This occasional paper illustrates how sectoral balance sheet relationships have evolved over time and how this matters for vulnerability analysis in emerging markets. By several measures, the external, public, nonfinancial, and financial sectors have grown more integrated over the past decade, with the latter playing a particularly important role in channeling and amplifying risks. As the case studies show, these transmission mechanisms bear both risks and opportunities at times of financial crisis. If poorly managed, sectoral balance sheet mismatches can reinforce each other and quickly snowball into the full-blown balance of payments crises witnessed in Argentina, Turkey, or Uruguay. But if the authorities are aware of vulnerabilities and are willing to act, they can preempt or mitigate external shocks, by strengthening confidence (as in Lebanon) or shifting risks from weaker to stronger sectors (as in Brazil and Peru). In practice, emerging market governments have often drawn on their own balance sheet—in the first instance their official reserves, and in the second instance their ability to raise taxes or tap foreign credit lines (including from the IMF). If the public sector is perceived to be taking responsibility for private sector mismatches, such implicit bailout guarantees raise questions of moral hazard.
This paper provides some empirical backing for the need for sound liquidity management as a primary tool for crisis prevention. Specifically, the analysis: (1) underscores the importance of temporary asset buffers associated with strong public sector balance sheets (as well as flexible exchange rates) to limit immediate disruptions and give time to implement appropriate policy responses; (2) highlights the benefits of promoting appropriate buffers and hedges in private balance sheets, which would improve risk allocation within and between sectors; (3) supports the strengthening of banking supervision to limit currency exposure (including to borrowers without foreign currency earnings) and maturity mismatches; and (4) shows how sound liability management by both the public and private sectors can play a major role in containing interest rate, currency, and rollover risk.
At the operational level, the paper shows that existing data sources can go some way to allow for intersectoral balance sheet analysis. Both the cross-country comparison in Section III and the case studies in Section IV rely on data readily available from public sources (such as the IMF’s International Financial Statistics, World Bank, and BIS databases) or, in some cases, obtained by country teams from their national counterparts. While recent statistical initiatives (SDDS and the IMF’s coordinated Portfolio Investment Survey) have contributed to improved balance sheet data, large information gaps exist. Sometimes, however, these can be overcome by making pragmatic assumptions (e.g., that banks maintain no open foreign currency positions, if this is required by supervisory regulations). In balance sheet analysis, the perfect can be the enemy of the good: not all questions require a full intersectoral asset-liability matrix as presented in Box 2.1 above. This is not to deny, however, that more systematic data gathering across the membership would greatly improve the quality of analysis.
An initial step toward operationalizing the BSA would be to complete the analysis for “low-hanging fruit”—simple ratios that can be easily calculated and compared across countries and time. Comprehensive indices of currency and maturity mismatches have recently been proposed, inter alia, by Goldstein and Turner (2003) and the MfRisk model. Rather than one single indicator, the present paper uses a range of ratios to gauge various balance sheet risks, which are summarized in the diamond presentation in Figures 3.20 to 3.22 in Section III. Such intertemporal and interregional comparisons provide a natural calibration of the ratios, with the caveats noted above. For example, a first assessment of a member country’s vulnerabilities could be obtained by mapping a set of national mismatch indicators against regional comparators. A multidimensional and flexible use of a variety of indicators also responds to concerns regarding a “one-size-fits-all” or mechanistic approach to vulnerability analysis.
Further analytical and empirical work is under way in the IMF to utilize the balance sheet approach for vulnerability analysis (Box 5.1). The examples presented in this paper are a first tentative step—necessarily impeded by the paucity of data—in a wider effort to use balance sheet analysis in bilateral and multilateral surveillance. In parallel, the BSA is being employed in an increasing number of Article IV consultations. The BSA’s input to policy dialogue and advice should point to areas in which the approach can be further refined. As better statistical information becomes available, the scope of both the indicators and the member countries covered in cross-country analysis can be expanded. In addition, one could seek further insights into balance sheet vulnerabilities by incorporating off-balance-sheet transactions into the analysis, and by using a more disaggregated sectoral breakdown—even if data limitations necessitate reliance on a smaller sample of countries. Moreover, the BSA could be extended to take into account the main channels of financial contagion identified in the literature. Another promising avenue of further work is the application of the contingent claims approach, which extends the static balance sheets compiled along the lines described in this paper to a stress-testing analysis.
Extensions of the Balance Sheet Approach in the IMF
The basic accounting exercise presented in this paper is being refined and extended throughout the IMF, especially with respect to the corporate sector. Initiatives to further operationalize the approach include the following:
A “bottom-up” compilation of corporate data. Some of the IMF’s vulnerability analysis, especially in Asian countries, draws on detailed studies of corporate data, based on the commercially available Worldscope database. Unlike the macroeconomic approach used in this paper, indicators are derived from firm-level information and aggregated across subsectors. However, many difficulties remain to be resolved, such as differing accounting standards and valuation problems.
Improving comparability across sectors and countries. Excel add-in components are now available that provide easy access to a variety of corporate risk indicators in comparable industries and countries. Measures of risk are derived from the above-mentioned Worldscope database.
Applying the contingent claims approach. This methodology allows one to estimate the risks of default and the associated value of a risk transfer across the interrelated balance sheets of the corporate, financial, and public sectors (Gapen, Gray, Lim, and Xiao, 2004). For this purpose a commercially available simulation model, Moody’s MfRisk, is being applied by rating agencies and the IMF to several countries (e.g., Brazil and Thailand). However, the model is a “black box,” which makes the results not always easy to interpret.
Integrating the BSA into early warning systems. A paper by Mulder, Perrelli, and Rocha (2002) finds that the BSA can enhance modern early warning models. Using commercial data for individual corporations in about 20 emerging market countries, the authors find that a number of corporate balance sheet indicators have a measurable relationship to the likelihood of a financial crisis. These include such measures as: (1) the ratio of debt to equity; (2) the ratio of short-term debt to working capital; (3) the corporate share of bank loans times the debt-equity ratio; and (4) the ratio of private sector external debt to exports. Nevertheless, in early warning systems balance sheet indicators can only supplement, rather than substitute for, traditional macroeconomic variables.
In its surveillance, the IMF is striving to apply the BSA to its entire membership, where appropriate. The obvious currency and maturity mismatches in emerging market countries have dictated the early focus on these countries, including in this occasional paper. A closer look at industrial countries (and their differences from emerging markets) could yield important insights. Indeed, balance sheet vulnerabilities relevant to mature markets, such as unfunded pension liabilities or asset price bubbles, are steadily moving to center stage in the IMF’s Article IV consultations with these countries. While a useful tool, the BSA is far from becoming a standard or even prescribed element of IMF surveillance.