Loan Guarantees and
Re-Lending
9.1 SUMMARY
There is increasing international focus on government guarantees, e.g. under the auspices of the IMF, the World Bank and the OECD. Prompted by the international work in the field of guarantees, the Ministry of Finance and Government Debt Management cooperate on reviewing the Danish model of loan guarantees and re-lending.[1] Government Debt Management, acting on behalf of the Ministry of Finance, manages most of the government-guaranteed loans and re-lending.
Government loan guarantees and re-lending are rooted in the political intention to support the financing of certain projects. In Denmark the major part of government loan guarantees and re-lending is issued to government-owned companies involved in large infrastructure projects.
By issuing a loan guarantee, the government guarantees that the lenders do not incur losses on their loans to the companies. In the case of government re-lending, the companies raise loans directly from the government. Both options entail lower financing costs than for non-guaranteed private borrowing. This is to the government's advantage in view of its ownership of the companies, but, at the same time, it often reflects a correspondingly higher risk.
Loan guarantees and re-lending expose governments to potential future losses and consequential budget deterioration. Focus of the international work in the field of guarantees and re-lending is therefore on their treatment in relation to government budgets and debt, as well as on how they are handled in relation to government risk management.
This chapter describes loan guarantees and re-lending; outlines a series of key recommendations from the IMF, the World Bank and the OECD; and rounds off by presenting a review of Danish practice.
9.2 LOAN GUARANTEES AND RE-LENDING IN BRIEF
Many countries use government loan guarantees and re-lending based on the political intention to support financing of certain projects. Large infrastructure projects are typical examples.
Under a government loan guarantee, the government guarantees that the repayments on the company's loans are met. Should the company default on a guaranteed loan, the company's obligations to the lender are transferred to the government. All other things being equal, this increases the government debt.
In the case of government re-lending, the company raises a loan directly from the government. The government finances the re-lending through government borrowing and pays the required proceeds to the company, which hereafter pays interest and redemptions to the government. Re-lending is a government asset that is set off by a government liability, i.e. higher debt. Should the company default on its re-lending obligations, this is equivalent to writing down the value of the government asset, while the government still holds the liability.
Government guarantees and re-lending in a similar way expose the government to a potential loss due to the credit risk on the companies' loans, and therefore cannot be considered free of charge. On the other hand, by utilising a high credit rating, loan guarantees and re-lending can reduce the companies' financing costs.
Borrowing under a government guarantee is de facto equivalent to borrowing in the government's name. When a bank determines the interest rate on a loan to a government-guaranteed company, the key aspect is the credit standing of the government rather than the company in question. In view of the guarantee, the company can typically achieve a lower interest rate in the private market than it would otherwise have achieved. All other things being equal, the interest rate will reflect the government's own borrowing rate. However, large issues mean that government issuers often achieve a liquidity premium that is not to the same extent available to the companies.
Through re-lending, the companies may similarly reduce their borrowing costs if the re-lending rate, i.e. the rate payable by the companies to the government, reflects the interest rate on the underlying government bond issues.
Box 9.1 describes the credit risk and the expected guarantee and re-lending costs.
|
COST SAVINGS AND RISKS RELATED TO LOAN GUARANTEES AND RE-LENDING
|
Box 9.1
|
|
For illustrative purposes, a borrowing rate, r, may be divided into three elements: 1) the risk-free interest rate, rrf, 2) a premium, rel, equivalent to the expected loss and 3) a risk premium, rrp, reflecting an additional premium required by the market for assuming the credit risk. That is:
The risk-free interest rate, rrf, is the interest rate on a loan with no credit risk. The premium, rel, reflects the expected loss (in a statistical sense) resulting from the borrower's possible default on the loan. In addition to rrf and rel, a risk-adverse lender will demand compensation, rrp, for the possibility that the actual loss may exceed the expected loss. Assume, for example, that a lender grants a company a loan of DKK 100. With a probability of 60 per cent, the company will be able to repay the loan in full, and with a probability of 40 per cent, the company will be able to repay only DKK 80. For the purpose of simplification, it is assumed that the company can always pay the interest. The expected loss on the loan is calculated as DKK 100-(0.6*DKK 100+0.4*DKK 80)= DKK 8. The expected repayment is thus DKK 100 -DKK 8=DKK 92. rel is determined by setting the lender's expected return on lending at the risk-free interest rate equal to the expected return on the risky investment. If the risk-free interest rate is 5 per cent, rel is then around 9 per cent:
In this case, a risk-neutral lender will charge an interest rate totalling r=5 per cent +9.13 per cent =14.13 per cent on loans to the company. However, the lender will never receive DKK 92 in repayment on the loan. The borrower either repays DKK 100 or DKK 80. Only if the lender has a large portfolio of similar loans, will he be repaid DKK 92 on average. The possibility of the lender receiving a lower return than expected will, for a risk-adverse lender, be reflected in the collection of a risk premium, rrp. The size depends on the risk aversion of the investors. If the government guarantees the company's borrowing, the company will, all other things being equal, be able to raise loans at the government borrowing rate. For a central government with a very high rating, such as the Danish central government, this will be approximately equivalent to the risk-free interest rate, rrf. A loan guarantee thus reduces the company's borrowing costs because the lender does not require compensation for the credit risk in the form of rel and rrp. In practice, the company's borrowing costs under a government guarantee are not necessarily equivalent to the government's own borrowing rate. The government achieves a liquidity premium by issuing large series that are traded actively on e.g. international electronic trading platforms. All other things being equal, investors are willing to pay a premium for a high turnover rate, and this helps to reduce borrowing costs. The companies cannot achieve a similar liquidity premium. By guaranteeing the company's borrowing, the government assumes an increased risk. In the example, the government's expected loss on issuing a loan guarantee is DKK 8. The companies' interest costs on re-lending are reduced if the re-lending rate reflects the government's own borrowing rate. On the other hand, the government is exposed to a potential loss. The expected loss on re-lending of DKK 100 to the company in the above example is DKK 8 – the same as for loan guarantees. |
|
9.3 INTERNATIONAL FOCUS ON GUARANTEES – BEST PRACTICE
Government guarantees have been the cause of major financial losses for a number of governments, highlighting that traditional debt figures do not always give a true and fair view of governments' actual financial obligations. Against this background, there is increasing international focus on the treatment of guarantees, and rating agencies increasingly take account of guarantees in their government credit ratings.
The IMF, the World Bank and the OECD have formulated best practice principles for handling government guarantees.[2] Some of the key recommendations are presented in Box 9.2. The point of departure is that the issue of government guarantees exposes governments to potential future budgetary losses. Therefore, two key areas of the recommendations are the treatment of guarantees in relation to government budget and debt compilation, and the handling of guarantees in relation to government risk management.
|
GUARANTEES – BEST PRACTICE
|
Box 9.2
|
|
In the publication Guidelines for Public Debt Management1, the IMF and the World Bank have listed recommendations for handling contingent liabilities, including guarantees. Contingent liabilities are obligations determined by the occurrence of uncertain future events, for instance bankruptcy. Overall, these liabilities may be divided into explicit and implicit liabilities. Explicit liabilities are defined by acts or legally binding contracts, while implicit liabilities are political or moral obligations. Loan guarantees are typical examples of explicit contingent liabilities. Economic aid provided by governments in case of natural disasters is an example of an implicit contingent liability. The messages of the IMF and the World Bank include the following:
OECD recommendations related to guarantees are described in the report Advances in Risk Management of Government Debt2. They include the following:
|
|
| 1 Guidelines for Public Debt Management is available at http://treasury.worldbank.org. 2 Forthcoming (2005). |
|
Debt compilation and budgetary treatment
Guarantees are not usually included in government budgets until they take effect and entail payments from the government to the beneficiary of the guarantee. The IMF and the World Bank, along with the OECD, point out that an estimate of the government's expected guarantee costs may be included in the budget process at the time that the decision to grant the guarantee is made. This can ensure that the political decision to issue a guarantee may be compared to other decisions regarding direct use of budgetary resources. This prevents that the issue of a guarantee may seem politically advantageous solely because the guarantee does not immediately strain the budget.
Budget funds may also be allocated to meet potential future obligations under government guarantees and to enhance transparency. The estimated cost may, for instance, be transferred to a guarantee fund.
Expected losses on loan guarantees are often difficult to estimate. This applies, for example, to government loan guarantees issued to government-owned companies set up for specific purposes and having no private-sector counterpart. In these cases there may be no performance history on which to base a risk assessment. However, the government's expected losses and risk may – with varying degrees of uncertainty – often be estimated using quantitative and qualitative assessments.
Where it is not possible to deduce an estimate of the expected losses, the IMF and the World Bank emphasise that the information available on risk and costs may be listed in notes to the budget or the government accounts.
Sweden and the USA are two of the few countries in which potential guarantee costs – and in the case of the USA also re-lending costs – are included in the budget, cf. Box 9.3.
|
HANDLING OF GOVERNMENT GUARANTEES IN THE USA AND SWEDEN
|
Box 9.3
|
|
USA1
Sweden2 The issue of guarantees for specific projects or companies is normally managed by Riksgäldskontoret. The tasks of Riksgäldskontoret include determination of the size of the guarantee fee. |
|
| 1 U.S. Office of Management and Budget, Task Force on the Harmonization of the Public Sector Accounting (TFHPSA). "Direct Loans and Loan Guarantees: Controlling 'Off-Budget' Expenditures in the United States". The document is available at www.imf.org/external/np/sta/tfhpsa. 2 The Swedish National Debt Office, Central Government Borrowing: Forecast and Analysis, 2003:2, State guarantees – proposals for an even better rule system.The publication is available at www.rgk.se. |
|
Guarantees are rarely included in the compilations of government debt. Best practice implies that the guarantees are, as a minimum, published at regular intervals as a supplement to the conventional debt statements.
Risk management and the role of government debt management offices
All other things being equal, the release of a guarantee will cause the government budget to deteriorate and increase government debt. The OECD, along with the IMF and the World Bank, highlights the importance of the availability of information to the government debt management offices on the expected payments under government guarantees. This will enable the borrowing and risk management of the government debt portfolio to be planned accordingly.
If the government guarantee portfolio gives rise to unacceptable risk, the government debt management office may adjust the government's risk exposure via adjustments to the government debt portfolio. The risk on loan guarantees depends on the credit quality of the underlying loans and it is difficult to directly adjust the government's exposure to credit risk. On the other hand, the market risk on government debt portfolios may typically be adjusted quickly, e.g. by changing the interest-rate or currency exposure, thereby affecting the government's overall risk. As highlighted by the OECD, government debt management offices may thus contribute to a consolidated management of government risk.
9.4 REVIEW OF THE DANISH LOAN GUARANTEE AND RE-LENDINGMODEL
In the light of the international work in the field of government guarantees, the Ministry of Finance and Government Debt Management at Danmarks Nationalbank cooperate on reviewing the Danish model, which is outlined below.
The portfolios in brief
Government Debt Management manages the largest part of the Danish government's loan guarantees and re-lending. Most government guarantees and re-lending relate to large infrastructure projects. The largest guarantee recipients are the companies behind the Great Belt and Øresund bridges. Most re-lending is issued to Ørestadsselskabet I/S (the Ørestad Development Corporation), which is e.g. responsible for establishing and running the metro.
At end-2004, Government Debt Management managed guarantees totalling DKK 82.4 billion, cf. Table 9.4.1.
| GOVERNMENT LOAN GUARANTEES |
Table 9.4.1
|
| DKK billion |
End-2004
|
| Hypotekbanken |
2.7
|
| A/S Storebælt |
37.9
|
| A/S Øresund |
6.6
|
| Øresundsbron |
22.5
|
| DSB and DSB S-tog A/S |
10.1
|
| Danmarks Radio |
2.5
|
| Total |
82.4
|
| Note: The debt of Øresundsbron (Øresund Bridge) is jointly guaranteed by the Danish and Swedish governments. | |
Government Debt Management issues the guarantees on behalf of the relevant ministries and contributes to establishing overall guidelines for the companies' borrowing, etc.
At the close of 2004, outstanding re-lending totalled DKK 19.1 billion, cf. Table 9.4.2.
| RE-LENDING, NOMINAL VALUE |
Table 9.4.2
|
| DKK billion |
End-2004
|
| A/S Storebælt |
1.0
|
| A/S Øresund |
3.9
|
| Ørestadsselskabet I/S1 |
13.6
|
| Danish Ship Finance2 |
0.5
|
| Total |
19.1
|
| 1 No government guarantees are provided for the borrowing of Ørestad Development Corporation as this is a partnership with the Danish government as co-owner. 2 Re-lending issued to Danish Ship Finance are converted into DKK at the USD exchange rate as of 30 December 2004 (DKK 546.76 per USD 100). |
|
Most government re-lending precisely reflects existing government securities, meaning that coupons, interest-payment dates and redemption dates match the characteristics of underlying government securities. The government securities eligible for re-lending are established in a re-lending list comprising all fixed-rate government bonds that are bullet loans in Danish kroner in the 2- to 10-year maturity segments. The price is determined on the basis of the market conditions when the loan is raised.
Danish Ship Finance may raise serial loans in kroner and US dollars. These loans do not reflect existing government securities. The interest rate on the serial loans is, however, based on the zero-coupon yield curve for government securities and, as such, reflects the government loan terms.[3].
Government-owned companies
Government loan guarantees and re-lending are mostly granted to government-owned companies. In view of the government's ownership of these companies, it is, all other things being equal, to the government's advantage that these companies have access to inexpensive financing. Lower financing costs improve these companies' bottom lines, which also benefits the government in its capacity as owner. However, less expensive financing via loan guarantees and, in certain cases, re-lending does also reflect increases in the government risk exposure.
The companies' loan savings and the government risk depend on the companies' legal structure. Most of the re-lending is to Ørestadsselskabet I/S, a partnership with the government as co-partner. Under this legal structure, the government is already a debtor in relation to the company's borrowing. The difference between the company's borrowing costs via re-lending and via the private borrowing market will therefore be limited. Moreover, the government does not assume an additional risk through re-lending relative to allowing the company to borrow in the private market.
As far as government-owned limited-liability companies are concerned – in which the government's risk is, in principle, limited to the equity contribution – the government's risk in connection with loan guarantees and re-lending is increased to include the credit risk on the debt. This enables the companies to save the interest premium on the government borrowing rate that would have been payable to private banks for non-guaranteed loans. This interest premium reflects the expected loss on the loan as well as a risk premium, cf. Box 9.1. The government's immediate financial gain – via the ownership – from cheap funding of the companies therefore reflects expected future additional costs related to the credit risk.
Even though the government's expected loss on loan guarantees and re-lending is set off by higher profit transfers from the companies, this does not mean that the government is better prepared to meet future losses. That would require either that budget funds be allocated or that the increased profit transfers from the companies be reflected in a budget improvement.
Government budget and debt compilation
An overview of the Danish government's loan guarantees, re-lending, etc., is provided in the notes to the government accounts. The notes disclose information on nominal outstanding amounts that are the maximum hypothetical loss that the government may incur as a result of these exposures. The annual publication Danish Government Borrowing and Debt also provides information on the government's loan guarantees and re-lending managed by Government Debt Management.
Companies that are eligible to borrow with government guarantees or to obtain re-lending in principle pay a commission fee of 0.15 per cent of the borrowed amount. This commission is stated as revenue in the government budget in line with any profit transfers from the companies to the government. On the expenditure side no estimates are budgeted for the expected government expenditure as a result of the credit risk.
On re-lending and loan guarantees, issuance of the government's CIL (current, investment and lending) balance is not affected. In contrast to loan guarantees, re-lending does have an impact on the central-government debt and the EMU debt. Re-lending is financed via increased government bond issues, which increases the debt. The government achieves an asset through re-lending that is not set off against debt. Given that the government's risk is the same whether re-lending or loan guarantees are involved, this does not provide any economic justification for preferring loan guarantees to re-lending.
Risk management
Due to the financial risks incurred by the government on issuing guarantees, the government lays down the overall guidelines for the government-guaranteed companies' activity in the loan markets. The risks to which the government is exposed via the companies' own borrowing are equivalent to the risks incurred by the government when it borrows in its own name. The guidelines are therefore designed to ensure that the government-guaranteed companies do not in their borrowing and other financial transactions assume risks that the central government would not assume directly. To this end, Government Debt Management prepares and maintains a list of acceptable loan types. In addition, the government-guaranteed companies must provide ongoing information on their borrowing, and meetings are held at regular intervals between the companies, the Ministry of Finance and Government Debt Management. The companies' boards of directors and management are, however, responsible for the companies' financial transactions, risk management, etc.
Establishing the interest-rate exposure on the central-government debt is a key element in Government Debt Management's risk management. Each year, a strategic benchmark is determined for the duration of the government debt which is a summary measure of the trade-off between interest costs and risk. The duration target is established on the basis of long-term analyses. In these analyses, the re-lending portfolio is set off as an asset against the liabilities in order to achieve a consolidated risk analysis.
The Ministry of Finance's estimate of budgetary developments is part of the analysis, given that the budget is crucial to debt and interest cost developments. Losses on loan guarantees and the re-lending portfolio result in budget deteriorations. Therefore, estimates of credit losses on loan guarantees and re-lending could, in principle, be included in the budget estimates, and thus in the determination of the government's interest-rate exposure. On the other hand, arguments can be presented for also including estimates of e.g. extraordinarily high profits from the government-owned companies. The potential impact on the government debt of credit losses on guarantees and re-lending forms part of the analysis on an ad hoc basis in line with other elements of budget uncertainty. This is achieved by performing stress tests on the budget in order to analyse interest-rate risk and the development in debt, subject to assumptions of various negative shocks to the budget.
Loan guarantees versus re-lending
From an overall perspective, loan guarantees and re-lending are equivalent in terms of objective, economic implications and government risk. In practice, however, there may be differences.
Use of re-lending rather than loan guarantees is supported by the government's falling borrowing requirement and intention to achieve liquid series. Re-lending increases the government's borrowing requirement and thereby sustains the possibility of building up liquid government series. By ensuring liquid series, the government achieves a liquidity premium that contributes to reducing its borrowing costs.
The government's liquidity premium on its own borrowing can be transferred to the government-owned companies. On account of the government ownership, this translates into government cost savings. Due to a limited borrowing requirement, the companies will not be able to achieve the same liquidity premium in their own government-guaranteed borrowing.
In principle, it is easier for the government to manage the companies' financial risks in the case of re-lending compared to allowing the companies to raise loans in the private market under loan guarantees. The companies' financial risks are, however, managed on the overall level by establishing a framework for the activities of the government-guaranteed companies in the financial market.
Besides, compared with loan guarantees, re-lending offers economies of scale in that the market access of Government Debt Management is made available to the companies. A limited range of borrowing opportunities under the re-lending facility may, however, entail that the companies' financial management may still require them to enter into financial transactions that do not form part of the government's re-lending facility.
[1] This Chapter is based on the cooperation between the Ministry of Finance and Government Debt Management.
[2] Best practice literature focuses mainly on guarantees. In practice, guarantees and re-lending are often treated differently in relation to e.g. government debt and budgets. However, the economic implications of guarantees and re-lending may overall be equated, so many of the arguments in the field of guarantees may also be applied to re-lending.
[3] Re-lending to Danish Ship Finance is described in Danish Government Borrowing and Debt, 2003, Chapter 10.