The Economic Impact of Fiscal Vulnerabilities: A Balance Sheet Approach1
Government’s balance sheet vulnerabilities have been rapidly rising, becoming a potential source of macro-financial risks for the economy. Banks and nonbank financial institutions, businesses and households have large exposures to the government and, in some cases, their own vulnerabilities. In this context, a fiscal shock can rapidly propagate into the economy through the financial sector. The financial sector is also likely to amplify the impact of shocks on the economy, possibly opening the way to deep recession. In the case of an extreme shock with difficulties in servicing debt, the banking system capitalization would be significantly hit. Staff analysis highlights the need for fiscal consolidation and for strengthening the CBS’s role in monitoring and managing macro-financial risks.
1. Since 2015, the government’s balance sheet, liquidity, and risk exposures have been rapidly deteriorating, raising concerns about the impact on other sectors of the economy. As in many countries, the government in Swaziland is a major economic player with strong linkages with both the financial (banks and non-bank financial institutions) and nonfinancial sectors (businesses and households). As the government’s balance sheet deteriorates, all exposures to the government become a potential source of vulnerabilities for the sectors linked to the government and for the whole economy. Relying on the balance sheet analysis (BSA), this paper examines the nature of balance sheet vulnerabilities the government in Swaziland faces, and how fiscal shocks could transmit through the economy via balance sheet linkages and affect other economic sectors.2
A. Government as a Source of Vulnerability
2. Over the last few years, the government’s balance sheet has been rapidly deteriorating.3 The deterioration has occurred on both the liability and the asset sides.
Rising public debt and short-term exposures. With declining SACU revenue and an expansionary fiscal policy, in FY16/17 the fiscal deficit widened considerably and, while still relatively low, government debt jumped to 25½ percent of GDP, with gross financing needs exceeding 22 percent of GDP. To cover its needs, the government placed an increasing amount of securities with domestic banks and non-bank financial institutions, particularly the public pension fund (PSPF), used some of its deposits at the central bank, borrowed directly from the central bank, and ran significant arrears with domestic suppliers. By March 2017, domestic arrears represented over 20 percent of government liabilities as mapped in the BSA (about 5½ percent of GDP). The composition of government liabilities creates high rollover needs due to the predominantly short-term maturity of both the arrears and outstanding securities (above 66 percent of domestic securities has a maturity below one year).
Limited liquid financial assets. Government’s assets mainly include deposits at the central bank. These are large, but have been on a declining trend since 2014, and reached 7 percent of GDP in March 2017.4 While these deposits are liquid and may in principle be used in the short run to cover expenses in domestic currency (e.g. wages), a significant drawdown would have a direct impact on international reserve coverage, risking to put the credibility of the peg with the South African rand at risk. Namely, deposit withdrawals would cause an expansion of the monetary base, and a drop of reserve coverage of the same. In addition to central bank deposits, the government holds various illiquid assets, mainly in the form of ownership of public corporations, and tax claims (3 percent of GDP), which are unlikely to be realized in full.
Government Liabilities, March 2017
Source: Central Bank of Swaziland
Composition of Domestic Debt, March 2017
Source: Central Bank of Swaziland
3. Large maturity mismatches in its balance sheet and high financing needs make the government a source of vulnerabilities and potential shocks to the economy. In the near term, the government is exposed to the risk of liquidity shortfalls, as its limited liquid financial assets are insufficient to cover its large short-term liabilities. As deposits at the central bank cannot be readily used without affecting external sustainability and putting at risk the credibility of the currency peg, the government is exposed to the risk of not being able to honor fully its short-term commitments (e.g. with suppliers). Apart from domestic arrears, in the extreme case, the government could have difficulty in servicing and rolling over debt, forcing balance sheet losses on government debt holders in the financial sector.
B. Transmission of Fiscal Vulnerabilities into the Economy
4. The balance sheet analysis of the different sectors of the economy reveals two main channels through which fiscal shocks could propagate into the economy. First, the government has links with the private nonfinancial sector (i.e., corporate suppliers and households) via domestic arrears and services demand and, indirectly, with banks, through their large loan exposures to nonfinancial sectors. Second, both banks and non-bank financial institutions have direct exposures to the government via securities holdings.
Linkages with the private sector and indirect links with banks. The accumulation of arrears by the government weakens the balance sheet of nonfinancial corporations, leading to liquidity pressures and potentially increasing corporate default rates, including on bank loans. In turn, corporates have strong links with the banking system in the form of loans received. Specifically, loans to corporates and households represent over 60 percent of bank assets, or approximately 20 percent of GDP in March 2017. While the banking system appears on average well capitalized and liquidity buffers satisfy regulatory requirements, the liquid assets to short-term liabilities ratio for banks in Swaziland is low when compared to neighboring countries. In addition, liquid assets include relatively large amounts of government securities with no secondary market. The large amounts of illiquid assets make the banking system a potentially powerful transmission channel for fiscal balance sheet shocks into the economy. On the liability side, banks finance most of their assets through short-term corporate and household deposits.5 Against this background, the balance sheet analysis suggests that the banking sector is particularly vulnerable to liquidity withdrawals. Indeed, stress tests show that the banking sector on average could find difficult to withstand even moderate liquidity shocks. In this context, an increase in government arrears that prompts corporate defaults on outstanding loans or large deposit withdrawals could force banks to shrink their balance sheet, with negative effects on credit growth and on the economy.
Direct linkages with the financial sector. Banks and NBFIs also have direct exposures to the government via security holdings (about 8 percent of GDP). Banks own about 11 percent of their assets in government securities. The PSPF is the largest non-bank financial institution in Swaziland, with a balance sheet of about 37 percent of GDP in March 2017.6 The PSPF had a combined exposure to the public sector of about 4 percent of GDP (11 percent of PSPF’s assets), including loans to parastatal institutions, while most its assets are invested abroad. The size and interconnectedness of other nonbank financial institutions is less clear, as assets under management may be double counted in the BSA table.7 Nevertheless, they are relatively smaller. However, direct linkages between the financial sector and the government may increase significantly if, following authorities’ plans, the domestic asset requirement policy is increased obliging financial institutions to repatriate some of their foreign assets and hold local assets, most likely government debt instruments.
Liquid Assets to Short-Term Liabilities, 2016 Q4
Source: IMF financial soundness indicators.
5. In sum, the BSA suggests that a fiscal shock could rapidly propagate throughout the sectors of the Swaziland economy with potentially significant macroeconomic effects. (Table 1). The initial shock generated by, for example, the government’s inability to service arrears or debt outstanding could cause corporate bankruptcies, rising NPLs (as a percent of total loans, from 8 percent in 2016Q1 to 10½ percent in 2017Q1) and possibly a decrease in the value of government debt held by banks. The banking system would suffer losses through markdowns and provisioning, and possibly run the risk of liquidity withdrawals from depositors. In such a scenario, banks would be forced to deleverage and decrease credit supply, with negative effects on growth. In addition, in the case of difficulties to rollover short-term debt, the PSPF would also suffer losses on its government debt holdings. As the PSPF’s liabilities are part of households’ financial wealth, should the shock create a solvency issue for the fund, this would put additional pressure on the government’s budget to bail out the fund’s beneficiaries.
|Government||Central Bank||Banks||PSPF||Other Non-Bank Financial||Nonfinancial Corporations||Households||External|
|Other Non-Bank Financial 1/||13.4||13.7||3.3||1.4||3.9||0.0||20.5||29.0|
Includes assets managed by asset management companies.
Includes assets managed by asset management companies.
C. Impact of Fiscal Vulnerabilities
6. Further payment delays and accumulation of domestic arrears may have far reaching implications on the financial sector and the economy. In March 2017, the NPL ratio of banks (as a percent of total loans) stood on average at 10½ percent, and government arrears with non-financial corporations (NFCs) are estimated to be approximately three times larger than NPLs. Therefore, if a large amount of government arrears is not repaid, the NPL ratio could rise substantially. While stress tests indicate that the banking sector is on average resilient to a further increase in NPLs, the impact would vary across banks, forcing increases in provisions and imposing losses, with some deleveraging and reduction in bank credit. Second-round effects would see the impact of shocks on the economy amplified. Credit rationing could lead to a general slowdown of the economy impacting both corporates and household consumption, and possibly lead to further bankruptcies and NPLs.
7. In the extreme case of difficulties in servicing government debt, a reduction in the value of government securities would directly affect banks’ capital buffers. As of March 2017, banks’ holdings of government securities amounted to 2.1 billions Emalangeni (3.8 percent of GDP; about 85 percent of qualifying capital). While the banking system is well capitalized, a reduction in the value of government securities will severely hit banks’ capital buffers. On average, capital would remain above regulatory requirements, but the effect would vary largely across banks and, in the case of large losses, the capital ratio for some banks would fall below regulatory requirements. Moreover, before a default on government debt occurs, corporate defaults rates and NPLs would have certainly increased, already weakening existing capital buffers, so that a default on government securties may likely bring capital below regulatory requiriments.
Capital Ratio and Losses on Government Securities
Source: IMF Staff Estimate
8. In sum, a weak public sector balance sheet and tight linkages between government and domestic financial institutions raise significant macro-financial risks and call for adequate policies. Fiscal adjustment is critical to avoid a further deterioration of the fiscal position both in terms of flows and balance sheet. At the same time, tightening linkanges between fiscal and financial sectors call for accelerating plans to create a financial regulatory architecture for the financial sector and provide the CBS with the powers and instruments to address macro-financial risks and exercise macro-prudential controls.
Prepared by G. Ugazio.
For details on the balance sheet approach see “Balance sheet analysis in Fund surveillance”, IMF 2015. The BSA matrix for Swaziland is based on official data provided by the authorities covering the fiscal, financial, and external sectors, as well as ad hoc data to fill gaps and estimate the missing links. By construction, the sum of all net positions allocated in the BSA matrix is zero.
The BSA analysis is based on the central government’s balance sheet and exposures to the rest of the economy. It does not include additional exposures related to non-central government entities.
The additional 3 percent of GDP claim on the central bank displayed in Table 1 refers to central bank’s capital.
Banks’ exposure to non-financial sectors on the assets and liability side is equally split between corporates and households.
PSPF’s liabilities are assumed to mainly cover individuals (members of the fund)’s claims on the PSPF.
Asset managers report on their financial statements those assets they manage on behalf of other institutions, but do not own them outright.