The probability game: Quantifying credit risks from public corporations in Cabo Verde

State-owned enterprises (SOEs) play a significant role in the economy of Cabo Verde, providing services in essential sectors such as energy, telecommunications, and transportation.  Despite their importance, SOEs have historically faced significant challenges, including financial constraints, inefficient operations, and governance issues. These have now been exacerbated by the global economic effects of the COVID-19 pandemic in 2020 and Russia’s invasion of Ukraine in 2022. As a result, Cabo Verde’s SOEs have been accumulating financial losses, leading to an increase in their debt. Central government guarantees to SOEs accounted for 25 percent of GDP in 2022.

Since 2016, the government has made SOE reform a priority, focusing on modernizing their management and accountability, increasing transparency of financial information, and mitigating fiscal risks. With support from the World Bank, an SOE oversight unit—Unidade de Acompanhamento do Setor Empresarial do Estado(UASE)—was created at the ministry of finance to supervise the sector’s operations, facilitate the privatization process, and support public-private partnerships. In 2022, UASE published annual and quarterly SOE performance reports, detailing the financial situation of SOEs, including quantitative indicators from their balance sheets. The publication of the quarterly SOE report was supported as part of the Performance and Policy Actions under IDA’s Sustainable Development Financing Policy framework.

World Bank Assistance

To continue the SOE reform agenda, the government sought technical assistance from the World Bank in 2022 to improve the process of evaluating requests from SOEs for new sovereign guarantees.  The World Bank helped officials from the ministry of finance implement the  Credit Rating Tool to Assess and Quantify Credit Risk from Public Corporations, which uses information on their standalone and guaranteed debts. These cover implicit and explicit contingent liabilities for the central government. Credit-risk analysis evaluates whether the SOE is likely to fully repay its creditors on time. This tool provides objective criteria to conduct a proper assessment of the credit risk stemming from additional guarantees.

Risk assessment is conducted using credit-rating methodology based on a scorecard. Risk quantification generates risk measures that support the policy decision-making process. Once the SOE gets a credit rating, the method attaches the annual probability of default onto the debt. This probability is then used to calculate other measures, such as expected, unexpected, and stressed losses per entity and for the portfolio. The analysis provides an overview of the exposure of the central government to the SOE’s total debt (figure 1). Finally, the tool provides guidance for the charging of risk-based guarantee fees to the beneficiary in return for explicit government guarantees on debt liabilities. The tool can also be used for on-lending operations.

Figure 1: Exposure of the central government to a notional state-owned enterprise

(Percentage of GDP)

Note: This figure shows the credit-risk assessment of a notional SOE, whose debts account for 10 percent of GDP. Expected losses indicate what the government would have to pay in the name of the SOE, considering the company's obligations, the probability the company will not make it, and what the government expects to recover from the company. Unexpected losses are what the government would lose if the SOE has a higher probability of failing to meet its obligations.

Mitigating Fiscal Risks

To help the government mitigate these fiscal risks, the World Bank project—Second Resilient and Equitable Recovery DPF with a Catastrophe Deferred Drawdown Option—supported the revision of the regulatory framework governing the evaluation, issuance, and monitoring of sovereign guarantees. The $52 million operation supported policies to strengthen the foundation for a resilient and equitable economic recovery by reducing fiscal risks and improving debt transparency; strengthening the resilience of poor and vulnerable households to climate shocks; and enabling a sustainable private sector-led recovery. The regulatory framework (extrato de despacho no 96/2022) established objective criteria to conduct a proper assessment of the credit risk stemming from additional guarantees, defined the method for assessing and managing credit risk stemming from guarantee’s beneficiaries, and established the fee structure, which ranges from 0.1 to 3 percent of the credit operation. The legislation also established that the proceeds from the guarantee’s fees will be deposited in a dedicated reserve fund that could be used in case guarantees are called.

The enhancement in the legal framework has four main benefits. First, it highlights the government’s intention to strengthen fiscal risk management through a rule-based decision process to evaluate requests for new guarantees. Second, it reduces moral hazard related to explicit contingent liabilities. Third, it builds technical capacity at the ministry of finance to assess and quantify credit risks from public corporations. Fourth, it helps to offset government losses if a guarantee is called. Because of this reform, it is expected that the reduction in fiscal support to SOEs above what is established in the annual budget will reduce from 30 percent in 2020 to 10 percent in 2023.