What Is the Balance Sheet Approach?

Unlike traditional analysis, which is based on the examination of flow variables (such as current account and fiscal balance), the balance sheet approach focuses on the examination of stock variables in a country’s sectoral balance sheets and its aggregate balance sheet (assets and liabilities). From this perspective, a financial crisis occurs when there is a plunge in demand for financial assets of one or more sectors: creditors may lose confidence in a country’s ability to earn foreign exchange to service the external debt, in the government’s ability to service its debt, in the banking system’s ability to meet deposit outflows, or in corporations’ ability to repay bank loans and other debt. An entire sector may be unable to attract new financing or roll over existing short-term liabilities. It must then either find the resources to pay off its debts or seek a restructuring. Ultimately, a plunge in demand for the country’s assets leads to a surge in demand for foreign assets and/or for assets denominated in foreign currency. Massive outflows of capital, a sharp depreciation of the exchange rate, a large current account surplus, and a deep recession that reduces domestic absorption are often the necessary counterpart to a sudden adjustment in investors’ willingness to hold a country’s accumulated stock of financial assets.

An economy’s resilience to a range of shocks, including financial shocks, hinges in part on the composition of the country’s stock of liabilities and assets. The country’s aggregate balance sheet—the external liabilities and liquid external assets of all sectors of the economy—is vital. But it is often equally important to look inside an economy and to examine the balance sheet of an economy’s key sectors, such as the government, the financial sector, and the corporate sector.

Our framework for assessing balance sheet risks focuses on four types of balance sheet mismatches, all of which help to determine a country’s ability to service debt in the face of shocks: (i) maturity mismatches, where a gap between liabilities due in the short term and liquid assets leaves a sector unable to honor its contractual commitments if the market declines to roll over debt, or creates exposure to the risk that interest rates will rise; (ii) currency mismatches, where a change in the exchange rate leads to a capital loss; (iii) capital structure problems, where a heavy reliance on debt rather than equity financing leaves a firm or bank less able to weather revenue shocks; and (iv) solvency problems, where assets—including the present value of future revenue streams—are insufficient to cover liabilities, including contingent liabilities. Maturity mismatches, currency mismatches, and a poor capital structure all can contribute to solvency risk, but solvency risk can also arise from simply borrowing too much or from investing in low-yielding assets.

An analytical framework that examines the balance sheets of an economy’s major sectors for maturity, currency, and capital structure mismatches helps to highlight how balance sheet problems in one sector can spill over into other sectors, and eventually trigger an external balance of payments crisis. Indeed, one of the core arguments that emerges from this approach is that the debts among residents that create internal balance sheet mismatches also generate vulnerability to an external balance of payments crisis. The transmission mechanism often works through the domestic banking system. For instance, broad concerns about the government’s ability to service its debt, whether denominated in domestic or foreign currency, will quickly destabilize confidence in the banks holding this debt and may lead to a deposit run. Alternatively, a change in the exchange rate coupled with unhedged foreign exchange exposure in the corporate sector can undermine confidence in the banks that have lent to that sector. The run on the banking system can take the form of a withdrawal of cross-border lending by nonresident creditors, or the withdrawal of deposits by domestic residents.

Many of the characteristics of a capital account crisis derive from the adjustment in portfolios that follows from an initial shock. Underlying weaknesses in balance sheets can linger for years without triggering a crisis. For example, a currency mismatch can be masked so long as continued capital inflows support the exchange rate. Consequently, the exact timing of a crisis is difficult to predict. However, should a shock undermine confidence, it can trigger a large and disorderly adjustment, as the initial shock reveals additional weaknesses and a broad range of investors, including local residents, seek to reduce their exposure to the country. Massive flows are the necessary counterpart of a sudden move toward a new equilibrium of asset holdings stemming from rapid stock adjustments. If these flows cannot be financed out of reserves, the relative price of foreign and domestic assets has to adjust. An overshooting in asset prices (including the exchange rate) is likely, as investors rarely have access to perfect information and may be prone to herding.

Policy Implications

Information about sectoral balance sheets is most useful if it is available in time to allow policymakers to identify and correct weaknesses before they contribute to financial difficulties. In practice, however, balance sheet information is often only partly available and can be obtained only with significant time lags, which limits its utility for all but ex post analysis. Balance sheet analysis starts with in-depth analysis of sector vulnerabilities; the first step is to identify gaps in country data and to develop the sources needed to provide this data. There is an obvious case for better data collection and enhanced external disclosure of key balance sheet data.

The balance sheet approach also focuses attention on policies that can reduce sectoral vulnerabilities—particularly the vulnerability to changes in key financial variables. It reinforces the importance of (i) sound debt management by the public sector to minimize the risk that weaknesses in the public sector’s balance sheet will be a source of financial difficulty and to preserve the public sector’s capacity to cushion against shocks originating in the private sector; (ii) policies that create incentives for the private sector to limit its exposure to various balance sheet risks, particularly the explosive combination of currency and maturity risks created by short-term foreign currency denominated borrowing; and (iii) the need to maintain a sufficient cushion of reserves. Flexible exchanges rates can help to limit exposure to currency risk and encourage ongoing hedging as well as facilitating adjustment to external shocks. But the balance sheet approach also underscores some of the risks that can continue to arise in a floating exchange rate regime, particularly if the public sector is the source of the financial instruments that help the private sector hedge against currency risk. While the balance sheet approach directs attention to indicators of financial strength rather than more classic macroeconomic indicators, it in no way diminishes the importance of sound macroeconomic policies. Large debt stocks emerge from persistent flow imbalances (fiscal and current account deficits), and underlying macroeconomic weaknesses are often the reason why countries can borrow only in foreign currency or with short maturities.

Information about sectoral balance sheets can also help policymakers evaluate the trade-offs between different policy objectives that arise after sectoral problems have snowballed into a systemic threat to the financial and economic system.

• A government faces the trade-off between helping the private sector hedge the exchange rate exposure on its balance sheet by selling foreign exchange (or other forms of exchange rate insurance) and the risk that government itself will experience a rollover crisis. Indeed, selling reserves to defend an overvalued nominal exchange rate has often aggravated a maturity mismatch on the government’s own balance sheet.

• An assessment of the relative scale of maturity and currency mismatches on sectoral balance sheets can help policymakers weigh the trade-off between an interest rate defense and a nominal exchange rate adjustment. In practice, policymakers are unlikely to be able to either direct monetary policy solely at domestic macroeconomic conditions or to direct monetary policy solely at exchange rate stabilization: they will need to aim for the right balance between exchange rate adjustment and monetary tightening.

• There is obvious appeal in running a countercyclical fiscal policy to limit the fall in output associated with a crisis that originates in the private sector. The scope to do so will depend critically on the strength of the government’s balance sheet and its ability to obtain the needed financing.

Finally, the balance sheet approach can help the official sector to assess the case for financial intervention, and to better understand the scale of official support needed. Not all sectoral financial crises in emerging market economies call out for official intervention. In many cases, problems in the private sector’s balance sheet can and should be resolved by restructuring the private sector’s liabilities without any government intervention or financing. In other cases, the national government will be able to use its own reserves and other elements of the strength of its own balance sheet to prevent a crisis in the private sector from spreading. Such intervention should be accompanied by steps to reinforce incentives for more prudent behavior in the future, including closing weak institutions. However, there are cases where the country’s authorities will lack access to the resources—notably foreign exchange reserves—on the scale needed to act to prevent a crisis on private sector balance sheets (for example, a run on foreign currency denominated bank deposits) from snowballing. And the government cannot intervene when it is the source of financial distress itself.

Exceptional external financing from the official sector may be justified under some circumstances as part of a strategy to prevent a broader crisis. The genesis of recent financial crises points to the need to address sector balance sheet problems quickly and in a targeted manner, before they snowball into even larger problems that put severe pressure on a country’s balance of payments and trigger a deep crisis that results in a large fall in output. In times of stress, a country may need to quickly increase its holdings of gross reserves to be in a position to support the orderly unwinding of balance sheet problems. Fund support can therefore play an important role in augmenting a country’s reserves so that it is better positioned to contain the crisis.

The scale of the needed support can be quite large, as a country’s financing needs will be proportionate to the stock of outstanding claims of the sector in distress. All foreign currency denominated debts—even if between residents—can generate pressure on official reserves. Claims denominated in domestic currency can also be a source of pressure, as there are limits to the extent monetary expansion can be used to address a domestic rollover crisis without ultimately putting pressure on reserves.

Yet even as the balance sheet approach highlights the case for official support to avoid a crisis that snowballs across sectors and becomes a generalized loss of confidence, it also underscores the limits on what official intervention can be expected to accomplish. Borrowing from the official sector does not transform either the country’s aggregate balance sheet or the government’s balance sheet for the better. Increased access to foreign exchange in the short run is offset by a new liability to preferred creditors. External borrowing from official creditors may help address a sectoral maturity mismatch, including a rollover crisis stemming from a maturity mismatch on the government’s own balance sheet. But official lending cannot resolve a country-wide currency mismatch. At best it can provide access to foreign exchange liquidity that allows the private sector to reduce its open foreign currency position—at the cost of increasing the government’s foreign currency exposure. The accumulation of additional senior debt will certainly increase capital structure risk. Official lending can temporarily cover a maturity mismatch and therefore provide time to make appropriate adjustments—whether to the exchange rate regime or to the fiscal account—to strengthen the country or the government’s long-term sustainability. But official lending itself will not make an unsustainable balance sheet sustainable.