Contingent Liabilities: Issues and Practice; Aliona Cebotari; imf working Paper 08/245; October 1, 2008

Box 2. When Are Guarantees Preferable to Other Forms of Support?
1 
Alternatives to guarantees as a way of providing support to an activity or a firm include direct loans, 
regular budget subsidies or transfers. A clear difference between these different types of support is how 
they are treated in the fiscal accounts: subsidies increase the deficit and net/gross debt immediately, direct 
lending does not affect the deficit or net debt but increases gross debt (if the government borrows to 
onlend), and guarantees generally do not affect either. This may lead to a bias in favor of guarantees over 
direct lending or subsidies.
Guarantees could be a more efficient form of intervention than providing direct subsidies or onlending 
when there are numerous beneficiaries (e.g., housing or student loan guarantees, export guarantees). In 
such cases, issuing guarantees, only a portion of which would be called, could be less costly than providing 
across-the-board subsidies to all potential beneficiaries. Moreover, the administrative costs of distributing a 
certain amount of subsidies or loans across them could be high and it may be more efficient for the 
government to involve lenders (banks) with established networks to reach the potential borrowers, and 
guarantee their borrowing (OECD, 2005).
In many other cases, however, guarantees may not be as cost-effective, since: (i) for a given amount of 
credit risk, it is cheaper for the government to borrow funds and onlend them directly to the private 
beneficiary than it is to guarantee debt incurred by the beneficiary, if only because the private debt would 
carry a premium for illiquidity compared to government debt; (ii) the moral hazard created by the 
guarantee could create additional cost, as a beneficiary whose debt is guaranteed by the government has 
little incentive to minimize the risks that it takes; and (iii) guarantees could also entail additional risk 
because they generally bypass the scrutiny of the budget process and are a “cheap” form of support for the 
government, creating a bias towards supporting more risky activities that otherwise may not have passed 
the competition with other government resources. 
1
The discussion draws on OECD, 2005a.