II Balance Sheet Shocks and Their Transmission in Capital Account Crises
Author:
Mr. Brad Setser https://isni.org/isni/0000000404811396 International Monetary Fund

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Mr. Ioannis Halikias
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Mr. Alexander Pitt
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Mr. Christoph B. Rosenberg
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Mr. Brett E. House
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Mr. Jens Nystedt https://isni.org/isni/0000000404811396 International Monetary Fund

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Mr. Christian Keller
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Language:
English
Print Publication Date:
24 Oct 2005
Keywords:
OP; debt; foreign currency; balance sheet indicator; sectoral balance sheet mismatch; dollar; stock data; government balance sheet; balance sheet problem; balance sheet exposure; sectoral balance sheets; Financial statements; Currencies; Capital account crisis; Currency mismatches
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Abstract

There is a growing recognition that the traditional financial programming approach may not fully explain some of the dynamics underlying modern-day capital account crises. Its flow-based analysis focuses on the gradual buildup of unsustainable fiscal and current account positions. The BSA, by contrast, focuses on shocks to stocks of assets and liabilities that can trigger large adjustments in (capital) flows. Such an approach can, therefore, be a useful complement to traditional flow analyses. Indeed, academics and policymakers have been paying increasing attention to the BSA’s further development as a result of the capital account crises of the 1990s. The IMF has been applying the insights from the BSA for some time and many of its elements have entered the IMF’s work on fiscal and external sustainability, liquidity and debt management, financial sector assessment, and so on.

There is a growing recognition that the traditional financial programming approach may not fully explain some of the dynamics underlying modern-day capital account crises. Its flow-based analysis focuses on the gradual buildup of unsustainable fiscal and current account positions. The BSA, by contrast, focuses on shocks to stocks of assets and liabilities that can trigger large adjustments in (capital) flows. Such an approach can, therefore, be a useful complement to traditional flow analyses. Indeed, academics and policymakers have been paying increasing attention to the BSA’s further development as a result of the capital account crises of the 1990s. The IMF has been applying the insights from the BSA for some time and many of its elements have entered the IMF’s work on fiscal and external sustainability, liquidity and debt management, financial sector assessment, and so on.

Balance Sheet Concepts

An economy can be viewed as a stylized system of the balance sheets of all its agents. Unlike the more traditional analysis of an economy that looks at the flows occurring over a defined period of time—such as the annual output, fiscal balance, current account balance, or investment flows—a balance sheet analysis looks at stocks of assets and liabilities—such as debt, foreign reserves, loans outstanding, and inventory at a certain point in time. Obviously, the two approaches are interrelated, as the difference in a stock variable at two dates is related to the flow in the period between them.2

As a first step, one may identify an economy’s main sectoral balance sheets: the government sector (including the central bank), the private financial sector (mainly banks), and the nonfinancial sector (corporations and households).3 These sectors have claims on and liabilities to each other, and to external (nonresident) entities. When consolidating the sectoral balance sheets into the country’s balance sheet, the assets and liabilities held between residents net out, leaving the country’s external balance vis-à-vis the rest of the world (nonresidents).4 Figure 2.1 shows a stylized system of such accounts, which excludes nonfinancial assets and liabilities. It illustrates how one sector’s liability is by definition another sector’s asset, and vice versa.

Figure 2.1.
Figure 2.1.

Sectoral Balance Sheets and Their Main Interlinkages

Sectoral balance sheets provide important information that remains hidden in the consolidated country balance sheet. A country’s balance sheet can show the potential scale of vulnerability to reversals in external financing flows, but it is often inadequate for examining the genesis of such reversals. Weaknesses in certain sectoral balance sheets may contribute to the creation of a country-wide balance of payments crisis, yet they may not appear in a country’s aggregate balance sheet. An important example is foreign currency debt between residents, which is netted out of a country’s aggregated balance sheet. Nevertheless, if the government is unable to roll over its hard currency debts to residents and must draw on its reserves to honor its debts, such debts can trigger an external balance of payments crisis. The risk that difficulties rolling over domestic debts can spill over into a balance of payments crisis is particularly acute in a world where capital accounts have been liberalized. Such risks are enhanced if difficulties in one sector can cascade into healthy sectors as a result of financial interlinkages.

Four general types of risks are worth highlighting when assessing balance sheet weaknesses: maturity, currency, capital structure, and solvency. Maturity and currency mismatches create exposure to particular sources of risk, including market risks such as a change in interest rates or exchange rates, while capital structure mismatches reduce a country’s ability to bear these as well as a range of other risks.5 All of these mismatches create vulnerabilities that can lead directly to solvency risk, although solvency risk can also arise from other sources.6 The interaction of these risks can be best understood when examining how they have come to bear in recent emerging market financial crises.

The Anatomy of Recent Balance Sheet Crises

Capital account crises typically occur as creditors suddenly lose confidence in the health of the balance sheets of one of a country’s main sectors—the banking system, the corporate sector, or the government. This confidence loss can prompt sudden and large-scale portfolio adjustments, such as massive withdrawals of bank deposits, panic sales of securities, or abrupt halts of debt rollovers. As the exchange rate, interest rates, and other asset prices adjust, the balance sheets of an entire sector—which may be largely solvent in the absence of these adverse events—can sharply deteriorate. In an integrated financial system and with an open capital account, concerns about asset quality on domestic balance sheets can provoke creditors to shift toward (safer) foreign assets. This will often result in capital outflows, which exert further pressure on the exchange rate or official reserves and ultimately result in a balance of payments crisis. The mechanisms underlying such balance sheet crises, which are illustrated in Figure 2.2, are discussed in more detail below.

Figure 2.2.
Figure 2.2.

Anatomy of a Balance Sheet Crisis

The initial shock to a balance sheet may take various forms, its impact depending on the existing mismatches on the balance sheet. Several patterns can be detected in capital account crises of the last decade:

  • A currency mismatch—a predominance of assets denominated in domestic currency over liabilities denominated in foreign currency—leaves a balance sheet vulnerable to a depreciation of the domestic currency (exchange rate shock).

  • A maturity mismatch—long-term, illiquid assets mismatched against short-term liabilities expose a balance sheet to risks related both to rollover and to interest rates: if liquid assets do not cover maturing debts, a balance sheet is vulnerable to a rollover risk, because emerging market economies can find themselves shut out of capital markets altogether. Furthermore, a sharp increase in interest rates (interest rate shock) can dramatically increase the cost of rolling over short-term liabilities, leading to a rapid increase in debt service.

  • Other market risks include any sharp drop in the price of assets such as government bonds, real estate, or equities, to which the balance sheets of a certain sector may be particularly exposed.

Any of the above shocks can bring about a deterioration in the value of a sector’s assets compared with its liabilities and hence to a reduction of its net worth; in the extreme case this net worth may turn negative and the sector becomes insolvent. The greater a balance sheet’s capital structure mismatch—too much debt relative to equity—the smaller its buffer against such an event.

Strong balance sheets protect against real as well as financial shocks. Many shocks originate in the real economy. For example, a collapse in the demand for a country’s main commodity or other major export product will lead to a deterioration in corporate earnings or government revenue. This will prompt a reassessment of these sectors’ sustainability and thus a reevaluation of the market value of their debt and other assets. Such real shocks are particularly dangerous when combined with financial vulnerabilities, as a real shock is often correlated with reduced market access. The impact of the commodity price shock of 1998, for example, was magnified in countries such as Russia, where maturity mismatches left balance sheets vulnerable to rollover risk and interest rate shocks.

Maturity and currency mismatches are sometimes hidden in indexed or floating rate debt instruments, making these mismatches less evident. In some emerging market economies (e.g., Brazil) liabilities may be formally denominated in local currency, but indexed to the exchange rate. Similarly, the nominal maturity of an asset may be long, but the interest rate it bears may be floating. Such indexation often creates the same mismatches as if the debt were denominated in foreign currency or as if the maturity were as short as the frequency of the interest rate adjustments.

Off-balance-sheet activities can substantially alter the overall risk exposure. Financial transactions such as forwards, futures, swaps, and other derivatives are not recorded on balance sheets, but imply predetermined or contingent future flows that will eventually affect them. Such transactions can be used to effectively reduce the risk created by balance sheet mismatches: for example, corporations with a foreign currency mismatch may enter into foreign currency forward contracts to reduce their exposure to exchange rate risk. By the same token, off-balance-sheet activities increase risk exposure when they are not used to hedge (taking a position that is negatively correlated to an existing balance sheet risk), but to speculate, or, in the particular case of monetary authorities, to support the domestic currency against market pressures.

Balance sheet problems in one sector can spill over into other sectors, often snowballing in the process. Balance sheet crises can originate in the corporate sector (as in some Asian countries in 1997–98) or the fiscal sector (as in Russia in 1998, Turkey in 2001, and, more recently, in some Latin American countries), with the banking sector playing a key transmission role in all these episodes. If a shock causes the corporate sector or the government to be unable to meet its liabilities, another sector, typically the banking sector, loses its claims. By the same token, if banks tighten their lending to prevent their asset portfolio from deteriorating, this further complicates the situation of a corporate sector or a government in dire need of fresh financing or a debt rollover. Because of these repercussions, balance sheet problems tend to snowball as they spill from one sector into another.

A loss of confidence in the banking system often not only triggers a run on deposits, but also a flight from the currency. The authorities may expand liquidity or lower interest rates to support the ailing banking system, while depositors may seek to protect their savings by switching into foreign currency assets. Both create pressure on the exchange rate. A depreciating exchange rate, however, further weakens the asset side of a banking sector that has a currency mismatch on its balance sheet. Thus, banking and currency crises may reinforce each other, creating the “twin crises” frequently observed in past cases.

Although a crisis may not originate in the government’s balance sheet, it is likely to spread to it, partly as a result of contingent liabilities. For instance, the banking system’s integrity is often explicitly or implicitly guaranteed by the government. In the event of a crisis, such contingent (off-balance-sheet) commitments become definite (balance sheet) liabilities, further adding to the deterioration of the government’s balance sheet and the fiscal pressures that are created by the macroeconomic disruptions resulting from the crisis. Contingent commitments may even exist to bail out corporations, especially when governments are involved in their investment and borrowing decisions. Furthermore, monetary authorities may be engaged in forward contracts and other off-balance-sheet transactions, which can entail large contingent drains on their foreign currency assets.

The interaction between financial balance sheets also magnifies the negative impact of a shock on real output levels. Autonomous investment cuts by corporations to restore the financial health of their balance sheets are usually compounded by a forced reduction in credit from distressed banks and lower consumption by households that experience a negative wealth effect. All this may contribute to a sharp decline in aggregate demand.

Operationalizing the Balance Sheet Approach

The IMF has been using insights based on balance sheet concepts in its surveillance work for some time. While this approach can also provide insights on crisis management and the design of IMF-supported programs, much of its recent application in the IMF has focused on vulnerability analysis. There is, for example, increased emphasis on the adequacy of official reserves in relation to short-term debt, monetary aggregates, and other stock variables; a sharpened focus on dollarization risks; and enhanced efforts at promoting better public liability management. Other important work that uses balance-sheet-related concepts includes the IMF’s framework for debt sustainability analysis (DSA) and the Financial Sector Assessment Program (FSAP). Over the past few years, a number of country teams have applied the BSA to support their policy advice in the context of the annual Article IV consultations. Recent examples include Bulgaria, Colombia, Latvia, Lebanon, Peru, Thailand, and Turkey.

Efforts to incorporate the BSA into the IMF’s work have been supported by statistical and transparency initiatives. These have improved the availability of some key balance sheet stock data and the accuracy of these data. In particular, the requirements of the Special Data Dissemination Standard (SDDS) have improved the dissemination of data and metadata on public and external debt, international reserves and foreign currency liquidity, international investment positions, and analytical accounts of the banking sector.7 The IMF’s Coordinated Portfolio Investment Survey has improved the availability and comparability of statistics on countries’ portfolio investment positions. An interagency task force chaired by the IMF has also developed a new guide on the measuring and monitoring of external debt.8 The IMF’s Government Finance Statistics Manual 2001 supports the balance sheet approach through a statistical framework that systematically links flows and stocks and introduces the concept of a government balance sheet.

A simple matrix presentation of sectoral asset and liability positions can serve as the basis for a sectoral balance sheet analysis. There is, of course, no single well-established way of presenting and analyzing sectoral balance sheet data, and, obviously, more complex ways of modeling are possible, for example, by explicitly incorporating measures of volatility. For an outline of some operational aspects of the balance sheet approach, see Box 2.1.

A number of caveats regarding the usefulness of the BSA for vulnerability analysis are in order. While the application of the approach in this paper holds much promise, it also suffers from a number of shortcomings that will have to be overcome over time:

  • First, as distinct from early warning systems, the BSA cannot be easily reduced to a small set of indicators that quantify vulnerabilities in a manner that is readily amenable to cross-country comparisons. Rather, the approach is better thought of as a conceptual framework for a fuller assessment of vulnerabilities and related policy options, in conjunction with other relevant country-specific factors.

  • Second, by definition, the BSA does not take into account off-balance-sheet transactions that have become increasingly important over time. As will be demonstrated in some of the country case studies, such transactions can be used to hedge balance sheet exposures, but have at times exacerbated them.

  • Third, a full assessment of underlying risks needs to factor in the probability distribution of key relevant shocks. For instance, under a fixed exchange rate regime, a situation of significant misalignment would raise the level of concern relating to any vulnerabilities identified by the BSA and sharpen the urgency of needed policy interventions.

  • Finally, a full assessment of sectoral balance sheets on welfare grounds needs to take explicitly into account the relevant trade-offs between reducing vulnerability (along the lines suggested by the BSA) and minimizing financial cost. Such an approach is clearly required, for instance, when evaluating financial system liquidity, currency and maturity composition of external debt, and optimal reserve accumulation.

The Balance Sheet Approach in Practice

The aim of the balance sheet approach (BSA) is to provide a comprehensive assessment of currency and maturity mismatches across different sectors of an economy. The composition and size of assets and liabilities of an economy’s main sectors provide information about the economy’s vulnerability to crisis and the channels by which one sector’s strengths or weaknesses could be transmitted to other sectors.

The operational foundation of the BSA is a matrix (see below) summarizing the asset and liability positions of the main sectors of the economy. Ideally, the analysis starts with a compilation of the data needed to fill the cells of this matrix for the public (including public enterprises), private financial, and private nonfinancial sectors vis-à-vis each other as well as the rest of the world. Data for the first two sectors are often readily available, while data for the nonfinancial private sector are usually harder to obtain. Information on the international investment position or external data sources (such as the Bank for International Settlements or the Special Data Dissemination Standard) can help in compiling the external position and deriving (as a residual) some of the unknown data elsewhere in the matrix. Data limitations notwithstanding, the insights from even a partial analysis can be useful. Where data availability permits, the BSA can be augmented by including off-balance-sheet items, such as contingent claims or derivatives. A higher degree of sectoral disaggregation and a breakdown by instrument could also be useful, where data permit. Further, linkages across economies could be examined to assess possible routes for contagion.

The data in the matrix can then be used to quantify sectoral mismatches in the short and the medium term. From a vulnerability viewpoint, the most important classes of assets and liabilities would be those denominated in foreign currency, and their position vis-à-vis the rest of the world. In a second stage, there is the possibility of conducting stress tests, for example, by simulating a change in market valuations of sectoral assets. One could also simulate a depreciation of the domestic currency. However, since the main point of the BSA is to highlight the coverage of foreign-currency-denominated liabilities by corresponding assets, the discrepancy between these two is already an indicator of the stress that an economy would be exposed to in the event of a depreciation.

Intersectoral Asset and Liability Position

article image
2

The change in stock is a combination of changes in valuation of the existing stock of assets and liabilities, and net additions to the stock from flows during the preceding period.

3

For the purposes of the following analysis, it is most important to distinguish assets that in the event of a crisis are under the control of the country authorities from those that are controlled by the private sector. To simplify the presentation, the separation of the government and the central bank is therefore not highlighted. The distinction between monetary and fiscal authorities—part of the internationally accepted statistical guidelines—is, of course, important for many other purposes, not least to reflect central bank independence and also the IMF’s lending to a country’s monetary as opposed to its fiscal authorities. In general, the statistical format used here can be adjusted to that of the System of National Accounts 1993—with flexibility in the sectorization of an economy and taking into account country circumstances.

4

In official balance of payments statistics, the balance sheet of the stock of external financial assets and liabilities, broken down in four sectors, is referred to as the international investment position (see International Monetary Fund, 1993).

5

Pettis (2001) and others whose analyses are grounded in corporate finance use the term “capital structure” to refer to the maturity and currency composition of an entity’s debts, as well as the debt to equity ratio. Because maturity and currency risk are of particular importance for countries, this paper isolates these sources of risk. This paper uses the term capital structure only to refer to the balance between debt and equity, not to the currency and maturity composition of debt.

6

This is not an exhaustive list of the risks to a balance sheet. Moreover, there are other possible ways of breaking down various types of balance sheet risks than those discussed in this paper: for example, one could identify rollover risks, market risks (which would include both currency and interest rate risk), credit risk, operational risk, and solvency risks. The categorization laid out here has the advantage of highlighting the underlying mismatches that create sources of vulnerability from a debtor’s perspective.

7

See also “Data Provision to the Fund for Surveillance Purposes” (International Monetary Fund, 2002a).

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Cover Debt-Related Vulnerabilities and Financial Crises
Debt-Related Vulnerabilities and Financial Crises
ISBN:
9781589064256
ISSN:
0251-6365
Publication Date:
24 Oct 2005
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589064256.084
Pages:
58
Figure 2.1.

Sectoral Balance Sheets and Their Main Interlinkages
Figure 2.2.

Anatomy of a Balance Sheet Crisis

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