Article

Research: Innovative Approach Can Help Countries Spot Balance Sheet Risks

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
October 2006
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Economies have become more reliant on private capital flows and have thus also become more vulnerable to capital account crises, when large and sudden withdrawals of capital cause sharp adjustments in the exchange rate. In many cases, capital outflows have been triggered by balance sheet imbalances, as was the case in the late 1990s in Korea and Thailand. In these instances, rising debt levels in corporate and banking sector balance sheets—without compensating increases in the value of assets—undermined investor confidence. A recent IMF Working Paper offers an innovative approach that can be used to measure the balance sheet risk of the sovereign, the financial sector, and the nonfinancial corporate sector.

This new approach can be particularly useful because it complements traditional flow analysis, which focuses on the gradual buildup of unsustainable fiscal and current account positions—but may no longer be adequate to fully explain the dynamics underlying modern-day capital account crises.

Until recently, the contingent claims approach has been widely applied by financial market participants, most notably by leading credit rating agencies to assess credit risk in individual firms. The IMF authors have extended this approach more broadly to measure aggregated balance sheet risk in a multisector framework and to analyze credit risk in individual sectors.

Applying the contingent claims methodology to a multi-sector framework allows policymakers to examine linkages between the corporate, financial, and public sectors, particularly where potentially important feedback effects between sectors can be estimated and valued.

Benefits of a new approach

To put it simply, the Fund’s contingent claims approach takes balance sheet information and combines it with current financial market prices to construct various risk indicators. Such an approach has several advantages. First, by using balance sheet information, the Fund is able to identify stock imbalances that, if left unattended, could leave a country vulnerable to shocks. This provides a useful—and essential—complement to flow analysis, which is the mainstay of Fund surveillance.

Second, since market prices represent the collective views and forecasts of many investors, the approach is forward looking, unlike an analysis based only on a review of past financial statements. Third, when estimating credit risk, the approach takes into account market volatility. Volatility is crucial in capturing changes in risk, especially during times of stress, when small shocks can quickly gain momentum and trigger systemic repercussions. And, finally, the approach distills the vulnerability assessment into a single statistic that is easy to interpret, so that the approach will be able to indicate at any time whether the balance sheet is improving or deteriorating.

Pinpointing vulnerabilities

How can this be used to assess vulnerabilities at the country or sovereign level? Using standard option pricing techniques, a measure called the distance to distress is derived. As its name implies, this indicator measures the “distance” in terms of standard deviations that sovereign assets are away from a critical debt threshold. If assets fall below the threshold, the sovereign is considered to have entered into a state of distress, which, if left unaddressed, may eventually lead to a default. The more volatile the sovereign assets or the closer the asset value is to the debt threshold, the higher the probability that the threshold could be breached and the higher the probability of default.

To test the approach, the authors applied it to the balance sheet risk of 12 emerging market economies at the sovereign level. The risk indicators are found to be robust and highly correlated with market spreads. Given its multisector setting, the approach was also able to put a value on the risk transfer across interrelated balance sheets of the corporate, financial, and public sectors. In sum, the results show that the approach holds promise as a tool to estimate and manage risk in key sectors of an economy.

Cheng Hoon Lim

IMF Monetary and Capital Markets Department

This article is based on IMF Working Paper No. 05/155, “Measuring and Analyzing Sovereign Risk with Contingent Claims,” by Michael T. Gapen, Dale F. Gray, Cheng Hoon Lim, and Yingbin Xiao. Copies are available for $15.00 each from IMF Publication Services; see page 308 for ordering details. The full text is also available on the IMF’s website (www.imf.org).

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