3 Key Features of the Framework for Analysis
Author:
Mr. Johan Mathisen
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Mr. Anthony J. Pellechio
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Language:
English
Print Publication Date:
29 Mar 2007
Keywords:
BOOK; BSA; BSA analysis; dataset; SRF data; balance sheet relationship; currency denomination; accounts receivable; deposit money corporation; foreign-currency-denominated assets; Financial statements; Business enterprises
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Abstract

The particular framework of a BSA application—a matrix of intersectoral balance sheets in terms of sectors of the economy and components of the balance sheet (Table 1)—depends on the focus of analysis and, as a practical matter, the availability of data. Allen and others (2002) provide a generic matrix encompassing four sectors (government, financial, nonfinancial, nonresident) with assets and liabilities broken down by (short- and long-term) maturity and currency (domestic, foreign). The framework presented in this paper uses the same breakdown of assets and liabilities but expands it to seven sectors.6

The particular framework of a BSA application—a matrix of intersectoral balance sheets in terms of sectors of the economy and components of the balance sheet (Table 1)—depends on the focus of analysis and, as a practical matter, the availability of data. Allen and others (2002) provide a generic matrix encompassing four sectors (government, financial, nonfinancial, nonresident) with assets and liabilities broken down by (short- and long-term) maturity and currency (domestic, foreign). The framework presented in this paper uses the same breakdown of assets and liabilities but expands it to seven sectors.6

This framework follows standard practice in balance sheet analysis: a sector’s liabilities to other sectors (debtor positions) are presented along the horizontal axis and its claims (creditor positions) on other sectors on the vertical axis. Each row of the framework presents the sector’s liability structure by currency, maturity, and creditor, and each column presents the corresponding asset structure, that is, its holdings of other sectors’ liabilities.

By way of illustration, the BSA framework was completed for South Africa using data from the recently introduced SRFs for monetary and financial statistics, QEDS, and CPIS (Table 2). The high level of detail of these data provides a fairly comprehensive picture of net positions of one sector against another, along with the underlying claims and liabilities. Another advantage is the inclusion of currency denomination of all assets and liabilities.

The guiding principle in establishing the framework for balance sheet analysis is that it must appropriately support the macroeconomic analysis. The appropriate framework for policy analysis should be determined by the country-specific risks or mismatches to be analyzed. Thus, the framework is flexible, as it can be and has been adapted to meet the analytical requirements and data availability for particular cases. The level of complexity of the matrix can vary by delineation of economic sectors, financial instruments, maturity, and currency denomination, which is discussed below.

The BSA framework presented in this paper is closely related to the traditional flow-of-funds matrix, which aggregates sectoral assets, liabilities, and net positions, but differs by estimating intersectoral assets and liabilities, that is, each sector’s position vis-à-vis that of other domestic sectors as well as nonresidents. Many countries, especially developed and larger emerging market economies, have developed comprehensive financial statistics that easily lend themselves to flow-of-funds analysis. In those instances where the underlying data used to compile the financial statistics are sufficiently detailed to estimate intersectoral positions by currency and maturity, this data source would be the logical choice to compile the BSA matrix.

A key benefit of this framework is to provide important information that is netted out in the consolidated country balance sheet. Sectoral balance sheets can reveal significant vulnerabilities and their potential transmission among sectors that remain hidden in the consolidated country balance sheet. A matrix of intersectoral positions can reveal how a high level of dollarization is a source of vulnerability by contributing to the creation of a country-wide balance of payments crisis. The intersectoral matrix of assets and liabilities—a key innovation of the balance sheet approach—can shed light on how difficulties in one sector spill over into other healthy sectors through financial linkages.

Table 1.

Intersectoral Asset and Liability Position Matrix

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Table 2.

South Africa: Net Intersectoral Asset and Liability Matrix

(In Millions of Rand; December 2004)

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Sources: Standardized report forms for monetary and financial data; joint external debt hub; coordinated portfolio investment survey; and quarterly external debt statistics.

Includes trade credit/advances, settlement accounts, new equity of households in life insurance, and pension funds (if applicable).

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Sectorization

The main guidance for sectorization is to group institutional units into sectors of the economy based on the similarity of their objectives, principal functions, behavior, and the types of units that control them. The most important aspect of this methodology is control, which can be defined as the power to govern the financial and operating policies of another entity so as to benefit from its activities. Appropriate sectorization is essential to ascertain, for example, which assets the authorities can draw on in times of crisis.

Distinguishing between the public and private sector is by far the most important delineation for analysis of macroeconomic vulnerabilities (Figure 2). Identifying which financial assets are under control of the authorities—or would be in times of crisis—is essential because a policy response to a macroeconomic calamity such as the collapse of the banking system would most likely take the form of a transfer of resources between the public and private spheres. To estimate the public sector’s financial positions vis-à-vis other sectors, it is important not only to identify public units, but also to properly distinguish between public and private corporations.7 Although this might be very difficult to ascertain, a benchmark might be whether government control over the corporation is currently exercisable. For example, do the authorities have the power, conferred by legislation, to appoint directors and influence dividend payments? General regulatory powers applicable to a class of entities or industry are not sufficient to distinguish between public and private enterprises.

The 1993 SNA’s sectorization, which is based on economic activity rather than control, can be simplified to accommodate the BSA’s data requirements. A fundamental requirement in many cases is the availability of data on the banking sector, as banks’ balance sheets are central to the allocation and transmission of risk in any economy. The 1993 SNA’s sectorization (Table 3) could be modified to be very close or identical to the sectorization described in IMF (2000), the Monetary and Financial Statistical Manual (MFSM) (Appendix I). The main advantage of this sectorization is its compatibility with the new SRFs for monetary and financial statistics, as published in International Financial Statistics (IMF, 2001a).8 The sectorization of the SRFs will be maintained in the foreseeable future. In most countries these statistics are available owing to accounting and regulatory standards applied to the financial sector. This is important, as this sector’s position can affect the health of many other sectors in the economy.

Sectorization can be customized, as in the application of the BSA to Colombia (Lima and others, 2006), where the balance sheets of individual institutions were aggregated into sectoral balance sheets, with sectors specifically defined to identify vulnerabilities and their transmission among sectors. All information was carefully checked by sector experts at the Colombian central bank for consistency, a time-consuming and exceptional undertaking. The economy was split into nine sectors: the nonfinancial public sector, the central bank, private banks, public banks, private nonbank intermediaries, public nonbank intermediaries, large and medium-sized companies, households and small companies, and the external sector. Based on this sectorization, the application of the BSA to Colombia analyzes the evolution of macroeconomic and financial vulnerabilities between 1996 and 2003, a period that encompasses a severe recession in 1999 and a currency and banking twin crisis, both following the Russian crisis of 1998.

Even when balance sheet data for all main sectors are not available, the BSA can be applied to examine the vulnerabilities of a particular sector known to be problematic. The examination of important individual sectoral balance sheets can help to detect weaknesses that have the potential to spill over into other sectors, as follows:

  • Financial sector. Balance sheets of the central bank and financial sector are key to assessing the main risks and overall resilience to shocks. Commercial banks’ balance sheets are central to the allocation and transmission of risk in any economy. Analysis of the balance sheets of systemically important financial institutions is the core work in preparing Financial Sector Assessment Programs and other financial sector surveillance. Maturity transformation—taking in short-term deposits to extend longer-term loans—is fundamental to financial intermediation, giving rise to the well-known risk of deposit runs. The financial systems of emerging market countries often face challenges not typically found in advanced economies. To accommodate loan demand, banks may tap foreign credit lines; to attract depositors, banks may offer foreign currency deposits; as a consequence of high public sector deficits, banks may have a large exposure to government debt, enhancing the potential for spillovers between the financial and public sectors; and weak supervision may not identify increasing balance sheet risks in a timely manner or at all.

  • Public sector. High levels of sovereign debt and weaknesses in its structure can make the balance sheets of government a potential source of vulnerability to the economy.

  • Nonfinancial corporate sector. Balance sheets of the nonfinancial corporate sector can be a source of vulnerability if a significant part of corporate debt is owed by corporations with inadequate capital and liquidity or earning power (as in the case of Indonesian toll roads that owed debt in foreign currency).

Vulnerabilities of the nonfinancial corporate sector have been analyzed recently using micro-level data on corporations to fill the gap left by more readily available aggregate data for the public and financial sectors. A new database that combines balance sheet and debt issuance data at the firm level for 15 emerging market countries has been used to analyze vulnerabilities in corporate finance.9 The analysis shows that emerging market corporations have substantial maturity and currency mismatches on their balance sheets that may become a source of financial instability if the external environment of low interest rates and appreciating emerging market currencies becomes less favorable. This suggests that firms’ exposures to market risk factors, such as exchange rates and interest rates, should be considered jointly, with the associated vulnerability measures reflecting the interaction among these factors.

Figure 2.
Figure 2.

Sectorizing Public Entities

(General Government versus Public Corporations)

Note: The government finance statistics system covers all resident public entities, that is, all entities that have a center of economic interest in the economic territory of the domestic economy (see paragraphs 2.70 to 2.77 in the GFSM 2001).
Table 3.

Sectors and Financial Instrument Categories

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System of National Accounts (IMF, 1993, Classification of Sectors, Annex V, Part I).

Monetary and Financial Statistical Manual (IMF, 2000, Section IV).

Classification and Valuation of Financial Instruments

The analysis should preserve the commonly used breakdown of financial instruments, if available in the source data (Appendix II). The key advantage of maintaining a high level of detail is that it facilitates estimating intersectoral assets and liabilities by financial instrument, which may be particularly useful if the economy is widely dollarized. However, this benefit should be weighed against the cost of handling a large dataset.

The main delineation of financial instruments for macroeconomic vulnerability analysis is between equity and nonequity instruments.10 Countries that finance substantial current account deficits with debt from unrelated parties incur more risk than those receiving foreign direct investment and equity portfolio investment flows (Roubini and Setser, 2004). Firms relying on debt rather than equity financing may be more vulnerable during crisis, as debt repayments are required regardless of circumstances.

Country circumstances may call for a more detailed analysis of certain categories of financial instruments. For example, liquidity analysis requires estimates of liquid foreign currency assets and short-term foreign currency liabilities of the banking system. In particular, in economies where dollarization in the financial sector is pronounced and maturity mismatches between foreign currency assets and liabilities are pervasive, runs on foreign currency deposits in domestic banks can trigger external difficulties (IMF, 2004b, pp. 11–12).

Solvency risk analysis and debt sustainability analysis focus on characteristics of central government debt. Many emerging market governments had difficulty placing long-term debt in their own currency on the domestic market. The critical mass needed to develop a sufficiently deep market may be lacking, or investors may simply lack confidence in the stability of the domestic currency—an important factor in many Latin American and Middle Eastern countries where legacies of high inflation are still fresh. In this situation, governments resorted to issuing debt formally denominated in local currency, but indexed or linked to the exchange rate, as in the cases of Mexico and Brazil.11 This creates currency risk similar to debt denominated in foreign currency, because a depreciation of the domestic currency increases the burden of foreign-currency-linked debt in domestic currency terms for resident debt holders.

The nominal maturity of an asset may be long, but the interest rate it bears may be floating, effectively shortening duration. Such floating rate debt creates the same interest rate risk as if the maturity were as short as the frequency of interest rate adjustments. In this case, data should be compiled according to the frequency of interest rate adjustment.

The method of valuing financial assets and liabilities might depend on the focus of the analysis. In general, the standard market valuation principle applies, but nominal values might be useful in certain circumstances, in particular for debt instruments. For example, applying nominal values might help identify maximum exposure, which can be used to assess liquidity risk. Also, if the timing of recording between creditors and debtors in financial account transactions is not consistent, it may aggravate the level of discrepancies in the dataset to the extent it affects end-period stocks.

Ideally, all financial claims should be examined in a macroeconomic vulnerability analysis based on their estimated market values subject to stress testing. The valuation of some instruments—deposits, for example—will not be affected when the economy is under stress. For other instruments, such as currency holdings and liabilities, a crisis could entail an offsetting or easily quantifiable impact on both sides of the balance sheet.

For a certain group of claims characterized by a high degree of uncertainty over their value12—such as insurance, financial derivatives, and contingent claims13—the impact of a crisis on their value could be asymmetric and significant. These claims might call for a different treatment than allowed by traditional financial statistics, which require that claims have demonstrable value. Several approaches have been developed to assess the risk posed by these claims in sectoral balance sheets. For example, stress testing examines scenarios corresponding to different degrees of risk exposure owing to these claims to help determine a likely range of exposure under each scenario.14 A stochastic simulation can be employed to compute a probability distribution of possible debt outcomes around baseline estimates.

Figure 3.
Figure 3.

Common Foreign Currency Balance Sheet Relationships in Partially Dollarized Emerging Market Economies

Government guarantees are potentially important contingent claims that need to be considered. There are two main types of government contingent future obligations: those that become due if certain events materialize, such as defaults on government guaranteed debt; and those that result from the government’s implicit or “moral” commitment, for example, to protect depositors or pay pensions. The BSA can help assess the potential for problems with these contingent future obligations of the government by identifying vulnerabilities and potential pressures.

Levels of Complexity

The complexity of the framework in terms of sectorization and delineation of financial instruments for macroeconomic balance sheet vulnerability analysis should be adapted to the particular country circumstances. As discussed above, the specification of sectors and financial instruments can vary according to the risks or mismatches to be analyzed and available data. However, the potential for a very detailed analysis, for example, based on the 1993 SNA for the sectoral breakdown and MFSM for delineation of the financial instruments, is substantial (Table 3). The desired level of detailed analysis has to be weighed against the cost of obtaining and handling more detailed data.

Some of this complexity can be overcome by focusing on the key relationships between particular sectors and financial instruments, in particular for currency mismatch analysis (Figure 3) (Reinhart and others, 2003b). For example, in many countries the main foreign currency liabilities of the general government are its external debt, as the central bank is acting as its agent for other foreign currency transactions. Similarly, the foreign-currency-denominated assets of other financial corporations are traditionally confined to deposits in the banking system and holdings of securities (usually claims against nonresidents) and, on the liability side, these corporations might have issued securities or contracted loans in foreign currency (Goldstein and Turner, 2004).

6

The 1993 SNA defines five broad sectors: (1) general government; (2) financial corporations (including the central bank); (3) nonfinancial corporations (including public nonfinancial corporations); (4) households and nonprofit institutions serving households; and (5) rest of the world. This paper follows the sectorization of the Monetary and Financial Statistics Manual (IMF, 2000) and defines three subsectors within the 1993 SNA’s financial corporations sector—the central bank, other depository corporations, and other financial corporations—as separate sectors, bringing the number of sectors to seven.

7

The 1993 SNA distinguishes between public corporations and general government on the basis of economic activity. Public corporations are entities that are controlled by the government but are engaged in market activities. From the point of view of risk assessment, however, this may not be the only criterion to consider. For example, some corporations operating in the market may not be controlled by government, but still have their liabilities covered by explicit or implicit government guarantees, thus resulting in public sector contingent liabilities, as discussed in IMF Executive Board papers on public investment and fiscal policy and government guarantees and fiscal risk.

8

The sectorization presented in this paper is also compatible with External Debt Statistics: Guide for Compilers and Users (IMF, 2003, paragraphs 3.4 to 3.12).

9

The database was developed for the Global Financial Stability Report (IMF, 2005, Chapter IV).

10

As indicated in footnote 5, the framework presented in this paper concerns financial assets and liabilities, and does not address the net worth of a sector or economy.

11

Mexico has not issued exchange-rate-linked debt since its 1994 crisis. For Brazil, instruments indexed to the exchange rate have represented a small share of total domestic debt of government, as Brazil has placed instruments indexed to inflation and interest rates in the domestic market as well. This share increased temporarily under extreme market pressures, but returned to low levels as exchange-rate-indexed instruments were replaced by other instruments when circumstances returned to normal.

12

See IMF (2003, Chapter 9) for a detailed discussion.

13

The literature usually distinguishes between three types of contingent obligations: legally binding guarantees to take on an obligation should a clearly specified uncertain event materialize (e.g., trade or exchange rate guarantees); a broader set of obligations that gives rise to an explicit contingent liability (e.g., government insurance schemes, including deposit, pension, war-risk, crop, and flood insurance); and an implicit contingent liability when there is an expectation to take on an obligation despite the absence of a contractual or policy commitment to do so (e.g., bailing out public enterprises).

14

See Appendix IV of the IMF’s “International Reserves and Foreign Currency Liquidity: Guidelines for a Data Template.” Available via the Internet: http://dsbb.imf.org/Applications/web/sddsguide/.

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Cover Using the Balance Sheet Approach in Surveillance
Using the Balance Sheet Approach in Surveillance
Framework and Data Sources and Availability
ISBN:
9781589066045
Publication Date:
29 Mar 2007
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589066045.071
Pages:
46
  • Figure 2.
    View in gallery
    Figure 2.

    Sectorizing Public Entities

    (General Government versus Public Corporations)

  • Figure 3.
    View in gallery
    Figure 3.

    Common Foreign Currency Balance Sheet Relationships in Partially Dollarized Emerging Market Economies

Figure 2.

Sectorizing Public Entities

(General Government versus Public Corporations)
Figure 3.

Common Foreign Currency Balance Sheet Relationships in Partially Dollarized Emerging Market Economies

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