payments likely to boost demand and spending.
  - Policy responses: fiscal tightening or central bank adjustments can offset demand stimulus; exchange-rate regime matters (peg vs flexible).
  - Cyclical position: near-capacity economies face inflationary pressure and current account deterioration; below-capacity can see output gains with limited inflation.
- GIMF overview (Box 2):
  - Micro foundations: optimizing forward-looking firms and consumers; nominal and real rigidities; tradable/non-tradable sectors; intra-industry trade; liquidity constrained agents and OLG structure.
  - Calibration to a “home” country resembling Ukraine (post-2002 balanced growth path); interest rate risk premium of 300-350 basis points; moderate inflation under a fixed exchange rate; structural parameters drawn from literature.
- GIMF simulation: a large upfront settlement (10 percent of GDP) — stylized results:
  - Much of the settlement would be spent, generating a significant increase in inflation (especially for domestic goods).
  - Real exchange rate would appreciate moderately.
  - Current account deficit would rise sharply.
  - In the medium-term, inflation must undershoot baseline under the peg, real interest rate increases, crowding out investment and lowering real GDP relative to baseline.
- Sensitivities:
  - Fewer liquidity constrained agents → smaller consumption, inflationary, and current account impacts.
  - Smaller price adjustment costs → larger inflationary impact.
- Policy offsets and staging:
  - Counter-cyclical fiscal policy reduces macro impacts significantly: total consumption response drops by about one-quarter under saving of excess revenues.
  - Spreading payments over 5 years reduces annual consumption and inflationary effects; but deterministic future payments can permit borrowing against them, reducing the liquidity constraint.
  - Combining phasing, counter-cyclical fiscal response, and a flexible exchange rate largely contains inflationary impacts; higher nominal and real interest rates dampen investment and income, containing consumption shock.

### Empirical case evidence on timing, staging, and macro conjuncture
- Debt settlement timing and macro conjuncture (country / Year / Type / Inflation / Growth / CA deficit):
  - Bosnia 2004 Up-front 0.3 6.3 -16.3
  - Croatia 2006 Up-front 3.2 4.8 -7.7
  - Lithuania 1997 Spread 10.3 8.5 -7.9
  - Macedonia 2000 Up-front 6.4 4.5 -1.9
  - Moldova 1997 Spread 11.8 1.6 -14.2
  - Russia 1997 Spread 14.8 1.4 0.0
  - Serbia 2001 Up-front 91.8 4.8 -2.4
  - Ukraine 1996 Spread 80.2 -10.0 -2.7
- Memorandum medians:
  - Up-front 4.8 4.8 -5.1
  - Spread 13.3 1.5 -5.3
- Case evidence:
  - Lithuania used phasing and discretion to postpone payouts when external conditions worsened in 2000-01.
  - Ukraine (1996) set no time limit; payments fell below macro-fiscal capacity in 2003-04, creating pressures for a new solution at a less attractive conjuncture.

### Governance, administrative, legal and operational design issues
- Verification and stock-taking:
  - Verification protects against fraudulent claims; example: Bosnia verification reduced amounts outstanding by 6½ percent of GDP.
  - Use independent auditors, supreme audit institutions, or private sector accounting firms when capacity limited.
- Prioritization and targeting:
  - Settling many small claims in cash can reduce administrative costs (Macedonia, Serbia).
  - Preferential treatment (elderly, disabled, students) used in Lithuania, Serbia, Ukraine, but may raise administrative costs and legal challenges (Ukraine’s constitutional court rejected an age-based criterion).
- Transparency:
  - Auditing and public disclosure of payments and receipts to prevent abuse; lack of transparency contributed to concerns in netting transactions in Russia, Ukraine, Moldova in late 1990s.
- Voluntary settlements, moratoria:
  - Requiring claimants to act to receive settlement reduces legal risk; time limits can close the books.
  - Moratorium legislation used to freeze claims until budget resources identified (Bosnia, Ukraine).
- Staging trade-offs:
  - Spread-out flexible settlements: allow discretion, avoid locking fiscal authorities into unsustainable commitments, and reduce annual fiscal stimulus; Lithuania example.
  - Upfront settlements: rapid closure; useful when closure is critical or to develop financial markets (Serbia securitized claims into bonds 1–16 years), but carry macro risks under a peg (euroization risk if fx-denominated).
  - Summary guidance: upfront preferred when (i) macro and fiscal risks are well contained; (ii) financial market development needs; (iii) achieving closure is pressing.

### Settlement techniques: evaluation of options
- Cash repayment and securitization:
  - Flexibility, ease of administration, transparency; greatest claimant welfare improvement; can spur financial market development.
- In-kind payments:
  - High administration costs, valuation problems, negative for growth, reduce claimant welfare the least; advised to avoid.
- Netting (mutual debt settlements):
  - Heavy risks: lack of transparency, valuation problems, high administrative cost for chains of obligations, disintermediation, moral hazard.
  - Netting appropriate only under very specific circumstances (credible one-off transaction and control of valuation abuse).

### Box 3: Mutual debt settlements (Netting) in the CIS — evidence and Ukraine application
- Mechanism:
  - Netting allows claimants to offset claims with tax liabilities or payments to state enterprises; can incentivize withholding current payments.
- Evidence:
  - Russia: arrears did not decline over time despite netting; rebounded rapidly after netting rounds.
  - Ukraine: declines in utility payment compliance after netting; government set aside up to 2¼ percent of GDP in 2008 budget for initial cash payments; triangular netting involving communal service payment arrears and local utility companies’ tax arrears proposed.
- Fiscal and macro consequences when netting entrenched:
  - Questions on fiscal sustainability; budget loses cash for debt service, wages, pensions; monetary and price system destabilization possible.
  - Privatization-linked settlements can reach 5 percent of annual GDP, creating sterilization burdens.
- Use of public assets in settlements:
  - Political economy motives and financing reasons for linking to privatization.
  - Macro-fiscal disadvantages: earmarks reduce budget flexibility; large privatization inflows under a peg inject liquidity and require sterilization.
  - Asset exchanges suffer valuation problems; voucher exchanges can produce governance issues.
- Ukraine technical recommendations:
  - Full verification and prioritization; focus on eliminating large numbers of de minimis claims.
  - Reconsider netting; if netting proceeds, audit netted claims and compensate utilities on-budget.
  - Privatization earmark design if used in 2009 and beyond:
    - (i) Cap annual spending through this channel, perhaps at no more than 2 percent of GDP.
    - (ii) Eliminate the “excess” formulation of the earmark to focus on a transparent, feasible and well-paced annual privatization plan.
- Ukraine macro-fiscal assessment:
  - Public debt is only 10 percent of GDP and falling.
  - Debt sustainable for shocks in range of existing liability; either upfront securitization or spread out cash repayment could work.
  - IMF staff: Ukrainian economy operating beyond capacity; excess demand contributing to inflation and rising current account deficit.
  - Many lost savings accounts likely belong to liquidity constrained pensioners (16-17 year age of claims), implying substantial restitution spending.
  - Privatization proceeds likely to come from abroad and, under Ukraine’s currency peg, could accommodate higher demand with money creation.
- Policy options for Ukraine:
  - Spread out the settlement over several years; halt further 2008 payouts given significant 2008 payments and high rising inflation; set a time limit (perhaps 5 years).
  - Move to a countercyclical fiscal rule to offset second-round effects.
  - Use gradual transition to a flexible exchange rate to tighten monetary conditions and lean against inflation.
  - Securitize opportunistically within a multi-year framework, continuing small annual budget payments and securitizing when macro conditions favorable (Serbian model).

### Ukraine-specific cases, proposals, and numerical items preserved exactly
- Proposed permanent settlement in cash, with payments scaled to past and projected GDP; NPV of 16 percent of GDP; 12 year completion — Outcome: Vetoed by the President (2005-06; 2005 pre-election period).
- Alternate proposal: "26.5 percent of GDP; 12 year completion" — also vetoed by the President (2005 pre-election period).
- Triangular netting scheme (public utility arrears and utility companies’ tax arrears):
  - Outcome: 0.4 percent of GDP in debt cleared, but no permanent reduction in utility arrears or utility companies’ tax arrears.
  - Timing: 1997-2007.
- Small annual cash payments + large increase in economy (plus small netting transactions):
  - Outcome: Liability shrinks dramatically. 17.9
- 2008 government commitment and early payments:
  - Executive commitment: Prime Minister promises full clearance and puts Hrv 20 billion (2.1 percent of GDP) in budget for this purpose, of which Hrv 14 billion contingent on privatization proceeds.
  - Verification ongoing.
  - In January, Hrv 1.3 billion paid out (0.15 percent of GDP).
- Other preserved numeric items referenced:
  - "0.4 percent of GDP in debt cleared"
  - "1997-2007"
  - "17.9"
  - "2008"
  - "Hrv 20 billion (2.1 percent of GDP)"
  - "Hrv 14 billion"
  - "Hrv 1.3 billion paid out (0.15 percent of GDP)"
  - "2005 pre-election period"
  - "2005-06"

### Conclusions and policy implications (summary)
- Objectives in addressing large contingent or off-balance-sheet fiscal liabilities:
  - Preserve fiscal sustainability and macro stability.
  - Minimize administrative burdens and legal risks.
- Fiscal sustainability guidance:
  - Assess post-settlement government debt level and structure using reasonable assumptions about primary revenue, spending, real interest rates, and growth.
  - NPV write downs may be needed; avoid bunched maturities in debt structure.
- Macroeconomic stability guidance:
  - Account for cyclical position, wealth effects (share of liquidity constrained consumers), settlement design (staging), and fiscal/monetary policy response.
  - GIMF simulations calibrated to Ukraine show impacts on inflation and the current account can range from alarming to moderate depending on these factors.
- Administrative and legal risk management:
  - Verify and prioritize claims; ensure transparency and careful audit.
  - Favor securitization for financial market development when appropriate; avoid in-kind payments and netting except under strict conditions.
  - Be cautious about accelerating privatization to fund earmarks; design privatization-linked settlements with caps and transparent pacing.

*Source — IMF working paper chapter “1. Recent European Cases of Large Off-Balance Sheet Liabilities” (extracted content).*

### 1. Recent European Cases of Large Off-Balance Sheet Liabilities ...........................................3

### 1. Recent European Cases of Large Off-Balance Sheet Liabilities

### Introduction: nature and origins of large off-balance sheet liabilities
- Governments may confront very large contingent or off-balance sheet fiscal liabilities that are typically not being serviced.
- Typical origins (recent Eastern European experience):
  - War damage claims and frozen fx deposits (Bosnia).
  - Pension arrears (court decision) (Croatia).
  - Frozen domestic currency deposits (Lithuania, Ukraine).
  - Frozen fx deposits (Macedonia, Serbia).
  - Pension and expenditure arrears due to government liquidity (Moldova, Russia).
- The imperative to address the debt can arise from accumulating court orders, past guarantees (e.g., of deposits), or political considerations.
- Table 1 summaries (country, timeframe, origin, size of liability in percent of GDP) include:
  - Bosnia 1992-01 149 (in 2003): War damage claims + frozen fx deposits
  - Croatia 1993-98 6 (in 2005): Pension arrears (court decision)
  - Lithuania 1991 9 (in 1996): Frozen domestic currency deposits
  - Macedonia 1991 18 (in 1999): Frozen fx deposits
  - Moldova 1994-98 11 (in 1996): Pension and expend. arrears (gov't liquidity)
  - Russia 1994-98 7 (in 1998): Pension and expend. arrears (gov't liquidity)
  - Serbia 1991-01 29 (in 2001): Frozen fx deposits
  - Ukraine 1991 160 (in 1996): Frozen domestic currency deposits
- Standard public finance and banking recapitalization approaches provide limited direct guidance:
  - Provisioning against realization may be infeasible when liabilities are very large.
  - When liabilities have already been assumed by the government, bank recapitalization may not address the core issue.

### Design of a settlement: economic considerations
- Primary economic trade-off:
  - A well-designed settlement can eliminate uncertainty, lower risk premia and debt service costs, and remove budget risks from court-ordered awards.
  - An overly generous or poorly structured settlement can undermine fiscal plans and macroeconomic stability.
- Fiscal sustainability (formal requirement summarized):
  - The present discounted value of expected primary surpluses (PS) must be large enough to pay off debt (B).
  - Debt dynamics depend on the relation between the real interest rate (R) and the growth rate (g), with GDP deflator growth (p) adjustments.
- Implications for settlements:
  - If debt rises because the government must pay a contingent liability, expected primary surpluses may no longer be sufficient to keep debt stable or falling.
  - The primary surplus may need to rise to restore sustainability, but tax and expenditure constraints limit feasible adjustments (see Box 1).
- Box 1 — The sustainable level of primary surplus:
  - Tax policy constraints:
    - Total tax burden limited by mobility of tax bases, evasion, and weak tax administration.
    - Taxation distorts incentives and can reduce supply and accumulation of factors of production, constraining growth objectives.
  - Expenditure policy constraints:
    - Historical legacies (e.g., pensions), public investment needs, and equity/redistribution preferences limit scope for cuts.
  - A medium-term budget framework is helpful to evaluate these constraints.
- Iterative approach recommended:
  - Determine sustainable primary surplus given constraints.
  - Assess additional debt capacity given conservative growth and real interest rate assumptions.
  - This yields the maximum net present value (NPV) of a settlement and guides choices over face value, maturities, interest rates, or cash payment schedules.
  - Ensure chosen maturity structure limits rollover risks; if settlement is too small, revisit the primary surplus assumption.
- Empirical pattern from Eastern European cases:
  - Primary surplus tended to rise even before a settlement; the difference between pre- and post-settlement averages is about 1½ percent of GDP (Figure 1).
  - Countries with relatively small claims often covered extra debt service via budget adjustments.
  - Countries facing larger claims relied more on significant write-downs in NPV terms.

### Settlement structures and country experience (selection from Table 2)
- Settlement methods observed:
  - Cash payments (sometimes scheduled or discretionary).
  - Bonds (with various maturities, grace periods, and coupon structures).
  - Netting against tax arrears and tax payments; triangular netting with public enterprises.
  - In-kind payments; exchangeability of bonds for land or public assets; notes redeemable against tax payments.
- Representative country cases and magnitudes (size of liability, clearance procedure, NPV in percent of GDP):
  - Bosnia (2003 & ongoing): 204.0 (in 2003); clearance: cash (small deposits and expenditure arrears), bonds (various maturities and interest rates across settlements); NPV examples: Cash: 4.0; Bonds-1: 6.0; Bonds-2: 5.3; Bonds-2: 0.9 / 0.1 (Max/Min)
  - Croatia (2005): 6.0 (in 2005); cash pre-established schedule; choice of 2 yrs (large haircut) or 8 yrs (3 yrs grace, smaller haircut); NPV: 3.4; Max/Min ~1.0
  - Lithuania (1997): 9.2 (in 1996); cash semi-discretionary schedule linked to privatization proceeds with annual cap; 10 years; NPV: 5.4; Max/Min 2.1 / 0.0
  - Macedonia (1999): 17.5 (in 1999); cash (small deposits) and bonds (10 yr maturity; 2 yr grace; 2 percent interest; exchangeable for land or public assets at face value); 12 years; NPV: 10.1; Max/Min 1.25 / 0.35
  - Moldova (1996-1998): Max 11.0 (in 1996); netting against tax arrears; triangular netting with public enterprises; in-kind; ongoing unresolved; NPV unclear; Max/Min 10.7 / 8.3
  - Russia (1996-1998): Max 6.9 (in 1998); netting against tax arrears; triangular netting; notes redeemable against tax payments; in-kind; ongoing unresolved; NPV 3.4 / 1.7
  - Serbia (2001): 29.2 (in 2001); cash for small deposits and bonds with 1-16 yr maturity, 3 yr grace, 2 percent interest, redeemable against social expenditures at a discount and useable in land/privatization deals; cash (4 yrs, 1998-2002) and bonds (16 yrs, 2001-16); NPV 11.5 (minimum); Max/Min 1.2 / 0.6
  - Ukraine (1996/ongoing): 161.1 (in 1996); discretionary annual cash payments (initial age-linked schedule rejected by courts); triangular netting with public enterprises; undefined overall; netting limited to 2005-06; NPV 3.5 total (through 2007); netting sub-total 0.4 (through 2007); Max/Min 0.4 / 0.1
- Practical design considerations highlighted:
  - In large settlements, write-downs in NPV terms were sometimes significant when fiscal space was limited.
  - Netting and triangular netting were used in several cases to reduce cash outlays and leverage tax/payment offsets.
  - Armenia/Serbia example: bonds structured to limit debt service to no more than 1 percent of GDP in any one year (Table 3 illustrates detailed conversion factors and resulting percent-of-GDP debt service paths for Serbian settlement).

### Macroeconomic stability: channels and model illustration
- Key channels through which a settlement affects macro stability:
  - Wealth effect of the debt shock:
    - If consumers are fully Ricardian, they would save to offset higher future taxes; evidence suggests non-Ricardian behavior and liquidity constraints make a positive wealth effect and demand stimulus likely.
  - Policy response to rising demand:
    - Government fiscal adjustments (taxes or reduced spending) can offset demand stimulus.
    - Central bank policy can offset demand effects through interest rate and exchange rate adjustments, subject to the monetary policy framework (e.g., a peg with free capital movement can draw in foreign resources and amplify demand if not sterilized).
  - Cyclical position:
    - Near-capacity economies: demand shock raises inflation, deteriorates current account, and raises nominal and real interest rates.
    - Economies below capacity: demand shock may raise output with less inflationary pressure.
- Empirical limitations:
  - Few cases, diverse settlement approaches, and many confounding shocks make empirical isolation of settlement effects difficult.
  - Limited variation in policy regimes (especially exchange rate regimes) constrains empirical inference.
- Model-based illustration:
  - The IMF’s GIMF (Global Integrated Monetary Fiscal Model) is used to illustrate macroeconomic considerations, calibrated to a steady-state baseline with shocks evaluated relative to that baseline (see Box 2 for model overview; full description in Kumhof and Laxton (2007)).

### Governance and administrative/technical design issues (high level)
- Technical design choices (administration, staging, repayment technique) materially affect fiscal and macro outcomes:
  - Administrative arrangements determine feasibility and verification (e.g., verification exercises reduced Bosnia’s initial estimate).
  - Staging: upfront securitization versus phased cash schedules have different fiscal and macro profiles.
  - Repayment instruments: cash, bonds, netting, in-kind, and exchangeable instruments alter NPV, rollover risk, and liquidity consequences.

_Italic: Source — IMF working paper chapter “1. Recent European Cases of Large Off-Balance Sheet Liabilities” (extracted content)._

### Box 2. The Global Monetary and Fiscal Model 1/

### Box 2. The Global Monetary and Fiscal Model 1/

### Microeconomic foundations
- Optimizing forward-looking firms and consumers.
- Nominal rigidities (prices (cascading); wages; plus pricing to market).
- Real rigidities (habit persistence; investment and import adjustment costs).

### Detailed Production structure
- Tradable and non-tradable sectors.
- Raw materials, intermediate goods, and final goods.
- Intra-industry trade across economies.
- Endogenous labor and capital supply.

### Non-Ricardian features
- Multiple (4) distortionary taxes, plus productive investment.
- Liquidity constrained agents without access to financial markets.
- Life-cycle income patterns.
- OLG agents with finite lifetimes and high subjective discount rates.

### Monetary and fiscal policy reaction functions
- Monetary and fiscal policy reaction functions are included. 1/  
- 1/ See Kumhof and Laxton (2007) for full details.

### Calibration and application to a “home” country (Ukraine)
- For the purposes of this paper, the home country in the model is calibrated to resemble Ukraine, on its post-2002 balanced growth path.
- Key calibrated characteristics: net energy imports; a high share of trade and size of government; a low deficit and public debt; a moderately high level of net foreign liabilities; a moderate current account deficit; and a interest rate risk premium of 300-350 basis points.
- Moderate inflation is assumed under a fixed exchange rate, with fiscal policy targeting the headline deficit.
- Ratios are drawn from the two most recent years of data, with adjustments to capture the underlying current account balance and fiscal deficit (consistent with IMF 2008).
- Structural parameters are drawn from the literature on the Czech Republic (Laxton and Pesenti, 2003; Allard and Muñoz, 2008); and Western Europe/the U.S. (Bayoumi, Laxton and Pesenti, 2004; Everaert and Schule, 2006; Kumhof and Laxton, 2007). See Appendix I for details of the calibration.
- Note: Ukraine is not in a steady state at present, as a credit boom and fiscal expansion have created a positive output gap, high and rising inflation, and a growing current account deficit. If Ukraine soon returns to a balanced growth path (at the underlying ratios used), the results that follow could be seen as having predictive content.6

*Source: Box 2 text from _wp08159 - Box 2. The Global Monetary and Fiscal Model 1/_*

### Section IV below discusses the specific application to Ukraine in more detail.

### _wp08159 - Section IV below discusses the specific application to Ukraine in more detail.

### GIMF simulation results: macroeconomic impacts of a large upfront settlement
- A large upfront settlement (10 percent of GDP) would have considerable macroeconomic impacts:
  - Much of the settlement would be spent, leading to a significant increase in inflation (especially for domestic goods, less so for final output and GDP deflator inflation).
  - The real exchange rate would appreciate moderately.
  - The current account deficit would rise sharply to satisfy excess demand.
  - In the medium-term, inflation must undershoot the baseline to restore the real exchange rate under the peg, leading to an increase in the real interest rate, which would crowd out investment and lower real GDP relative to the baseline.

### Sensitivity to behavioral and price-adjustment assumptions
- Results are sensitive to non-Ricardian features and price adjustment costs:
  - With a smaller proportion of liquidity constrained agents:
    - Impact on overall consumption would be somewhat less.
    - Corresponding reductions in inflationary impact, current account impact, and output impact.
  - With smaller price adjustment costs:
    - The inflationary impact is considerably larger.

### Policy offsets and staging to reduce macro impacts
- Counter-cyclical fiscal policy reduces macroeconomic impacts significantly:
  - Under a deficit target, the shock is amplified as the burst of additional consumption raises taxes and, therefore, spending.
  - If fiscal policy is geared to save excess revenues, second-round impacts are greatly diminished:
    - The total consumption response drops by about one-quarter.
    - Similar reductions occur for inflation and deterioration of the current account.
- Spreading the settlement over time significantly reduces macroeconomic impacts:
  - When payments are staggered over 5 years:
    - Consumption response by non-liquidity constrained agents is the same, but liquidity constrained agents’ consumption increase becomes much lower in any given year.
    - Overall consumption rises much less, with diminished effects on inflation and the current account.
  - Caveat: a spread-out settlement that is too deterministic about future payments could allow recipients to borrow against them, especially where financial markets and consumer lending are well-developed; the liquidity constraint may disappear and impacts could resemble those of an upfront securitization.
- Combining offsets:
  - With phasing, a counter-cyclical fiscal response, and a flexible exchange rate (freeing monetary policy), the inflationary impact of even a large settlement can largely be contained.
  - A sharper increase in the nominal and real interest rate, as the central bank responds to rising inflation projections for 1 year out, dampens investment, GDP and labor income, containing the consumption shock and inflation.

### Empirical case study evidence on timing and macro conjuncture
- The approach taken in case study countries on staging of settlements aligns broadly with GIMF findings: Large upfront settlements have been a minority and generally undertaken at a more favorable macroeconomic conjuncture.
- Table 4: Debt Settlement Timing and Macroeconomic Conjuncture (country / Year / Type / Inflation / Growth / CA deficit)
  - Bosnia 2004 Up-front 0.3 6.3 -16.3
  - Croatia 2006 Up-front 3.2 4.8 -7.7
  - Lithuania 1997 Spread 10.3 8.5 -7.9
  - Macedonia 2000 Up-front 6.4 4.5 -1.9
  - Moldova 1997 Spread 11.8 1.6 -14.2
  - Russia 1997 Spread 14.8 1.4 0.0
  - Serbia 2001 Up-front 91.8 4.8 -2.4
  - Ukraine 1996 Spread 80.2 -10.0 -2.7
  - Memorandum items (Median)
    - Up-front 4.8 4.8 -5.1
    - Spread 13.3 1.5 -5.3
- Case evidence on timing:
  - Lithuania used phasing and some discretion to postpone cash payouts when external circumstances deteriorated in 2000-01.
  - Ukraine (1996) set no time limit for redeeming recognized liabilities and no annual guidance; payments fell below macro-fiscal capacity in 2003-04, leading to pressures for a new solution at a less attractive macroeconomic conjuncture.

### Country-level measures and other approaches to mitigate impacts
- Measures adopted in case studies to reduce macro impacts and risks:
  - Creating incentives to save cash payouts:
    - Lithuania created a new class of small-denomination government savings bonds and offered above-market interest rates to claimants if they maintained their (now-unfrozen) bank account.
  - Penalties for selling newly issued securities as a disincentive to spending:
    - Rediscount restrictions on securities issued would reduce the sale price and be effective unless close substitutes for “restitution” bonds exist in banks’ portfolios.

### Administration: operational and legal design considerations
- Key administrative challenges and strategies:
  - Verification and stock-taking of claims:
    - Verification protects against fraudulent claims; example: in Bosnia verification reduced amounts outstanding by 6½ percent of GDP.
    - Involving independent bodies (e.g., bank auditors, supreme audit institutions) and private sector accounting/auditing firms where capacity is insufficient.
  - Prioritization of claims—within limits:
    - Majority of claims often represent a small share of total outstanding debt; settling small claims upfront and in cash can reduce administrative costs (Macedonia and Serbia).
    - Preferential treatment (elderly, disabled, students) used in Lithuania, Serbia, Ukraine, but raises administrative costs and potential legal challenges (Ukraine’s constitutional court rejected an age-based criterion).
  - Transparency:
    - Auditing and public disclosure of payments and receipts to prevent abuse; lack of transparency contributed to concerns in netting transactions in Russia, Ukraine, Moldova in the late 1990s.
  - Voluntary settlement:
    - Requiring claimants to take action to receive settlement reduces legal risk; time limits can close the books on hard-to-trace claimants; negotiating with umbrella claimant organizations can improve acceptance (Croatia).
  - Moratorium legislation:
    - Used to freeze claims until budget resources are identified to prevent seizure of government assets or successful lawsuits from disrupting outcomes (Bosnia, Ukraine).

### Staging of settlements: trade-offs between upfront and spread-out approaches
- Spread-out flexible settlements: benefits
  - Do not lock fiscal authorities into potentially fiscally unsustainable settlements: staggered approach with discretion allows altering NPV ex-post by shifting time profile of payouts.
  - Help manage macro impacts and shocks by reducing fiscal stimulus in any one year; useful where capacity to implement policy is weak.
  - Lithuania (1997) used phasing effectively; when external environment worsened in 2000-01, it postponed cash payouts targeted to be completed in 10 years but not specified annually.
- Upfront settlements: benefits and risks
  - Achieve rapid closure; once implemented, the issue can be ended quickly.
  - Useful when closure (time consistency) is critical.
  - Can be leveraged for immediate financial market development (Serbia securitized claims into bonds with maturities 1–16 years to provide liquidity along the yield curve), but may contribute to euroization if bonds are fx-denominated.
- Summary guidance:
  - Neither approach dominates.
  - Upfront settlement generally preferred when:
    - (i) macro and fiscal risks are well contained;
    - (ii) there are financial market development needs;
    - (iii) achieving closure (time consistency) is a pressing concern.

### Settlement techniques: cash, securitization, netting, and in-kind
- Cash repayment and securitization:
  - Offer flexibility, ease of administration, transparency.
  - Provide the greatest improvement in claimant welfare; securitization can spur financial market development.
  - Cases of successful settlement have typically used these approaches.
- In-kind payments:
  - Impose high administration costs, lack transparency (valuation problems), and create fiscal side-effects by reducing cash revenue receipts.
  - Encourage barter, were judged highly negative for growth, and improve claimant welfare the least.
  - Country experience indicates in-kind payments should always be avoided.
- Netting (mutual debt settlements):
  - Carry heavy risks and should only be used under very specific circumstances.
  - Problems observed:
    - Lack of transparency and rampant valuation problems (CIS experience).
    - High administrative cost when netting involves chains of obligations.
    - Disintermediation of the economy and distortion of price signals, undermining macroeconomic performance.
    - Considerable moral hazard: taught agents to generate arrears to obtain quick settlement; introduced entrenched macro-fiscal costs.
  - Netting may be appropriate only if the government can credibly commit to a one-off transaction and can control valuation abuse.

*Source: IMF staff estimates and case study synthesis as presented in the source document.*

### Box 3. Mutual Debt Settlements (Netting) in the CIS

### Box 3. Mutual Debt Settlements (Netting) in the CIS

### Description and mechanism
- Mutual debt settlement (netting) allows claimants to offset their claims against the government with current obligations to the government (tax liabilities or payments to state enterprises such as public utilities).
- Netting can create a persistent incentive: claimants learn that withholding current payments is a way to realize remaining claims, encouraging future noncompliance.

### Evidence from Russia and Ukraine
- Russia:
  - Arrears did not decline over time despite netting and rebounded very rapidly after netting rounds.
  - The situation only improved once the underlying liquidity strains preceding Russia’s debt default disappeared.
- Ukraine:
  - Figure evidence indicates declines in utility payment compliance consequent on Ukraine’s public utility netting scheme.
  - The government commenced a verification exercise and set aside up to 2¼ percent of GDP in funds in the 2008 budget for initial cash payments (including amounts financed by an earmark related to privatization proceeds in excess of the budget target).
  - The plan includes a triangular netting exercise involving communal service payment arrears and local utility companies’ tax arrears to the government.

### Fiscal and macroeconomic consequences of entrenched netting
- When netting becomes entrenched:
  - Fiscal sustainability comes into question.
  - Fiscal management is complicated as the budget loses the cash needed to pay debt service, wages and pensions.
  - If operations are large enough, the monetary and price system can begin to collapse, with extremely negative consequences for structural adjustment and growth.
- Privatization-linked settlements can reach the scale of 5 percent of annual GDP in some countries, creating sterilization burdens.

### Use of public assets in settlements (key observations)
- Many countries linked debt settlements to asset sales (privatization), either directly or indirectly.
- Motivations:
  - Political economy: earmarks can build public support for privatization by creating the appearance that citizens directly benefit in proportion to their claims.
  - Financing: governments may prefer asset sales to debt issuance to retain financial flexibility and avoid rigid servicing requirements.
- Macro-fiscal disadvantages and risks:
  - Earmarks reduce budgetary flexibility and may subvert higher priorities.
  - Large privatization inflows under a peg can inject liquidity into the economy, requiring sterilization—manageable for small amounts but burdensome for large inflows (privatization has reached 5 percent of annual GDP in some cases).
  - Direct debt-asset exchanges can suffer valuation problems and be associated with government losses (e.g., loans-for-shares-type problems).
  - Voucher-type exchanges can produce dispersed ownership and corporate governance problems.

### Ukraine application — technical design considerations
- Verification and prioritization:
  - Full verification and some prioritization would reduce administrative burdens given long passage of time, inheritance of claims, and changes in identification documents.
  - Initial focus recommended on eliminating large numbers of de minimis claims to reduce administrative burden.
- Netting reconsideration and transparency:
  - The netting exercise should be reconsidered in light of fiscal risks; an alternative is to withhold payment for those in arrears to the government.
  - If netting proceeds, netted claims should be audited and the government should compensate utilities on-budget for their costs.
- Privatization role:
  - Existing earmark against excess proceeds may accelerate privatization and create macro and fiscal risk, particularly if privatization transparency cannot be quickly improved.
  - If an earmark is used in 2009 and beyond, recommended design elements:
    - (i) Cap annual spending through this channel, perhaps at no more than 2 percent of GDP.
    - (ii) Eliminate the “excess” formulation of the earmark to focus on a transparent, feasible and well-paced annual privatization plan.

### Ukraine application — fiscal sustainability and macroeconomic stability
- Fiscal sustainability:
  - Public debt is only 10 percent of GDP in Ukraine and falling.
  - Debt is sustainable for debt shocks in the range of the existing liability, implying either upfront securitization or spread out cash repayment could work.
  - In securitization, feasibility of annual debt service requirements needs careful consideration (private sector debt rollover also relevant).
- Macroeconomic risks of a full upfront settlement:
  - IMF staff estimates indicate the Ukrainian economy is operating beyond capacity, with excess demand contributing to inflation and a rising current account deficit.
  - Many lost savings accounts likely belong to liquidity constrained pensioners (given the 16-17 year age of the claims), implying a substantial share of restitution could be spent.
  - Privatization proceeds are likely to come from abroad and, under Ukraine’s currency peg, could accommodate higher demand with money creation.
- Policy options to limit macroeconomic concerns:
  - Spread out the settlement over several years; given significant 2008 payouts and high and rising inflation, further 2008 payouts could be halted but a time limit (perhaps 5 years) is needed.
  - Move to a countercyclical fiscal rule to offset second-round effects of the shock.
  - Use the room available under the planned gradual transition to a flexible exchange rate to tighten monetary conditions and lean against residual inflationary pressures.
- Securitization within a multi-year framework:
  - Continue small annual budget payments and opportunistically securitize remaining claims when macro conditions are favorable (modeled on the Serbian experience).

### Conclusions and policy implications
- Key objectives when addressing a large contingent or off-balance-sheet fiscal liability:
  - Preserve fiscal sustainability and macro stability.
  - Minimize administrative burdens and legal risks.
- Fiscal sustainability considerations:
  - Assess appropriate post-settlement level and structure of government debt using reasonable assumptions about primary revenue, spending, real interest rates, and growth.
  - NPV write downs may be needed; avoid bunched maturities in debt structure.
- Macroeconomic stability considerations:
  - Account for cyclical position and structure of the economy, wealth effects from the settlement (share of liquidity constrained consumers), settlement design (including staging), and fiscal/monetary policy response.
  - GIMF simulations calibrated to Ukraine show impacts on inflation and the current account can range from alarming to moderate depending on these factors.
- Administrative and legal risk management:
  - Verify and prioritize claims; ensure transparency and careful audit.
  - Non-cash settlement techniques: securitization can promote financial market development; other methods (in-kind payments, tax or public enterprise receivable offsets, asset swaps) bring high risks.
  - Indirect use of asset sales may have benefits but requires careful formulation.
- Specific advice for Ukraine:
  - Spread out restitution (without ruling out later securitization).
  - Avoid netting where possible.
  - Be cautious about over-accelerating privatization to fund an earmark.
  - Carefully audit the settlement.

*Source: Country authorities, and Fund staff estimates.*

### 26.5 percent of GDP; 12 year completion)

### _wp08159 - 26.5 percent of GDP; 12 year completion)

### Proposed permanent settlements and political outcomes
- Proposal: Permanent settlement in cash, with payments scaled to past and projected GDP; NPV of 16 percent of GDP; 12 year completion.
  - Outcome: Vetoed by the President.
  - Timing noted: 2005-06; associated with a 2005 pre-election period mention.
- Alternative entry: "26.5 percent of GDP; 12 year completion" — also noted as vetoed by the President (timing: 2005 pre-election period).

### Triangular netting scheme (public utility arrears and utility companies’ tax arrears)
- Implementation details: Triangular netting scheme involving public utility arrears, and utility companies’ tax arrears.
- Outcome: 0.4 percent of GDP in debt cleared, but no permanent reduction in utility arrears or utility companies’ tax arrears.
- Timing: 1997-2007.

### Small annual cash payments and economic growth scenario
- Mechanism: Small annual cash payments combined with a large increase in size of economy (plus small netting transactions).
- Outcome: Liability shrinks dramatically. Recorded figure: 17.9 (context implies percent of GDP).

### 2008 government commitment and early payments
- Executive commitment: Prime Minister promises full clearance and puts Hrv 20 billion (2.1 percent of GDP) in budget for this purpose, of which Hrv 14 billion contingent on privatization proceeds.
- Implementation notes:
  - Verification ongoing.
  - In January, Hrv 1.3 billion paid out (0.15 percent of GDP).
- Source attribution within text: Source: Ukrainian news media.

### Key numerical items preserved exactly
- "26.5 percent of GDP; 12 year completion"
- "NPV of 16 percent of GDP; 12 year completion"
- "0.4 percent of GDP in debt cleared"
- "1997-2007"
- "Liability shrinks dramatically. 17.9"
- "2008"
- "Hrv 20 billion (2.1 percent of GDP)"
- "Hrv 14 billion"
- "Hrv 1.3 billion paid out (0.15 percent of GDP)"
- "2005 pre-election period"
- "2005-06"

*Source: Ukrainian news media.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2008/_wp08159.pdf_