It’s time to redefine the concept of public debt

The hidden public debt is important for the sustainability of public finances, both in Poland and in the world. The latest financial crisis and expanding a scope of state responsibilities have contributed to the global increase in this type of debt.

The scope of the state’s activities has been expanding for many years. The growing size of the state apparatus is affecting public finances. The pace at which these changes are taking place is so fast that the vast majority of countries are currently running a public sector deficit. As a result, their debt levels are growing, which is accompanied by an increase in general fiscal risk.

Part of this phenomenon is also an increase in hidden (or potential) public debt. This is due to the fact that not all forms of public debt are classified as part of the State Treasury debt or even the so-called EDP debt (the debt of the general government sector). Not all of the processes that lead to an increase in the overall debt level are monitored. This means that the general debt ratio, as presented by finance ministries or central banks, should only be treated as an indicative measure.

According to Arkadiusz Kamiński, PhD, the director of the Public Debt Department at the Poland’s Finance Ministry, the global increase of hidden (potential) public debt was caused by the last financial crisis and by the universal access to the capital market which preceded the crisis. “Disregard for fiscal constraints led countries to ignore the principles of a balanced fiscal policy. This led to an increase of debt above a level resulting from the future tax base, or the possibilities of refinancing it in the future,” Mr. Kamiński wrote in his book “Potential public debt”.

Poland is not free from the threat of excessive debt, which is linked to the existence of the hidden debt. “Despite Poland’s honest debt management policies over the last 20 years, it is still balancing close to a debt-to-GDP ratio of 50 per cent, and taking into account the future liabilities and the persistent deficits, Poland is in the area of fiscal risk,” states Mr. Kamiński.

What constitutes potential public debt

According to Mr. Kamiński, the source of the potential debt is the assumed size of the projected liabilities in the public sector entities. The potential public debt has been growing in recent years. Following the financial crisis an attempt was made to move various types of risk beyond the scope of the public sector. Therefore, according to Mr. Kamiński, the potential debt may include, among others:

  • credit and export guarantees;
  • various financial guarantees (e.g. the retirement pension system);
  • the state’s liabilities in the area of healthcare;
  • government insurance programs (e.g. crop insurance);
  • the state’s liabilities in the event of various disasters;
  • the state’s liabilities in the area of infrastructure maintenance;
  • the public entities’ liability for the recapitalization of institutions that are too-big-to-fail.

All types of liabilities involve various types of risk. Professor Maciej Cieślukowski, the head of the Department of Public Finance at Poznań University of Economics and Business, points out that state guarantees may act as an incentive for state-owned enterprises to abuse the system (the so-called moral hazard phenomenon) — since the state has provided them with a guarantee. “In such a situation everything depends on the policy pursued by the state and the quality of the management staff at the state-owned enterprises,” emphasizes Prof. Cieślukowski.

Debt can also be “pushed out” from the public sector to the private sector, for example, through the creation of companies (owned by either the State Treasury or municipalities). This may have far-reaching consequences, not limited to the area of finances. “In such cases we have to ask whether the quality of the public services is not deteriorating, whether the prices of services are appropriate for the residents, etc. Are these entities able to survive on the market on their own?” asked Prof. Cieślukowski.

Accrual accounting will reveal that which is hidden

According to Mr Kamiński in order to fully capture all the potential liabilities in the public sector, it is important to transition from cash-based accounting (where the hidden debt is recognized and reported at the time of its repayment) to accrual-based accounting (where the hidden debt is recognized and reported when it is incurred). “We can assess that the gradual transition towards accrual accounting — in line with European standards — will expand the scope of potential debt monitoring,” believes Mr. Kamiński.

However, Prof. Cieślukowski warns that a transition to accrual accounting could be dangerous. “The adoption of such an approach may lead to a rapid and dangerous increase in the deficit. In addition, it would require us to develop a new methodology to measure the budget balance taking into account the potential liabilities”, he points out. “We have to admit, however, that this would be desirable from the point of view of tax policy planning.”

Mr. Kamiński indicates that it is almost impossible to estimate the exact amount of potential debt. “Even if we take, as the basis for our calculations, the future budget deficits of the central government, the local government units and other public entities, we only create a base for all the maturing liabilities. We still need to estimate the flows occurring between the entities […]. The final result, which indicates the required amount of funds, is only an approximation of the real size of the future debt,” emphasized Kamiński and added that this does not mean that countries should not try to forecast the size of the potential public debt.

We must not sweep our liabilities under the rug

According to data collected by the Statista website, the global public debt has already reached the amount of USD61 trillion, and has grown by 100 per cent since the end of the financial crisis. How big is the hidden public debt? According to estimates of the Bank for International Settlements from 2017, it may amount to USD13 trillion, but no one knows exact numbers. “If we assume, that the level of potential liabilities in many countries, including Poland, is estimated at 6 per cent of the GDP, then — taking into account the analyses prepared by INTOSAI and IMF — there is an urgent need to improve our accounting and reporting. We have to take into account the assessment according to which one-fourth of the broadly understood indirect debt transforms into real debt,” wrote Mr. Kamiński. He also has no doubt that the growth of unsecured fiscal risk in the form of hidden public debt will be destabilizing states and local governments.

Prof. Maciej Cieślukowski is certain that an uncontrolled increase in the level of debt — both explicit and hidden — is dangerous for the stability of the public finance sector, as well as for the real economy. “The absolute limit for debt should be determined by the ability to settle the existing liabilities without worsening the situation of other entities, which relates to the Pareto efficiency. One example of the consequences of crossing this limit is, for example, the situation in Greece after 2008. If a state is unable to settle its liabilities, and its debt securities become junk ones, problems emerge with the provision of public services, the banking sector develops liquidity problems and a domino effect occurs,” he warned.

Professor Krystyna Piotrowska-Marczak, a member of the European Financial Management Association, believes that before anyone considers the significance of potential debt, has to attempt to answer the question of what is really meant by the term “stability of public finances”. “Do we define the sustainability of public finances as a state or as a process? Are stable public finances simply defined as sustainable finances, or finances where a certain level of revenues and expenditures is maintained, or is it about their mutual relationship? In the literature there are virtually no attempts to define the stability of the public finance sector”, she emphasized.

Then, as indicated by Prof. Piotrowska-Marczak, it is also important to determine whether the potential public debt is the sum of the actual public debt and the liabilities that are not accounted for in the official statistics, or does it only include the unreported liabilities. “If we choose the first option, then it is necessary to determine the share of unrecorded liabilities in the total debt, and to examine the rate at which these constituent parts are growing. If it is assumed that conceptual issues are not a problem, then it must be determined whether this buildup of public debt is a regular wave or a tsunami?”, Prof. Piotrowska-Marczak added.

“When considering the changes in the size of public debt in the future, it is necessary to primarily take into account the public expenditures belonging to the group of the so-called legally determined expenditures, which include the servicing of public debt, subsidies to the social funds and subsidies to the local government units”, Prof. Piotrowska-Marczak said. “If we were to generalize, in view of the transparency of public finances no liabilities should be left out of these considerations.”

How not to spook the markets

If we were to include some of the liabilities currently remaining hidden into the official public debt statistics, would that cause a nervous reaction on the part of the markets? According to Prof. Piotrowska-Marczak, a nervous reaction to the disclosure of potential debt would primarily be observed among the speculators who pursue quick profits. “The market reaction would depend on the manner in which the operation is carried out,” she emphasized.

Prof. Cieślukowski said that everything would depend on the context. “Studies indicate that the size of the budget deficit resulting from potential debt could range from 2 to 8 per cent of the GDP. If, for example, the inclusion of hidden debt caused the public debt to exceed the threshold of 60 per cent of the GDP, then it would be necessary to balance the state budget and to stop further borrowing. The question would then arise of how the state intends to achieve a budget balance. If it decided to impose taxes on the financial sector or on trade in financial instruments, then the reaction of the markets, at least in the short term, would be rather negative. In such cases all the costs are passed on to the consumers, the demand for financial instruments decreases, and the capital moves to another country”, argued Prof. Cieślukowski.

He is convinced that the reaction of markets could be completely different if the size of the hidden debt was “safe”. “In such a case the disclosure of potential debt should calm the market. The transparency of the rules and a public policy aimed at a gradual reduction of the debt and the debt servicing costs are usually seen positively by investors,” he added.

Most of the scientists agree that the inclusion of hidden debt into the official public debt statistics should have to be carried out gradually. The pace of such an operation should depend on the given country’s debt-to-GDP ratio — in order not to breach the debt limit of 60 per cent of the GDP established by the EU.

Prof. Piotrowska-Marczak points out that in the case of Poland, the decision to include in the official government debt statistics some of the liabilities which are currently not reported, could not be made independently. It would have to be a part of a solution agreed within the EU, i.e. applicable to all member states.

The struggle against growing potential debt

Prof. Cieślukowski points out, that, above all, it is necessary to stick to the goal of minimizing the debt servicing costs. “We can try to limit the rate at which conventional debt is incurred. The EU regulations concerning the provision of state aid also play an important role in limiting the use of state guarantees and sureties.” he noted.

Good debt management practices would be more effective than strict legal regulations and penalties. “The paramount consideration in this respect should be the sense of responsibility for future generations on part of politicians. The problem frequently lies in politicians’ lack of awareness and education concerning the consequences of growing debt,” indicated Prof. Cieślukowski.

Special purpose funds, or a cyclical budget

Some scientists suggest that special purpose funds and stabilization funds are good tools for the stabilization of public finances. In his book Mr. Kamiński cites the example of Colombia, as a country exposed to natural disasters, which has introduced a number of quasi-fiscal solutions, such as a system of guarantees for bank deposits or a compensation system in the event of natural disasters. The question is, however, whether it would be a good idea to create special purpose funds in Poland. “In conditions of a constant shortage of budgetary funds and the necessity of borrowing money in order to fill the temporary budget shortages, the idea that special purpose funds could provide stabilization seems to be wrong. Additionally, it should be pointed out that the operation of such funds entails certain costs,” emphasized Prof. Piotrowska-Marczak.

“In Poland the rationale for the creation of such a fund is questionable, not only due to the low institutional culture, but also when it comes to the sources of the financial surpluses. Where are they supposed to come from?”, asked Prof. Cieślukowski. In his opinion Poland could consider the introduction of a cyclical budget, in which higher taxation and savings are applied during periods of economic growth, and during recessions taxes are deliberately lowered and the previously accumulated reserves are used. “In the case of a cyclical budget, the main problem is stopping the politicians from reaching for the reserves during periods of prosperity and ensuring that there are sufficient funds available during a recession,” he added.

“Putting additional emphasis not only on the budget deficit, but also on off-balance-sheet commitments, including potential commitments, requires adopting a new approach to public finances as a whole. We would have to monitor all phenomena that may result in additional public expenditures and analyze processes that may occur in the future,” argued Mr. Kamiński.

The level of public debt will increase in the future due to the expanding scope of the responsibilities assumed by the authorities at the national or regional level. “A more responsible view of international and local security will force us to adopt a global approach towards the maintenance of less profitable infrastructure elements as well as the expenditures related to the environment,” he wrote and added: “The public debt, regulatory liabilities and potential debt, which are constantly growing and burdening future generations, already exist. We have no other choice but to describe them and manage them wisely.”

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