VI. Assessing Ukraine’s Vulnerabilities from a Balance Sheet Perspective55
142. The high degree of dollarization of the Ukrainian economy calls for a systematic assessment of its vulnerabilities to currency and maturity mismatches. This chapter undertakes a first step at such an assessment. It utilizes newly available data to give a broad overview of Ukraine’s asset and liability position vis-à-vis the rest of the world. Going beyond this aggregate picture, this chapter discusses some key vulnerabilities relating to the international investment position of the economy’s main sectors. Such a sectoral approach is essential in identifying the key areas where a potential crisis associated with sharp exchange rate movements may be triggered, as well as the main channels through which the impact of such movements could be transmitted. As such, it can provide useful input in the design of appropriate policy responses.
143. Until very recently, data availability has limited the assessment of external vulnerabilities to the position of Ukraine’s public sector. Overall, the public sector’s balance sheet can be regarded as strong. The level of its external liabilities is low by international standards. Moreover, the level of foreign exchange reserves has been providing an increasingly adequate hedge to exchange rate movements; and the medium- to long-term nature of public external debt implies limited rollover risk.
144. Exclusive focus on the public sector’s external position clearly provides a very partial picture of Ukraine’s vulnerabilities; the very recent compilation by the Ukrainian authorities of international investment position data for the economy as a whole goes a long way towards remedying this shortcoming. Taking the private sector’s external position into account leads to a less benign assessment of the Ukrainian economy’s vulnerabilities, in terms of the level of its overall external liabilities, its net currency exposure, and the maturity structure of its external debt. The vulnerability of the external position of Ukraine’s private sector is compounded by the extensive domestic liabilities denominated in foreign currency, which could add to the pressure on the balance of payments in the event of adverse exchange rate movements.
145. The rest of the chapter is organized as follows. Section B presents a brief description of the basic analytical framework. Utilizing this framework, Section C discusses the external position of the economy’s main sectors, focusing in particular on currency and maturity mismatches. Section D expands the assessment to incorporate the vulnerabilities stemming from domestic liability dollarization. Section E brings together the main conclusions and policy implications of the analysis; importantly, it also points to further data refinements that would be needed for a better understanding of the economy’s dollarization-induced vulnerabilities.
B. Analytical Framework and Methodology 56
146. To explore and assess balance sheet risks, the economy is decomposed into four sectors. The sectors considered are the monetary authorities, the general government, the financial sector, and the nonfinancial private sector (NFPS). 57 For part of the analysis, the balance sheets of the monetary authorities and the general government are consolidated into the “public sector”, and those of the financial sector and the NFPS into the “private sector” (or “non-government sector”). The sectoral asset and liability positions, along with each sector’s assets and liabilities vis-à-vis the rest of the world (external sector), are presented in matrix form in Table 1. This matrix summarizes the balance sheet linkages between the economy’s sectors, and the exposure of each domestic sector to the rest of the world. The sectoral assets and liabilities vis-à-vis the external sector can be aggregated to yield the country’s overall exposure to the rest of the world. Each row of the matrix presents the liability structure (by currency, maturity, and creditor) of a sector; each column presents the corresponding asset structure of a sector—its holdings of another sector’s liabilities. Appropriate netting out of financial assets from financial liabilities provides indicators of exchange rate and rollover risk.
|Holder of the liability (Creditor)||Monetary authorities||General government||Financial sector||Non-financial sector||External sector4/||Total liabilities|
|Issuer of the liability (Debtor)|
|in foreign currency||0||40||0||0||40|
|in domestic currency||933||747||22||0||1,702|
|medium & long-term||0||0||0||1,919||1,919|
|in foreign currency||0||0||0||1,919||1,919|
|in domestic currency||0||0||0||0||0|
|in foreign currency||0||0||0|
|in domestic currency||0||0||0|
|medium & long-term||3,479||491||8,929|
|in foreign currency||115||0||8,929|
|in domestic currency||3,364||491||0|
|deposits & other short-term||218||209||11,577||1,257||13,261|
|in foreign currency||0||0||3,729||1,257||4,986|
|in domestic currency||218||209||7,847||0||8,275|
|medium & long-term||228||0||16||489||733|
|in foreign currency||0||0||0||489||489|
|in domestic currency||228||0||16||0||244|
|Nonfinancial sector 3/|
|in foreign currency||29||2,353||7,705|
|in domestic currency||7||4,640||0|
|medium & long-term||0||6,368||11,015|
|in foreign currency||0||3,588||11,015|
|in domestic currency||0||2,781||0|
|External sector 4/|
|currency & short-term 5/||7,198||0||1,352||2,292||10,842|
|medium & long-term||0||4||6||183||193|
|Equity (incl, FDI)||0||0||0||164||164|
|(holdings of liabilities)||11,159||n/a||15,998||n/a||31,314|
|in foreign currency||7,341||7,333||31,314|
|short-term and foreign||7,227||3,745||8,962|
147. Currency and maturity mismatches are the focus of analysis in this chapter; such mismatches have been at the heart of most of the crises in emerging markets since the mid-1990s, and have motivated much of the so-called “third generation” currency crisis literature. A currency mismatch, i.e. a situation where foreign currency-denominated liabilities exceed foreign currency denominated assets, exposes a sector or an economy to exchange rate risk: adverse exchange rate movements can entail substantial balance sheet losses, triggering a destabilizing run on the currency. Similarly, a maturity mismatch, i.e. a situation where short-term liabilities are not matched by a sufficient amount of liquid assets, generates rollover risk, rendering an economy vulnerable to sudden shifts in investor sentiment. In particular, recent experience suggests that large currency and/or maturity mismatches in the private sector can generate economy-wide crises, even in situations where solvency is not an issue for the sectors concerned and the financial position of the public sector (which had been the focus of earlier currency crisis theories) appears strong.
148. For the purposes of this chapter, a number of caveats and data limitations need to be emphasized at the outset. Some of these considerations apply to the approach generally, while others are more specific to the case of Ukraine.
The data in Table 1 do not include non-financial assets: these would be relevant for assessing solvency issues, which is not a central concern of this chapter.
Assets are recorded at face value; it can be argued that a mark-to-market approach that takes into account asset price changes may be warranted—unfortunately, this information is not available for Ukraine.
The underlying vulnerability of particular sectors could be underestimated due to aggregation: specifically, the assets of one private entity may not be available to cover the liabilities of another. This issue is briefly revisited in the discussion of the needed further refinement of the available data.
It is conceivable that in the case of Ukraine official data could understate the true foreign assets of the private sector. The amounts of assets that were repatriated this year in connection with the privatization program could suggest that such assets may be under-recorded.
C. An Assessment of Ukraine’s Sectoral External Positions
149. This section explores the balance sheet positions of Ukraine’s main economic sectors vis-à-vis the rest of the world. For the purposes of exposition, the external positions of the public and private sectors are discussed separately.
The public sector’s external position
150. The public sector’s external position has strengthened considerably since the 1998-99 financial crisis.
Following the 1999 sovereign debt restructuring, consistent primary budget surpluses and strong output growth have contributed to a steady decline in the public external debt as a share of GDP between 2000 and 2003, from 33 to 22 percent (Figure 1). This level compares favorably with that in other transition economies, as well as the broader group of emerging market economies, where public external debt stands above 25 percent of GDP on average. And given that virtually all of Ukraine’s public debt held by residents is denominated in domestic currency, Ukraine compares even more favorably in terms of its foreign currency public external debt.
Figure 1.Public Sector External Debt
Sources: Ministry of Finance; and Fund staff estimates.
151. The medium term prospects for the public sector’s external position also appear quite favorable. On the basis of the staff’s baseline scenario, Ukraine’s public external debt as a share of GDP is projected to continue to decline steadily in the coming years. Moreover, the vulnerability of the public sector’s external position to a variety of possible shocks appears relatively low. Standard stress tests involving shocks to the exchange rate, interest rates, and GDP growth (described in Appendix V of the staff report) do not result in significant destabilizing trends for Ukraine’s public external debt ratio.
152. Beyond the low level of public external debt, the public sector’s external position is characterized by increasingly adequate hedging and negligible rollover risk.
The combination of a steadily declining public sector external debt as a share of GDP in the aftermath of the financial crisis of the late 1990s, together with rapid accumulation of foreign exchange reserves by the monetary authorities, have resulted in a steady and substantial decline in the public sector’s currency mismatch vis-à-vis the rest of the world. Between 2000 and 2003, the public sector’s open position vis-à-vis the rest of the world has narrowed from US$8.7 billion to US$3.6 billion, equivalent to just over 7 percent of GDP (Figure 2); the sector’s exchange rate risk has correspondingly diminished substantially. The very large reserve accumulation so far this year implies that the public sector’s currency mismatch has continued to narrow. At the same time, with the public sector consistently issuing debt at medium- to long-term maturities, the stock of short-term external debt has remained at or very close to zero: this has kept rollover risk minimal.
Figure 2.Public Sector Currency Mismatch
Sources: Ministry of Finance; and Fund staff estimates.
The private sector’s external position
153. The release early this year of Ukraine’s international investment position (IIP) data by the authorities offers the opportunity to pursue a more comprehensive assessment of the economy’s vulnerabilities linked to currency and maturity mismatches. 58 As mentioned above, in the authorities’ presentation, the non-government sector is decomposed into the financial sector, comprising both privately and publicly owned financial institutions, and the nonfinancial private sector (NFPS), comprising private enterprises, households, and public enterprises.
154. Taking into account the external position of the non-government sector paints a much less benign picture of the economy’s overall vulnerabilities (Table 2). As can be seen from Table 1, by 2003 the gross liabilities of the private sector vis-à-vis the rest of the world amounted to some $19.5 billion, almost twice as large as the corresponding liabilities of the public sector. Removing non-debt-creating liabilities (essentially foreign direct investment) yields the private sector’s gross external debt: in 2003, it stood at $13 billion, over 26 percent of GDP, and significantly above public external debt. It can also be noted that private external debt has been much slower to come down, having declined by only 4 percentage points of GDP between 2000 and 2003, despite strong real output growth during this period. In all, incorporating the non-government sector in the analysis brings Ukraine’s total external debt in 2003 to just under 50 percent of GDP. While this level of external debt is not excessive by international standards, it clearly provides less room for comfort than focusing exclusively on the public sector’s external position: experience suggests that it is not uncommon for emerging markets to experience “sudden stops” at such levels of external indebtedness.
|Gross external debt||19,940||21,165||22,079||23,812|
|(in percent of GDP)||63.8||58.7||52.1||48.1|
|Nonfinancial private sector||9,167||10,453||11,020||11,218|
155. The private sector’s external position is characterized by large currency mismatches, exposing the sector, and the economy as a whole, to substantial exchange rate risk. An inspection of Table 1 reveals that the external position of Ukraine’s non-government sector is to a large extent unhedged: by 2003, private sector foreign assets visà-vis the rest of the world fell short of corresponding liabilities by some US$16 billion (Table 3), about one-third of GDP (or just under 20 percent of GDP if equity is excluded). A currency mismatch of this magnitude renders the economy vulnerable to sudden adverse exchange rate movements: a large depreciation of the exchange rate would entail very substantial balance sheet losses for the non-government sector, inevitably resulting in large-scale pressure on the country’s foreign exchange reserves. Given the potential severity of these effects, a better picture of the underlying vulnerabilities is provided by looking at the financial sector and the NFPS separately.
|Nonfinancial private sector||-16,245|
The currency mismatch in the balance sheet of the financial sector remains relatively limited, but its rapid deterioration over the last few years is cause for concern(Figure 3). As of 2003, the financial sector’s net open position vis-à-vis the rest of the world stood at just over 15 percent of tier 2 capital (or some 17 percent of regulatory capital). From a comparative perspective, this ratio also remains well below the thresholds reached by other emerging market economies on the eve of major banking crises.59 At the same time, the rapid pace of the deterioration in the financial sector’s exposure to the rest of the world is cause for concern: in a span of four years, the sector’s balance sheet has shifted from a net asset position of over US$0.5 billion to a net liability position of some US$0.4 billion. Arresting this deteriorating trend over the coming years is clearly an important priority for bank supervisors.
The bulk of the private sector’s currency mismatch vis-à-vis the rest of the world can be traced to the NFPS. In 2003, the currency mismatch in the NFPS balance sheet stood at over US$16 billion, accounting for virtually the entire mismatch of the non-government sector (Figure 4). Even if one were to exclude foreign direct investment from consideration, the NFPS net liabilities to the rest of the world remain substantial, at a little under 20 percent of Ukraine’s GDP. Addressing this sector’s currency mismatch is thus a clear prerequisite for reducing the economy-wide vulnerability to exchange rate risk.
Figure 3.Financial Sector Currency Mismatch
Sources: National Bank of Ukraine; and Fund staff estimates.
Figure 4.NFPS Currency Mismatch
Sources: National Bank of Ukraine; and Fund staff estimates.
156. In contrast to the public sector, the maturity structure of the private sector’s external debt renders it vulnerable to rollover risk. Whereas all of the public sector’s external debt is at medium- to long-term maturities, Table 1 indicates that some 70 percent of the private sector’s external debt in 2003 (or 18 percent of GDP) was of a short-term nature. This maturity mismatch renders the private sector particularly vulnerable to rollover risk in the event of a deterioration in investor sentiment. However, such a vulnerability assessment could be overstated, given that some 60 percent of the private sector’s short-term external debt consists of trade credit, which sometimes tends to be viewed as less volatile relative to other sources of capital inflows. While the jury on this is still out, it is becoming increasingly clear that the stability of trade financing cannot be taken for granted, and that the behavior of these types of flows depend crucially on the nature of the underlying shock hitting an economy. A case in point is Brazil during its most recent financial crisis: in that case, the reversal of trade credit flows turned out to be at least as pronounced relative to other sources of capital account financing.
D. Domestic Liability Dollarization
157. The structure of assets and liabilities of the non-government sector vis-à-vis the rest of the world provides only a partial picture of the sector’s exposure to exchange rate risk; domestic liability dollarization also needs to be taken into account. In addition to currency mismatches vis-à-vis the rest of the world, it is being increasingly recognized that large currency mismatches between domestic sectors can also generate a run on a country’s foreign exchange reserves, and thus trigger, or amplify, a currency crisis. Such “domestic liability dollarization” was at the heart of the Asian financial crisis. This type of vulnerability becomes particularly pronounced in cases where the capital account has been sufficiently liberalized or capital controls can be easily circumvented.
158. Large currency mismatches between domestic sectors are prevalent in the case of Ukraine, compounding the vulnerabilities associated with similar mismatches vis-àvis the rest of the world. The relevant cross-sector balance sheet linkages are summarized in Table 1. The table reveals that the most pronounced currency mismatch between domestic sectors relates to the NFPS exposure to the Ukrainian financial system. This mismatch is a reflection of the large share of foreign currency credit in total credit extended by Ukrainian financial institutions to domestic borrowers—an issue which has already received considerable attention in policy discussions in Ukraine, and which is explored in more detail in Chapter II of this paper.60 The net exposure of the NFPS to the financial system, at over 5 percent of GDP, compounds the sector’s corresponding mismatch vis-à-vis the rest of the world, adding to its vulnerability to adverse exchange rate movements.
159. The counterpart of higher exchange rate risk for the NFPS could be higher credit risk for Ukraine’s financial system. The foreign currency liabilities of the NFPS to the financial system clearly constitute assets for the latter, allowing it to meet its prudential currency exposure requirements in the presence of a net liability position vis-à-vis the rest of the world. This type of hedge, however, could turn out to be particularly problematic. Rather than insulating the financial system from the impact of adverse exchange rate movements, it could expose it to credit risk to the extent that the borrowers concerned do not have adequate sources of foreign exchange earnings. This type of mechanism played a particularly damaging role in the Asian crisis, where exchange rate depreciation triggered widespread defaults by borrowers on their domestic debt obligations, greatly amplifying the crisis. A quantification of this risk for the case of Ukraine is not feasible in the absence of precise information on the composition of domestic borrowers holding foreign currency debt. However, the fact that a substantial share of foreign currency loans (just under 20 percent) goes to households, which presumably have no sources of foreign exchange income, is sufficient cause for concern.
E. Summary Assessment and Policy Implications
160. The above discussion suggests that Ukraine’s non-government sector, especially the NFPS, constitutes the main source of vulnerabilities relating to currency and maturity mismatches. While the external position of the public sector appears strong and well-hedged, the same cannot be said for the non-government sector; and these problems are compounded by extensive domestic liability dollarization. Under these conditions, it is clear that this sector is particularly vulnerable to adverse exchange movements or shifts in investor sentiment. A better refined assessment of these vulnerabilities would depend on more accurate data on the private sector’s foreign assets, whose true level may exceed the recorded amount: this is an area that clearly needs to be explored further.
161. While the non-government sector is the weak link in the economy’s vulnerability chain, more disaggregated data would be useful in refining the assessment of likely propagation channels further. By way of illustration, to the extent that unhedged corporates with large exposures to the rest of the world are simultaneously exposed to the domestic banking system, and given the large share of foreign currency loans to households, the banks could come to bear a major share of the adjustment burden, and in turn constitute a key propagation mechanism (via a credit crunch or other channels) to the rest of the economy. Alternatively, to the extent that public enterprises (financial or nonfinancial) carry an important portion of the exposure to the rest of the world, an exchange rate shock could directly translate into a fiscal problem.
162. Better data could also inform appropriate policy to address the underlying currency and maturity mismatches. The Ukrainian authorities are increasingly recognizing the vulnerabilities generated by these mismatches and are contemplating strengthening the regulatory framework to address them. Recently, they have introduced measures to curb foreign borrowing by (financial and nonfinancial) enterprises, including by barring such borrowing above a certain interest rate ceiling. Taking into consideration the net foreign asset position of the enterprises concerned could constitute a better targeting approach. This, however, would presuppose better information about the balance sheet structure of potential borrowers, especially in the nonfinancial sector.
163. At a more fundamental level, policy needs to address potential distortions that could be encouraging open positions by Ukrainian enterprises. Among the potential contributing factors discussed in the literature, at least two could be relevant in the case of Ukraine: implicit government guarantees; and a pegged exchange rate.
Implicit government guarantees could have played a role in encouraging open positions by fostering moral hazard. Given the lack of disaggregated data, however, it is very hard to make a judgment on the quantitative importance of this factor. At the very least, the balance sheet of public enterprises need to be monitored closely, and prudential limits considered should evidence of moral hazard emerge. Moreover, experience suggests that allowing enterprises to fail can have a powerful signaling effect in improving incentives.
The de facto peg to the dollar pursued over the last few years has probably affected behavior and encouraged excessive risk taking by households and enterprises. Introducing exchange rate flexibility could provide strong incentives to economic agents to improve their balance sheet structures.
164. Aiming at faster accumulation of foreign exchange reserves to provide an economy-wide hedge may not be the best response to address balance sheet problems, and could prove counterproductive. While a good case can be made that reserves were suboptimally low in the recent past, rapid reserve accumulation through end-2003 and so far in 2004 have largely addressed this concern: by now, foreign exchange reserves have risen to a comfortable level in terms of import coverage, and to a comparable level in terms of key monetary aggregates relative to transition and emerging market economy norms. In addition, aiming at a faster growth in reserves than what is needed to keep pace with imports, by (formally or informally) adopting a target linked to the extent of balance sheet mismatches, could actually backfire, worsening the problems it aims to address. In the first place, the mechanism by which reserves are accumulated could have a bearing on the issue at hand: to the extent that faster reserve accumulation is brought about by maintaining the exchange rate pegged at an undervalued level, a policy that has been effectively pursued up to now, this would almost certainly continue to foster incentives biased toward maintaining currency mismatches. Moreover, effectively signaling to the market that the public sector stands ready to accommodate private sector position-taking could entail further moral hazard problems that may actually exacerbate balance sheet mismatches.
165. Balance sheet considerations also have a bearing on the pace and sequencing of capital account liberalization. While this is clearly a much broader issue, policymakers should take into considerations the need by Ukrainian enterprises to augment their foreign asset position, preferably through the accumulation of short-term, liquid assets, so as to strengthen their balance sheets and reduce their vulnerabilities. On this basis, a prudent strategy of capital account liberalization in the near future could reduce currency and maturity mismatches in sectoral balance sheets and actually improve the risk profile of the economy as a whole.
Prepared by Ioannis Halikias.
This section follows the approach described in Allen, M., C. Rosenberg, C. Keller, B. Setser, and N. Roubini, “A Balance Sheet Approach to Financial Crisis,” IMF Working Paper, WP/02/210, 2002.
Reflecting the authorities’ presentation, the NFPS includes private enterprises, households, as well as public enterprises. Similarly, the financial sector includes both privately and publicly owned financial institutions.
The data are available at an annual frequency, and cover the period 2000-03.
To illustrate, on the eve of Turkey’s 2000 banking crisis, the financial sector’s open position had reached over 100 percent of bank capital; and this ratio becomes much larger if one were to adjust for off-balance sheet forward contracts with connected parties that were of dubious quality.
The share of foreign currency credit in total credit is an area of vulnerability. Ukraine’s ratio, at nearly 40 percent, is higher than the average of transition economies (some 30 percent) and other emerging market economies (less than 30 percent).