## Annex I ## Source details **Canonical URL:** [Annex I](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2002/_wp02210.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2002/_wp02210.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2002/_wp02210.pdf.json) --- ### Summary of the Balance Sheet Approach and Key Findings - Financial markets increasingly integrated over the past ten years. - Foreign borrowing financed higher investment than domestic savings alone and contributed to sustained periods of growth, but opening capital markets placed exceptional demands on financial and macroeconomic policies in emerging market economies. - Private capital flows are sensitive to market conditions, perceived policy weaknesses, and negative shocks; flows have been more volatile than many expected, and several major emerging economies experienced sharp financial crises since 1994. - The financial structure of many emerging market economies—the composition and size of liabilities and assets on the country’s financial balance sheet—has been an important source of vulnerability to crises. - 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 external debt, - a government’s ability to service its debt, - a banking system’s ability to meet deposit outflows, - 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 and must find resources to pay off debts or seek restructuring. - A plunge in demand for a country’s assets leads to a surge in demand for foreign assets and/or assets denominated in foreign currency; massive capital outflows, sharp exchange rate depreciation, a large current account surplus, and a deep recession often accompany sudden adjustments in investors’ willingness to hold accumulated financial assets. ### What Is the Balance Sheet Approach? - Contrasts with traditional flow-based analysis (current account, fiscal balance) by focusing on stock variables in sectoral and aggregate balance sheets (assets and liabilities). - Framework emphasizes four types of balance sheet mismatches that determine a country’s ability to service debt under shocks: - (i) Maturity mismatches: gap between liabilities due in the short term and liquid assets, exposing sectors to rollover risk and interest rate risk. - (ii) Currency mismatches: changes in the exchange rate can produce capital losses. - (iii) Capital structure problems: heavy reliance on debt rather than equity financing reduces ability to withstand revenue shocks. - (iv) Solvency problems: assets, including present value of future revenue streams, insufficient to cover liabilities, including contingent liabilities. - Maturity mismatches, currency mismatches, and poor capital structure can contribute to solvency risk; solvency risk can also arise from excessive borrowing or investing in low-yielding assets. - Examination of sectoral balance sheets (government, financial sector, corporate sector) for maturity, currency, and capital structure mismatches helps trace spillovers across sectors and eventual external balance of payments crises. - Internal debts among residents that create internal balance sheet mismatches generate vulnerability to external balance of payments crises, often transmitted via the domestic banking system. - Confidence concerns about government debt (domestic or foreign currency) can destabilize banks holding that debt and may trigger deposit runs; exchange rate changes coupled with unhedged corporate foreign exchange exposure can undermine banks that lent to that sector. - Runs on the banking system can take the form of withdrawal of cross-border lending by nonresident creditors or withdrawal of deposits by domestic residents. - Balance sheet weaknesses can remain latent for years if capital inflows support the exchange rate; the timing of crises is difficult to predict, but shocks can trigger rapid, disorderly adjustments revealing additional weaknesses and prompting broad investor retrenchment. - Massive flows are the necessary counterpart of rapid stock adjustments; if flows cannot be financed from reserves, relative prices of foreign and domestic assets must adjust, leading to possible overshooting in asset prices and exchange rates. ### Policy Implications and Operational Issues - Timely sectoral balance sheet information is most useful for preventive action, but such information is often only partly available and obtained with significant time lags, limiting its utility except for ex post analysis. - Balance sheet analysis should begin with in-depth sector vulnerability analysis and identification of data gaps; there is a strong case for better data collection and enhanced external disclosure of key balance sheet data. - Policy focus to reduce sectoral vulnerabilities: - (i) Sound public sector debt management to minimize the risk public sector balance sheet weaknesses become sources of financial difficulty and to preserve capacity to cushion private-sector shocks. - (ii) Policies creating incentives for the private sector to limit exposures to balance sheet risks, particularly the combination of currency and maturity risks from short-term foreign currency borrowing. - (iii) Maintaining a sufficient cushion of reserves. - Flexible exchange rates can help limit currency exposure, encourage hedging, and facilitate adjustment to external shocks, but risks can persist in floating regimes if the public sector issues instruments that are used by the private sector to hedge currency risk. - The approach emphasizes financial strength indicators but reaffirms the importance of sound macroeconomic policies; large debt stocks emerge from persistent flow imbalances (fiscal and current account deficits), and macroeconomic weaknesses often explain why countries must borrow in foreign currency or short maturities. - Balance sheet information assists policymakers in weighing trade-offs after sectoral problems threaten systemic stability: - Trade-off between selling foreign exchange to help private-sector hedging and the risk of precipitating a government rollover crisis (selling reserves to defend an overvalued exchange rate can aggravate government maturity mismatch). - Assessment of relative scale of maturity and currency mismatches helps weigh interest rate defense versus nominal exchange rate adjustment; policymakers must balance exchange rate adjustment and monetary tightening. - Scope for countercyclical fiscal policy depends critically on the strength of the government’s balance sheet and its access to financing. - Role and limits of official intervention: - Not all sectoral financial crises require official intervention; many private-sector balance sheet problems can be resolved by private restructuring without government financing. - National governments with adequate reserves and strong balance sheets can prevent private-sector crises from spreading, but intervention should include measures to improve future incentives and close weak institutions. - Authorities may lack sufficient foreign exchange reserves to prevent a crisis (for example, a run on foreign currency–denominated bank deposits); government cannot intervene effectively when it is the source of financial distress. - Exceptional official external financing may be justified to prevent broader crises; rapid augmentation of gross reserves can support orderly unwinding of balance sheet problems. - Scale of support can be large because financing needs are proportionate to the stock of outstanding claims of the sector in distress; all foreign currency–denominated debts—even between residents—can generate pressure on official reserves. - Domestic currency claims can also pressure reserves because monetary expansion to address domestic rollover crises has limits before impacting reserves. - Official borrowing does not transform a country’s aggregate or government balance sheet: it provides short-run foreign exchange access at the cost of creating a new liability to preferred creditors and increases capital structure risk. - Official lending can temporarily cover maturity mismatches and provide time for adjustments (exchange rate or fiscal) but cannot make an unsustainable balance sheet sustainable nor resolve a country-wide currency mismatch. ### Context, Literature, and Historical Insights - Balance sheet approach gained prominence after crises in the 1990s; overview of model generations: - First-generation models emphasized monetized fiscal deficits and mechanical reserve thresholds. - Second-generation models introduced endogenous policy responses and self-fulfilling panic dynamics. - Asian crisis of 1997-98 motivated third-generation models based on balance sheet analysis. - Balance sheet approach can strengthen IMF surveillance and, where data permits, help gauge ex ante the scale of potential pressures on reserves and financing needs if reserves are insufficient. ### Microeconomic drivers, currency mismatches, and runs (Box 1 highlights) - Microeconomic distortions driving vulnerabilities: - weakly supervised and regulated financial systems, - connected and directed lending, - moral hazard from implicit/explicit government guarantees, - fixed exchange rates distorting external borrowing toward short-term foreign currency debt. - Liability dollarization effects: - large currency depreciation with foreign currency liabilities increases real debt burdens and can trigger investment and output contraction. - models produce self-fulfilling runs or fundamental-shock-driven depreciation with adverse balance sheet effects. - Self-fulfilling runs and international bank-run analogies: - liquidity mismatches make governments and financial institutions vulnerable to self-fulfilling runs; risk greater under fixed exchange rates. - Sudden stops and capital inflow reversals: - combine currency/liquidity mismatches, balance sheet effects, moral hazard, panicky behavior, financial sector frictions, overinvestment in non-tradables. - Corporate finance / capital structure perspective: - country “capital structure” matters; reliance on debt (high debt-to-equity) magnifies shocks. ### Sectoral application matrix (Box 2 summary) - Government - Maturity mismatch: short-term hard currency debt v. liquid assets (reserves). - Currency mismatch: foreign currency–denominated government debt v. hard currency assets (reserves). - Solvency: liabilities v. assets including discounted value of future primary surpluses (including seignorage); includes implicit and contingent liabilities. - Banks - Maturity mismatch: short-term hard currency debts v. liquid hard currency assets and central bank access. - Currency mismatch: foreign currency assets (loans) v. foreign currency liabilities (deposits/interbank lines). - Capital structure mismatch: deposits-to-capital ratio; capital adequacy. - Solvency: bank liabilities v. bank assets and capital. - Firms - Maturity mismatch: short-term debts v. liquid assets. - Currency mismatch: foreign currency debts v. hard-currency-generating assets. - Capital structure mismatch: debt-to-equity ratio. - Solvency: liabilities v. present value of assets. - Households - Maturity mismatch: short-term debt v. liquid household assets. - Currency mismatch: foreign currency assets v. foreign currency liabilities. - Solvency: liabilities v. future earnings. ### Key analytical points and surveillance implications - Identifying maturity, currency, capital structure, and solvency mismatches at the sectoral level is crucial to understanding crisis genesis and transmission mechanisms not visible in consolidated country balances. - Policy and surveillance should pay attention to: - currency composition of debts across sectors, - maturity profile of liabilities and availability of liquid assets/reserves, - capital adequacy of financial institutions relative to true risk exposures, - fiscal position’s capacity to generate future primary surpluses and implicit/contingent liabilities. ### Indicators of potential financing needs in recent capital account crises (Table 1 excerpts, percent of GDP) - Brazil (1998) - Short-term external debt1: 10.5 - Deposit base (M2): 26.9 - Gross foreign reserves2: 5.4 - Memorandum items: - Fund access in percent of GDP3: 2.3 - Fund access in percent of quota4: 600 - Fund access in million of U.S.$: 18,262 - Indonesia (1997) - Short-term external debt1: 42.7 - Deposit base (M2): 55.6 - Gross foreign reserves2: 7.7 - Memorandum items: - Fund access in percent of GDP3: 4.4 - Fund access in percent of quota4: 490 - Fund access in million of U.S.$: 10,083 - Korea (1997) - Short-term external debt1: 12.4 - Deposit base (M2): 46.2 - Gross foreign reserves2: 1.9 - Memorandum items: - Fund access in percent of GDP3: 4.0 - Fund access in percent of quota4: 1938 - Fund access in million of U.S.$: 20,990 - Thailand (1997) - Short-term external debt1: 31.3 - Deposit base (M2): 84.8 - Gross foreign reserves2: 5.5 - Memorandum items: - Fund access in percent of GDP3: 2.2 - Fund access in percent of quota4: 505 - Fund access in million of U.S.$: 3,926 - Footnotes (as in source): - 1 End-period stocks at residual maturity, original maturity for Korea. - 2 End-period stocks; only usable reserves for Korea; net of forwards and swaps for Thailand. - 3 U.S. dollar value of GDP for year prior to arrangement. - 4 Using quotas existing at the time of program approval (before recent increase in quotas). ### Crisis prevention and IMF policy advice implications - Balance sheet approach complements flow analysis by focusing on accumulated debt stocks in sectoral balance sheets; stocks reflect cumulative past deficits. - Solvency requires present discounted value of future flows (primary balances or trade balances) sufficient to service current stocks of debt. - Key implications: - Adjustment in a balance sheet crisis is typically sharp and front-loaded. - Asset price overshooting is common. - Balance sheet effects greatly affect aggregate supply and demand, with pronounced output repercussions. - The approach captures cascading effects from sector to sector due to contingent liabilities. - Financing a current account deficit by issuing external debt affects the country’s aggregate balance sheet; persistent flow deficits translate into stock problems. - Governments can strengthen national balance sheets through: - developing data sources to monitor asset and liability positions, - adopting policies that build a solid government balance sheet, - creating incentives for sound private sector balance sheets. ### Data availability as prerequisite for balance sheet analysis (Box 4 highlights) - Reliable data on assets and liabilities of sectoral and aggregate balance sheets is essential. - Most countries lack relevant stock data; Fund focus often limited to public sector stock positions: gross debt, deposits in the financial system, and NIR. - Data-improvement efforts encouraged: - compile the International Investment Position (IIP) and conduct the Coordinated Portfolio Investment Survey (CPIS) in line with BPM5, - move towards preparation of the general government’s balance sheet according to GFSM 2001, - present debt data consistent with the External Debt Statistics Guide (Debt Guide). - Expected benefits of improved data: external assets/liabilities by sector, maturity and instrument; reveal foreign currency and interest rate sensitivity; facilitate residual maturity calculation. - SDDS timing: - SDDS subscribers required to disseminate end-2001 IIP data by end-June 2002. - SDDS categories for external debt become mandatory for SDDS subscribers by end-March 2003. - Policy recommendations: - Flexible exchange rate regimes to limit currency risk exposure. - Strengthen public sector balance sheet: aim for balanced budgets and augment reserves. - Develop domestic markets for equity and long-term local-currency debt and hedging instruments. - Sound public debt management focusing on short maturities, currency sensitivity, contingent liabilities. - Monitor private sector debt structures and limit contingent government claims. - Transparency: collect and disseminate data on foreign exchange and maturity exposures. - Compile and disclose IIP. - Monitor financial system resilience via FSAPs. - Prudential regulation to account for direct and indirect foreign currency exposure. - Avoid tax/regulatory biases favoring debt over equity. - Strengthen insolvency regimes. - Improve balance sheet vulnerability analysis and macro-prudential indicators. ### Public sector debt management and private liability dollarization - Public sector: key asset is capacity to run future primary surpluses; often illiquid and long-term. - Emerging markets face choices: longer-term foreign currency borrowing or shorter-term domestic currency borrowing when long-term local-currency debt markets do not exist. - Private-sector liability dollarization risks: - sudden withdrawal of foreign currency deposits, - financial sector exposure to currency shocks from real depreciation. - Prudential options: - higher reserve requirements for foreign currency liabilities, - policies to discourage short-term external borrowing (example: Chile’s encaje), though implementation is difficult. ### Policy choices and trade-offs during crises (Box 4 examples) - Exchange rate policy: - Overvaluation usually best addressed by nominal depreciation; both nominal devaluation and deflation increase real burden of foreign currency debts. - Governments should generally hesitate to use reserves to defend a currency peg under sustained pressure; reserve sales increase government maturity mismatch and can precipitate runs on short-term government or financial sector liabilities. - Only very high official reserves justify reserve use ex ante to minimize balance sheet effects. - Monetary policy and foreign exchange intervention after devaluation: - Tightening monetary policy can limit depreciation but increases burden on sectors with maturity mismatches. - Access to emergency external financing eases trade-offs. - Capital outflow controls: - May prevent exchange rate overshooting without sharp monetary contraction but risk rent-seeking and erosion of effectiveness. - Case evidence: Thailand, Malaysia, Russia, Argentina. - Fiscal policy: - Countercyclical fiscal policy can offset balance sheet impacts when private sector currency mismatches are pronounced, subject to availability of financing and fiscal sustainability. - If public sector balance sheet weaknesses are central, limiting government borrowing must take precedence. ### Role and limits of official external financing - Reserves are both financial and monetary assets; they back currency and provide emergency liquidity to meet payment needs arising from sectoral mismatches. - Timing and scale of official support matter: early financing can prevent snowballing. - With deeper financial integration, sectoral problems are more likely to generate balance of payments crises. - Official external financing or debt restructuring may be necessary when reserves and private financing cannot meet surge in foreign currency demands. - Official financing best suited to addressing maturity mismatches; it can temporarily replace maturing private foreign currency debt but creates preferred claims and can weaken capital structure. - Nonconcessional official lending cannot reduce the country’s aggregate currency mismatch. - Sustainability requirement: both government and country balance sheets must be sustainable (assets exceed liabilities under reasonable assumptions) for official lending to be appropriate without private debt restructuring. ### Annex I — operational issues in estimating balance sheet needs - Sectoral and aggregate balance sheet data (size, maturity, currency composition) are first steps; estimating actual financing needs requires behavioral assumptions (rollover rates, deposit behavior) and identification of which sectoral needs generate reserve/BOP pressure. - A matrix of intersectoral asset and liability positions highlights interlinkages and mismatches; diagonal (intrasectoral holdings) is empty due to consolidation. - Valuation issues: state enterprise and private nonfinancial assets are difficult to value; off-balance-sheet items and residence of counterparties matter. - Data sources and gaps: - IFS provides monthly information on international liquidity; Money and Banking section provides domestic currency claims/liabilities; 78 countries’ IFS includes IIP with sector and maturity information. - BIS international banking statistics provide quarterly creditor-side statistics with residual maturity breakdown on an aggregated country basis. - White spots remain for sectoral residual maturities and foreign currency items not involving nonresidents. - Lack of corporate balance sheet data is a major concern for systemic risk assessment. ### Annex II — approaches to providing official financing and limits - Four official-sector approaches when large stock of hard-currency short-term debt may not be rolled over: - (i) provide financing on a scale sufficient to cover a large fraction of potential financing need; - (ii) provide more limited financing hoping to catalyze additional private financing; - (iii) seek private sector commitment to roll over claims and extend maturities rather than debt reduction; - (iv) condition official financing on concerted private sector restructuring or limits on capital outflows. - Voluntary approaches can be very expensive; non-voluntary restructuring risks shattering market confidence. - Official financing can be complementary with debt restructuring when debts are disaggregated by sector. - Official financing is strongest when: - balance sheet problem cannot be remedied with domestic resources and policy adjustment alone; - official financing can help address relevant mismatch (e.g., temporary maturity cover or transfer currency risk to a stronger sector); - government and country balance sheets are sustainable under reasonable assumptions with appropriate policy adjustments. ### Key conclusions from the balance sheet framework - Currency and maturity structure of outstanding debt is almost as important as total debt size. - Liabilities among residents can pressure reserves, particularly if denominated in foreign currency. - Sectoral balance sheets matter; domestic debts between residents can snowball due to interlinkages among government, financial system, and firms. - Private actors should hedge currency risk, but if government is primary hedger the mismatch is passed to government. - A domestic balance sheet crisis will not stay domestic with open capital accounts; residents and non-residents will seek foreign assets. - Combination of short-term debt and foreign currency debt is extremely dangerous—even if mismatches are split across sectors—because currency mismatch constrains government’s capacity as domestic lender of last resort. - Prompt action to contain crises before cross-sector propagation can prevent larger crises. - Financing need must be assessed relative to outstanding relevant claims; effective scale may be large and vary from a single sector to entire country. - Official intervention has limits: preferred lending cannot radically transform balance sheets and adding new senior debt weakens capital structure. ### Thailand before the 1997 crisis — stylized calculations and sensitivity (Annex II) - End-December 1996 (assumption 1US$=25.6 baht): - short-term liabilities to rest of world: government sector less than $0.04 billion; commercial banks almost $29 billion; nonbank sector almost $19 billion — aggregate roughly $48 billion short-term foreign currency debt. - Bank of Thailand (BOT) foreign reserve assets: close to $39 billion. - commercial banks’ foreign assets: somewhat over $7 billion, of which $2.6 billion are liquid (cash and deposits with nonresident banks). - commercial banks’ claims on domestic nonbank sector: about $207 billion; about $0.5 billion are liquid deposits with other financial institutions. - assumed practically all lending to residents was in foreign currency, implying commercial banks had additional $32 billion foreign currency assets as claims against domestic nonbank sector. - nonbank foreign currency deposits with resident commercial banks: $0.48 billion. - December 1996 stylized financing-gap accounting: - Scenario A (only banks’ foreign deposits liquid; zero rollover of short-term liabilities): reported potential financing gap about $7 billion (country aggregate) under pessimistic assumptions. - Scenario B (all banks’ foreign assets liquid; 50 Percent rollover of short-term liabilities): under optimistic assumptions, a $12 billion surplus for country aggregate (December) becomes $7 billion when accounting for swaps/forwards. - End-June 1997 developments: - BOT had lost almost $7 billion of its foreign reserves (reserves still over $32 billion). - BOT outstanding forward and swap obligations increased from about $5 billion to some $29 billion. - June 1997 stylized financing-gap accounting: - Scenario A (only banks’ foreign deposits liquid; zero rollover): reported potential financing gap about $14 billion (country aggregate) under pessimistic assumptions, and $41 billion when including swaps/forwards. - Scenario B (all banks’ foreign assets liquid; 50 Percent rollover): under optimistic assumptions a $5 billion surplus becomes a $-24 billion aggregate gap when subtracting outstanding swaps/forwards. - Sensitivity conclusions: - Financing-gap calculations highly sensitive to behavioral assumptions (rollover rates, liquidity of bank foreign assets) and inclusion of outstanding swaps/forwards. - December 1996: pessimistic scenario yields $7 billion gap; optimistic scenario yields $12 billion surplus; subtracting $24 billion in swaps/forwards reverses outcomes. - June 1997: pessimistic scenario yields $14 billion gap; optimistic scenario yields $5 billion surplus; subtracting $41 billion in swaps/forwards reverses outcomes. - Observations: - Potential financing needs concentrated in private sector balance sheets rather than government sector. - Quality and liquidity of domestic foreign-currency claims (banks’ onlending) critical to true exposure. - BOT off-balance-sheet exposures (swaps/forwards) substantially increased aggregate vulnerability when counterparties were nonresident. - Any financing need assessment must consider off-balance-sheet items and residence of counterparties. - Estimating financing gaps is difficult even with hindsight. ### Additional Thailand metrics and cross-country comparisons - Swaps and counterparties: - If resident commercial banks had been counterparts to the $29 billion of swaps, they would have hedged short-term foreign liabilities; with offshore counterparts, swaps constituted an outflow. - Corporate leverage metrics (average corporate debt-to-equity ratios, percent): - Thailand: 196 - Taiwan Province of China: 90 - United States: 106 - Germany: 144 - Malaysia: 160 - Japan: 194 - Korea: 317 - Solvency observations (Thailand): - Commercial banks: claims of over $206 billion on nonfinancial private sector versus claims a little above $5.5 billion on the government sector; total claims on nonbanks amounted to over 115 percent of GDP. - Government sector debt about $14 billion, equivalent to about 6 percent of GDP and about one-half of annual tax revenue collected by the central government; adding $12 billion government guarantees would about double those ratios; adding BOT’s $29 billion forward obligations would raise total public debt to 28 percent of GDP. - Aggregate country solvency: Thailand’s total external debt ($115 billion) reached over 60 percent of GDP and over 200 percent of the exports of goods and services. - Financial institutions’ claims on the private sector (end-1996, percent of GDP): - Thailand: 142 - Mexico: 22 - Turkey: 24 - Philippines: 48 - Indonesia: 55 - Brazil: 31 - Malaysia: 144 - Korea: 66 *Source: Annex I and related boxes from _wp02210 (IMF working paper excerpt).* ### Annex I ### Annex I ### Summary of the Balance Sheet Approach and Key Findings - Financial markets have become increasingly integrated over the past ten years. - Foreign borrowing helped finance higher investment than domestic savings alone and contributed to sustained periods of growth, but opening capital markets placed exceptional demands on financial and macroeconomic policies in emerging market economies. - Private capital flows are sensitive to market conditions, perceived policy weaknesses, and negative shocks; flows have been more volatile than many expected, and a number of major emerging economies experienced sharp financial crises since 1994. - The financial structure of many emerging market economies—the composition and size of liabilities and assets on the country’s financial balance sheet—has been an important source of vulnerability to crises. - 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 external debt, - a government’s ability to service its debt, - a banking system’s ability to meet deposit outflows, - 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 and must find resources to pay off debts or seek restructuring. - A plunge in demand for a country’s assets leads to a surge in demand for foreign assets and/or assets denominated in foreign currency; massive capital outflows, sharp exchange rate depreciation, a large current account surplus, and a deep recession are often counterparts to sudden adjustment in investors’ willingness to hold accumulated financial assets. ### What Is the Balance Sheet Approach? - Contrasts with traditional flow-based analysis (current account, fiscal balance) by focusing on stock variables in sectoral and aggregate balance sheets (assets and liabilities). - Framework emphasizes four types of balance sheet mismatches that determine a country’s ability to service debt under shocks: - (i) Maturity mismatches: gap between liabilities due in the short term and liquid assets, exposing sectors to rollover risk and interest rate risk. - (ii) Currency mismatches: changes in the exchange rate can produce capital losses. - (iii) Capital structure problems: heavy reliance on debt rather than equity financing reduces ability to withstand revenue shocks. - (iv) Solvency problems: assets, including present value of future revenue streams, insufficient to cover liabilities, including contingent liabilities. - Maturity mismatches, currency mismatches, and poor capital structure can contribute to solvency risk; solvency risk can also arise from excessive borrowing or investing in low-yielding assets. - Examination of sectoral balance sheets (government, financial sector, corporate sector) for maturity, currency, and capital structure mismatches helps trace spillovers across sectors and eventual external balance of payments crises. - Internal debts among residents that create internal balance sheet mismatches generate vulnerability to external balance of payments crises, often transmitted via the domestic banking system. - Confidence concerns about government debt (domestic or foreign currency) can destabilize banks holding that debt and may trigger deposit runs; exchange rate changes coupled with unhedged corporate foreign exchange exposure can undermine banks that lent to that sector. - Runs on the banking system can take the form of withdrawal of cross-border lending by nonresident creditors or withdrawal of deposits by domestic residents. - Balance sheet weaknesses can remain latent for years if capital inflows support the exchange rate; the timing of crises is difficult to predict, but shocks can trigger rapid, disorderly adjustments revealing additional weaknesses and prompting broad investor retrenchment. - Massive flows are the necessary counterpart of rapid stock adjustments; if flows cannot be financed from reserves, relative prices of foreign and domestic assets must adjust, leading to possible overshooting in asset prices and exchange rates. ### Policy Implications and Operational Issues - Timely sectoral balance sheet information is most useful for preventive action, but such information is often only partly available and obtained with significant time lags, limiting its utility except for ex post analysis. - Balance sheet analysis should begin with in-depth sector vulnerability analysis and identification of data gaps; there is a strong case for better data collection and enhanced external disclosure of key balance sheet data. - Policy focus to reduce sectoral vulnerabilities: - (i) Sound public sector debt management to minimize the risk public sector balance sheet weaknesses become sources of financial difficulty and to preserve capacity to cushion private-sector shocks. - (ii) Policies creating incentives for the private sector to limit exposures to balance sheet risks, particularly the combination of currency and maturity risks from short-term foreign currency borrowing. - (iii) Maintaining a sufficient cushion of reserves. - Flexible exchange rates can help limit currency exposure, encourage hedging, and facilitate adjustment to external shocks, but risks can persist in floating regimes if the public sector issues instruments that are used by the private sector to hedge currency risk. - The approach emphasizes financial strength indicators but reaffirms the importance of sound macroeconomic policies; large debt stocks emerge from persistent flow imbalances (fiscal and current account deficits), and macroeconomic weaknesses often explain why countries must borrow in foreign currency or short maturities. - Balance sheet information assists policymakers in weighing trade-offs after sectoral problems threaten systemic stability: - Trade-off between selling foreign exchange to help private-sector hedging and the risk of precipitating a government rollover crisis (selling reserves to defend an overvalued exchange rate can aggravate government maturity mismatch). - Assessment of relative scale of maturity and currency mismatches helps weigh interest rate defense versus nominal exchange rate adjustment; policymakers must balance exchange rate adjustment and monetary tightening. - Scope for countercyclical fiscal policy depends critically on the strength of the government’s balance sheet and its access to financing. - Role and limits of official intervention: - Not all sectoral financial crises require official intervention; many private-sector balance sheet problems can be resolved by private restructuring without government financing. - National governments with adequate reserves and strong balance sheets can prevent private-sector crises from spreading, but intervention should include measures to improve future incentives and close weak institutions. - Authorities may lack sufficient foreign exchange reserves to prevent a crisis (for example, a run on foreign currency–denominated bank deposits); government cannot intervene effectively when it is the source of financial distress. - Exceptional official external financing may be justified to prevent broader crises; rapid augmentation of gross reserves can support orderly unwinding of balance sheet problems. - Scale of support can be large because financing needs are proportionate to the stock of outstanding claims of the sector in distress; all foreign currency–denominated debts—even between residents—can generate pressure on official reserves. - Domestic currency claims can also pressure reserves because monetary expansion to address domestic rollover crises has limits before impacting reserves. - Official borrowing does not transform a country’s aggregate or government balance sheet: it provides short-run foreign exchange access at the cost of creating a new liability to preferred creditors and increases capital structure risk. - Official lending can temporarily cover maturity mismatches and provide time for adjustments (exchange rate or fiscal) but cannot make an unsustainable balance sheet sustainable nor resolve a country-wide currency mismatch. ### Context, Literature, and Historical Insights - The balance sheet approach has gained prominence in academic literature following crises in the 1990s: - First-generation models (e.g., Krugman (1979); Flood and Garber (1984)) emphasized monetized fiscal deficits and mechanical reserve thresholds for crises. - Second-generation models (post-ERM 1992 and Mexican crisis of 1994-95) introduced endogenous policy responses and self-fulfilling panic dynamics; short-term foreign currency–linked debt (tesobonos) and rollover risk in Mexico illustrated liquidity-run aspects. - The Asian crisis of 1997-98 highlighted private-sector origins of crises, “twin crises” (currency and banking), “sudden stops” and reversals of capital inflows; this prompted third-generation models based on balance sheet analysis (see Dornbusch (2001)). - The balance sheet approach can strengthen IMF surveillance and, where data permits, help gauge ex ante the scale of potential pressures on reserves and financing needs if reserves are insufficient. *Source: Annex I, _wp02210 - Annex I* ### Box 1 (concluded). The Balance Sheet Approach in Recent Academic Literature ### Box 1 (concluded). The Balance Sheet Approach in Recent Academic Literature ### Microeconomic distortions as balance sheet drivers - Balance sheet vulnerabilities are driven by microeconomic distortions including: - weakly supervised and regulated financial systems; - connected and directed lending; - moral hazard from implicit and explicit government guarantees leading to over borrowing and over lending and excessive current account deficits; - fixed exchange rates distorting external borrowing toward short-term foreign currency debt. - Representative citations referenced in the source for these mechanisms include Krugman (1999), IMF (1998), Corsetti, Pesenti and Roubini (1999a, 1999b). ### Currency mismatches and liability dollarization - Large currency depreciation in the presence of foreign currency liabilities (“liability dollarization”) can: - increase the real burden of debts denominated in foreign currencies; - trigger investment and output contraction. - Modeling approaches and implications described: - Some models generate self-fulfilling currency crises where expected depreciation leads to a currency run and collapse of a peg; the subsequent strong real depreciation wipes out private sector balance sheets and validates the loss of confidence and the currency crash.1/ - Other models posit fundamental shocks (for example, terms of trade shocks) that require real depreciation and thereby prompt adverse balance sheet effects. - Comparisons are made across models of fixed versus flexible exchange rate regimes in the presence of liability dollarization. - In some formulations even a real shock that requires depreciation triggers overshooting of the real exchange rate, exacerbating balance sheet effects of foreign currency liabilities. - Representative citations include Krugman (1999), Cespedes, Chang and Velasco (1999), Gilchrist, Gertler and Natalucci (2000), Aghion, Bacchetta and Banerjee (2000), Cavallo, Kisselev, Perri and Roubini (2002). ### Self-fulfilling runs and international bank-run analogies - A strand of literature emphasizes “non-fundamental” runs analogous to domestic bank runs (Diamond and Dybvig (1983)): - Liquidity mismatches make governments and financial institutions in emerging markets vulnerable to partly self-fulfilling runs. - Panics can be self-fulfilling because of feedbacks between currency depreciation and deterioration of banks’ balance sheets when borrowers have unhedged currency exposure. - These models provide an explanation for the “twin crises” (currency and banking crises). - Foreign currency liquidity provision from external official creditors (in some formalizations an international lender of last resort) may help contain such liquidity runs. - The risk of such runs is greater under fixed exchange rates because both local currency and foreign currency liquid assets are potential claims on limited central bank reserves. - Representative citations include Chang and Velasco (1999), Jeanne and Wyplosz (2001), Burnside and others (1998), Schneider and Tornell (2000). ### Sudden stops and capital inflow reversals - Models of “sudden stop” and “capital inflow reversal” combine multiple mechanisms to explain joint phenomena of crisis: - Currency and liquidity mismatches; - balance sheet effects; - moral hazard distortions; - “panicky” behavior of partially informed domestic and international investors leading to a “rush to the exits” and contagion; - financial sector frictions; - over investment in the non-tradable sectors. - These eclectic models seek to explain sudden stops, credit crunches, currency crises and output contraction after a crisis. - Representative citations include Calvo (1998), Calvo and Mendoza (1999), Mendoza (2000), Schneider and Tornell (2000). ### Corporate finance approaches: country “capital structure” and macro-finance - Corporate finance concepts are applied to country vulnerability: - Pettis (2001) emphasizes the importance of a country “capital structure” in determining vulnerability to market volatility and argues emerging markets have underestimated volatility and failed to manage balance sheets to minimize exposure. - Pettis highlights “inverted” capital structures that magnify shocks: debt servicing costs increase as payments capacity decreases. - The “macro-finance” approach (See Gray, 2002) draws on corporate finance and “contingent claims analysis” to evaluate robustness of country financial systems and to assess sovereign risk. ### Implications for Fund analysis, crisis management, and the rest of the paper - The balance sheet approach can: - make explicit the assumptions used to assess financing needs and the risks that those needs may be larger or smaller than forecasted; - provide theoretical underpinning for the Fund’s macroeconomic policy advice during capital account crises, which may differ from advice in conventional current account-driven balance of payment difficulties; - help identify how external official lending can address various balance sheet mismatches and when external official financing should support debt restructuring. - Limits and scope noted: - The impact of a financial crisis in emerging economies on the balance sheets of external creditors and investors—a potential contagion mechanism—is not explored in this paper; focus is on impacts across sectors within the affected emerging market economy. - The balance sheet approach highlights the broad sets of claims that can generate crises and puts emphasis on assessing the scale of financing relative to stocks of relevant claims. - It underscores limits on the capacity of official financing to provide effective solutions for many balance sheet problems and the risks inherent in meeting large surges in demand for foreign currency liquidity with large-scale borrowing from official creditors. - Organization of the remainder of the paper: - Section II introduces general concepts underlying the balance sheet approach, discusses their application to recent crises, and identifies characteristics of capital account crises, including the large and unpredictable size of financing gaps (Annexes show how the approach could be used to estimate prospective financing gaps). - Section III sketches how balance sheet analysis might sharpen the Fund’s crisis prevention work, discusses the essential role of data availability, and concentrates on policy trade-offs faced by countries experiencing capital account crises. - Section IV focuses on the role of external official financing in addressing balance sheet vulnerabilities, particularly gaps between short-term foreign currency denominated debt and liquid reserve assets; explores justifications for external official financing and circumstances when debt restructuring may be necessary; and notes limits on types of crises that can be addressed through official financing from a balance sheet perspective. 1/ An expected depreciation leads to a currency run and collapse of a peg. Then, the strong real depreciation wipes out the private sector’s balance sheets (also determining their perceived ability to borrow) and ex post validates the loss of confidence and the currency crash. - 12 - *Source: _wp02210 - Box 1 (concluded). The Balance Sheet Approach in Recent Academic Literature* ### Section V presents conclusions. ### _wp02210 - Section V presents conclusions. ### The anatomy of balance sheet crises: overview - Analysis contrasts flow-based macro approaches (annual output, fiscal balance, current account balance, investment flows) with stock-based balance sheet analysis (debt, foreign reserves, loans outstanding, inventory at the end of the year). - The difference in a stock variable at two dates is related to the flow in the period between them. - Main sectoral balance sheets distinguished: government sector (including the central bank), private financial sector (mainly banks), and the non-financial sector (corporations and households). - Consolidation of sectoral balance sheets nets out intra-resident claims, leaving the country’s external balance vis-à-vis non-residents (International Investment Position in official Balance of Payments Statistics; IMF’s Balance of Payments Manual, 5th edition, 1993). ### Importance of sectoral balance sheets - Sectoral balance sheets reveal vulnerabilities hidden in the aggregated country balance sheet; intra-resident foreign currency debt can be netted out at the country level but still trigger external crises if the government must honor such debts using reserves. - Financial interlinkages can cause difficulties in one sector to cascade into other sectors. - Capital account liberalization amplifies risk that rollover problems in domestic debt spill into balance of payments crises. ### Four general types of balance sheet risks (definitions and mechanisms) - Maturity mismatch risk - Arises when assets are long term and liabilities are short term. - Creates rollover risk and interest rate risk (including when longer-maturity liabilities carry floating rates linked to short-term rates). - Can occur in domestic or foreign currency; e.g., short-term foreign currency debts exceeding liquid foreign currency assets. - Empirical relevance: maturity mismatch risk was significant in recent crisis episodes; sources of pressure included short-term government debt (Mexico, Russia, Turkey, Argentina) and short-term liabilities of the banking system (Korea, Thailand, Russia, Turkey, Brazil, Uruguay, Argentina). - Interest rate spikes on short-term government debt preceded crises in Russia, Turkey, Brazil, and Argentina. - Banks often faced interest rate exposure: short-term sensitive liabilities vs. longer-term, often fixed-rate assets. - Currency mismatch risk - Caused by disparity in currencies of assets and liabilities; liabilities in foreign currency while assets in domestic currency create severe losses on sharp nominal/real depreciation. - More pronounced in emerging economies because agents often cannot borrow from non-residents in local currency. - Hedging in one sector can transfer currency mismatch to another sector (example: banks borrowing and lending in dollars shifts risk to corporate borrowers). - Currency mismatches can trigger shifts in capital flows and reserve pressures; increased demand for hedging instruments often occurs immediately before/after collapse of an exchange rate peg. - Empirical relevance: currency mismatch exposures appeared at government level in Mexico, Brazil, Turkey, Argentina, Russia; in banking systems in Korea, Thailand, Indonesia, Turkey, Russia, Brazil (early 1998); in nonfinancial private sector in Korea, Thailand, Indonesia, Turkey, Argentina, Brazil (before 1998), and probably Uruguay. - Inflexible exchange rate regimes prior to crises contributed to development of large currency mismatches. - Capital structure mismatch risk - Results from excessive reliance on debt financing rather than equity; absence of an “equity buffer” increases distress when shocks occur. - Debt-service obligations are less state-contingent than equity payouts. - Causes include weak corporate governance and tax/regulatory distortions favoring debt. - Empirical relevance: Korea and Thailand—restricted FDI or tax regimes favored debt, producing very high debt-to-equity ratios at crisis onset; banks were undercapitalized with capital ratios often well below BIS standards. - Undercapitalized financial institutions had limited buffers against liquidity and currency shocks, non-performing loans, losses on open currency positions, and deposit runs. - Solvency risk - Arises when assets no longer cover liabilities (negative net worth). - Linked to maturity, currency, and capital structure mismatches but can also arise from other sources. - Government solvency: defined by the present discounted value of future primary fiscal balances relative to current net government debt; government’s greatest net asset is ability to generate primary fiscal surpluses (including seignorage). - Country solvency: present discounted value of future non-interest current account balances relative to current net external debt. - Debt commonly compared to GDP, revenues, or exports in solvency assessments; IMF analytical framework referenced (IMF (2002a)). - Empirical relevance: sovereign solvency seemed clear in Mexico, Korea, and Thailand despite macro/structural weaknesses; high debt-to-GDP or debt-to-revenue ratios signaled sovereign solvency/default risk in Russia, Argentina, and to some extent Turkey, Indonesia, Brazil. - Real exchange rate appreciation prior to crises could mask underlying foreign-currency indebtedness; real depreciation during crisis increased government debt Stocks and external debt ratios, contributing to defaults in Russia and Argentina. - Bank recapitalization costs, adverse debt dynamics from higher real interest rates, and growth slowdowns amplified solvency problems. ### Empirical examples and crisis episodes (as discussed) - Countries and years cited as informing the analysis: Mexico (1994), Thailand (1997), Indonesia (1997), Korea (1997), Russia (1998), Brazil (1999), Turkey (2001), Argentina (2002), Uruguay (2002). - Brazil’s recent financial difficulties at the time of writing were noted as not explicitly covered because an assessment would be premature. ### Sectoral application matrix (Box 2): how risks map to sectors - Government - Maturity mismatch: government short-term hard currency debt (domestic and external) v. government liquid assets (reserves); short-term domestic currency debt v. government liquid domestic currency assets. - Currency mismatch: government debt denominated in foreign currency (domestic and external) v. government hard currency assets (reserves). - Capital structure mismatch: N/A in the box. - Solvency: liabilities of government and central bank v. their assets, including discounted value of future primary surpluses (including seignorage) and financial assets; liabilities may include implicit liabilities (pension plans) and contingent liabilities (guarantees). - Banks - Maturity mismatch: short-term hard currency debts (domestic and external) v. banks’ liquid hard currency assets and ability to borrow from central bank; short-term domestic currency debts (often deposits) v. liquid assets. - Currency mismatch: difference between foreign currency assets (loans) v. foreign currency liabilities (deposits/interbank lines). - Capital structure mismatch: deposits-to-capital ratio (closely related to capital-to-assets ratio). - Solvency: bank liabilities v. bank assets and capital. - Firms - Maturity mismatch: short-term debts v. firms’ liquid assets. - Currency mismatch: debts denominated in foreign currency v. hard-currency-generating assets. - Capital structure mismatch: debt-to-equity ratio. - Solvency: firms’ liabilities v. present value of firms’ assets. - Households - Maturity mismatch: short-term debt v. liquid household assets. - Currency mismatch: foreign currency assets (deposits) v. foreign currency liabilities (often mortgages). - Capital structure mismatch: N/A. - Solvency: liabilities v. future earnings (wages and assets). ### Key analytical points and implications - Identifying maturity, currency, capital structure, and solvency mismatches at the sectoral level is crucial to understanding crisis genesis and transmission mechanisms that are not visible in the consolidated country balance sheet. - Policy and surveillance should pay particular attention to: - The currency composition of debts across sectors and the potential for devaluation-induced balance-sheet losses. - The maturity profile of liabilities and the availability of liquid assets/reserves to meet rollovers. - Capital adequacy of financial institutions relative to true risk exposures. - The fiscal position’s capacity to generate future primary surpluses and implicit/contingent liabilities that could affect sovereign solvency. *Source: _wp02210 - Section V presents conclusions.* ### Box 2 (concluded). How Balance Sheet Risks Apply to Different Sectors ### Box 2 (concluded). How Balance Sheet Risks Apply to Different Sectors ### Sectoral balance sheet indicators and mismatches - Country as a whole - Maturity mismatch: Short-term external debt (residual maturity) v. liquid hard currency reserves of government and private sector * - *foreign exchange reserves of the central bank/government plus liquid foreign currency reserves of banks and firms - Currency mismatch: Net hard currency denominated external debt - *External debt denominated in hard currency minus external assets denominated in hard currency - Capital structure mismatch / Solvency (Liabilities v. Assets): Net external debt stock (external debt minus external assets) relative to net stock of FDI. - *Flow analogue: Heavy current dependence on debt rather than FDI to finance current account deficit - Stock of external debt relative to both external financial assets held by residents and the discounted value of future trade surpluses, (resources for future external debt service)* - *A more complex analysis would need to include remittance of profits on FDI as well. While such remittances are variable, they are another claim on the external earnings of the country as a whole - Accounting note: Debts between residents should appear on the sectoral balance sheet. Debts between non-residents, particularly if the debts are denominated in a foreign currency, can be a source of financial difficulty. Example structure: if the banking system borrows foreign exchange from the household sector and lends foreign exchange to firms, this should appear as a foreign currency asset on the household balance sheet and an equal foreign currency liability on the balance sheet of firms. ### Related risks and transmission mechanisms - These different types of risks are closely related and may all lead to credit risk—the risk that a debtor will not be able to repay its debts. - Solvency risk to the debtor is credit risk to its creditors. - The banking system is particularly prone to credit risk; credit risk can trigger a bank run. - It is rational for depositors or other short-term domestic or external creditors to run to the exits if bank solvency is deteriorating. - Payment difficulties in one sector can quickly spread to the economy as a whole if they trigger a widespread bank run. ### Characteristics of recent capital account crises from a balance sheet perspective - Exchange rate regime role - Pegged exchange rate regimes have played an important role in recent financial crises; in each capital account crisis of the 1990s the country maintained some form of exchange rate peg. - Expectations of nominal exchange rate stability—and possible expected real appreciations—contributed to accumulation of large currency mismatches. - Countries with floating regimes are often better equipped to withstand external shocks: the exchange rate can adjust and the absence of expectations for nominal stability limits incentives for excessive currency risk accumulation. - Snowballing and sector spillovers - Sectoral balance sheet problems spilled over into other sectors and grew larger (“snowballed”), with the banking sector often crucial in transmission. - Balance sheet crises have emerged from weaknesses in private sector balance sheets (banks and corporates) and from public sector balance sheet weaknesses. - A shock that suddenly exposed vulnerabilities—a terms of trade shock, bad political or economic news, recognition that debt levels are increasing more rapidly than income, or a crisis elsewhere—could cause reversal of capital flows, pressure on reserves, and exchange rate stress. - Currency depreciation plus investor panic created mutually reinforcing mechanisms that amplified the snowballing. - Example: In Asian countries, deterioration in corporate financial health contributed to sudden reversal of capital flows and an exchange rate shock, which then affected all sectors with foreign exchange denominated debts, enlarging the problem by the time it reached banks as nonperforming loans. - Other cases (Russia, Turkey, Argentina): sovereign financial weakness triggered domestic bank distress because banks held large amounts of government short-term obligations. - Even when banking sectors were formally currency-matched before a crisis, depreciation weakened banks’ asset sides; banking and currency crises reinforced each other. - Balance sheet difficulties → balance of payments crises - Foreign investors cutting credit lines forced drawing down of liquid assets—domestic and external—to meet external debt payments; unwinding of portfolio investment put pressure on the exchange rate. - Lack of transparency and herd behavior by investors exacerbated pressures; domestic investors sometimes shifted to external assets, selling local assets or withdrawing funds from local banks, pressuring reserves or the exchange rate. - Increased residents’ demand for external assets requires an increase in the economy’s ability to generate resources to purchase external assets (a shift in the current account). - Private sector problems often become public liabilities - Implicit and explicit guarantees of banking system integrity created contingent liabilities for governments (examples cited: Indonesia, Thailand; exacerbated in Brazil, Turkey, Argentina). - Transfers of banking sector difficulties onto government balance sheets created or worsened fiscal problems, reducing confidence in government solvency and contributing to further snowballing. - Real economy effects - Sectoral balance sheet problems reduced output via wealth effects on consumption and investment and, with credit crunches, sharply lower aggregate spending. - Corporate expenditure cuts to restore financial health, combined with forced reduction of bank credit, often exceeded the competitiveness gains from exchange rate depreciations—leading to larger-than-expected initial output declines in several Asian crisis countries. - However, shifts in trade balances sometimes allowed quick rebuilding of reserves; Mexico and Korea experienced external demand pulling economies out of recession fairly quickly and a resumption of rapid growth without return of underlying flow imbalances. - Assessment and forecasting challenges - Assessing countries’ external financing needs has been extremely difficult due to incomplete or unavailable balance sheet information, especially for banking and corporate sectors. - Even with detailed information on maturity and currency composition of external liabilities, it indicates only potential maximum financing need; additional assumptions about creditor and investor behavior (e.g., willingness of foreign banks to roll over short-term debt) are required to estimate likely net flows. - The stock of liabilities can change quickly if central bank or government enters into new financial contracts to resist depreciation (Thailand’s sale of forward contracts is cited). - Forecasting the extent of real exchange rate adjustment is challenging and makes anticipating how large initial overshoots will affect foreign currency–borrowed firms’ balance sheets difficult. ### Scale of foreign exchange demands and crisis responses - Liquid foreign currency needs associated with repayment of external debt across sectors typically far exceeded official foreign currency reserves. - Acute reserve gaps occurred when reserves were not effectively available because monetary authorities had large outstanding off-balance sheet obligations. - Table 1: Indicators of Potential Financing Needs in Recent Capital Account Crises (as percent of GDP) - Brazil (1998) - Short-term external debt1: 10.5 - Deposit base (M2): 26.9 - Gross foreign reserves2: 5.4 - Memorandum items: - Fund access in percent of GDP3: 2.3 - Fund access in percent of quota4: 600 - Fund access in million of U.S.$: 18,262 - Indonesia (1997) - Short-term external debt1: 42.7 - Deposit base (M2): 55.6 - Gross foreign reserves2: 7.7 - Memorandum items: - Fund access in percent of GDP3: 4.4 - Fund access in percent of quota4: 490 - Fund access in million of U.S.$: 10,083 - Korea (1997) - Short-term external debt1: 12.4 - Deposit base (M2): 46.2 - Gross foreign reserves2: 1.9 - Memorandum items: - Fund access in percent of GDP3: 4.0 - Fund access in percent of quota4: 1938 - Fund access in million of U.S.$: 20,990 - Thailand (1997) - Short-term external debt1: 31.3 - Deposit base (M2): 84.8 - Gross foreign reserves2: 5.5 - Memorandum items: - Fund access in percent of GDP3: 2.2 - Fund access in percent of quota4: 505 - Fund access in million of U.S.$: 3,926 - Footnotes (as in source): - 1 End-period stocks at residual maturity, original maturity for Korea. - 2 End-period stocks; only usable reserves for Korea; net of forwards and swaps for Thailand. - 3 U.S. dollar value of GDP for year prior to arrangement. - 4 Using quotas existing at the time of program approval (before recent increase in quotas). - Despite sizeable adjustments and some private sector contributions (roll-over agreements, debt restructuring), the scale of potential pressures prompted unprecedented financial support packages from the official sector. ### Implications for crisis prevention and IMF policy advice during crises - The balance sheet approach complements traditional macroeconomic flow analysis by focusing on accumulated debt stocks in sectoral balance sheets. - Stocks of debt result from cumulative flows of past deficits. - Solvency requires that the present discounted value of future flows (primary balances or trade balances) be large enough to service current stocks of debt. - Current flow imbalances also play an important role in crisis dynamics; difficulties attracting new inflows needed to finance flow deficits may impair roll-over/refinancing of short-term debt stocks. - Balance sheet approach implications (Box 3) - Adjustment in a balance sheet crisis is typically sharp and front-loaded as sudden changes of stocks generate large flows consistent with a new equilibrium. - Asset price overshooting is common. - Balance sheet effects greatly affect aggregate supply and demand, with pronounced output repercussions. - The approach captures cascading effects from sector to sector due to contingent liabilities being triggered. - Possibility of vicious circles involving asset prices, desired asset stocks, and the real sector. - Crisis prevention policy implications - Balance sheet mismatches do not arise by accident; persistent flow deficits translate into stock problems. - Financing a current account deficit by issuing external debt affects the country’s aggregate balance sheet; fiscal deficits feed into government balance sheets. - As financing flow imbalances becomes more difficult, borrowers often take on more currency and maturity risk, weakening balance sheets. - Governments in emerging market economies can strengthen national balance sheets through: - Developing data sources to monitor asset and liability positions. - Adopting economic policies that build a solid government balance sheet (history of prudent fiscal management and careful stock management). - Creating incentives for sound private sector balance sheets (examples: choice of exchange rate regime influences incentives for foreign currency borrowing; quality and content of banking regulation influences financial sector aggregate balance sheet). *Source: Box 2 (concluded). How Balance Sheet Risks Apply to Different Sectors (excerpts) from the provided IMF PDF content unit.* ### Box 4. Data Availability as Prerequisite for Balance Sheet Analysis ### Box 4. Data Availability as Prerequisite for Balance Sheet Analysis ### Data availability and measurement requirements - Reliable data on assets and liabilities of sectoral and aggregate balance sheets is essential for operationalizing the balance sheet approach. - Most countries lack relevant stock data, leading to Fund focus on a few public sector stock positions: gross debt, deposits in the financial system, and NIR. - Comprehensive balance sheet analysis requires detailed information on size, maturity and currency composition of assets and liabilities across all sectoral balance sheets, including debt among residents. - Ongoing data-improvement efforts encouraged by Fund staff: - compile the International Investment Position (IIP) and conduct the Coordinated Portfolio Investment Survey (CPIS) in line with the fifth edition of the Balance of Payments Manual (BPM5), - move towards preparation of the general government’s balance sheet according to the new Government Finance Statistics Manual (GFSM 2001), - present debt data consistent with the new External Debt Statistics Guide (Debt Guide). - Expected benefits of improved data: - provide a country’s external assets and liabilities by sector, maturity and instrument, - reveal foreign currency and interest rate sensitivity of public sector liabilities, - facilitate retrieval of effective residual maturity of debt stocks, - significantly improve the Fund’s capacity to use the balance sheet approach in surveillance and program design. - SDDS-related timing and requirements: - SDDS subscribers have been required to disseminate end-2001 IIP data by end-June 2002. - SDDS prescribed and encouraged categories for external debt have been adopted as a benchmark for surveillance; these categories will become mandatory for SDDS subscribers by end- March 2003. ### Findings and policy recommendations to guard against balance sheet vulnerabilities - Flexible exchange rate regimes: - can provide protection against build-up of currency risk exposure and help adjust to external shocks. - Strengthen public sector balance sheet: - aim for balanced budgets and build financial cushions (augmenting reserves). (Footnote 15 notes marginal cost/benefit trade-offs for reserves and recent crises justify higher reserves for emerging markets.) - Develop domestic markets: - markets for equity and local currency denominated long-term debt and hedging instruments to limit firm vulnerability; monitor risks to hedging suppliers. - Sound public debt management: - pay attention to short maturity structures, sensitivity to currency movements, and exposure to contingent liabilities. - Attention to all debt structures: - Fund surveillance and domestic authorities should monitor private sector debt structures that can cause balance sheet shocks; External Debt Statistics Guide provides conceptual basis. (See Annex I.) - Limit contingent government claims: - avoid explicit and implicit guarantees that expand government contingent liabilities. - Transparency: - collect and disseminate data on foreign exchange and maturity exposures of government, banks, and corporations to support market discipline and discourage herd behavior. - Compile and disclose IIP: - present the country’s financial assets and liabilities vis-à-vis the rest of the world as a starting point. - Monitor financial system resilience: - Fund/Bank Financial Sector Assessment Program (FSAP) is one means to assess financial sector strength and exposure to balance sheet risks. - Prudential regulation of banks: - account for direct and indirect exposure to foreign currency risk; matching assets and liabilities is not sufficient because foreign exchange loans to unhedged corporates can leave the banking system vulnerable. - Avoid tax/regulatory biases: - eliminate distortions favoring debt—particularly foreign currency debt—over long-term equity. - Strengthen insolvency regimes: - robust bankruptcy regimes facilitate early restructuring of private debts to avoid larger problems. - Improve balance sheet vulnerability analysis: - develop analysis of vulnerabilities to changes in sentiment and macro fundamentals (exchange rates, interest rates); recent macro-prudential indicator work moves in this direction. (Footnote 16 references Mulder, Perelli and Rocha (2002); Evans et al. (2000).) ### Public sector debt management — practical challenges and guidance - Public sector is often the largest external debtor; its domestic debt is often the largest asset on domestic intermediaries’ balance sheets. - Government’s key asset—capacity to run future primary surpluses—is illiquid, long-term and typically a claim on domestic currency resources; in principle should be matched by long-term domestic-currency liabilities. - In many emerging markets, markets for long-term domestic-currency debt do not exist; choices faced: - longer-term foreign currency borrowing, or - shorter-term domestic currency borrowing. - Implications: - emerging markets may not be able to sustain as high a debt level relative to GDP as industrial countries; - limiting debt levels may be necessary if assets and liabilities cannot be matched; - sovereign borrowers should avoid taking on both currency and maturity risk (i.e., short-term foreign currency debt). ### Foreign currency debt of the private sector (liability dollarization) - Large private-sector currency mismatches create two primary risks: - sudden withdrawal of foreign currency denominated deposits, - financial sector exposure to currency shocks from real depreciation. - Limits of matching and net open position rules: - requiring financial institutions to match foreign currency assets and liabilities and limit net open positions relative to capital may be insufficient because foreign currency assets may be illiquid in a run. - Maturity mismatches in foreign currency remain particularly dangerous given limited authority capacity to act as lender of last resort in foreign currencies. - Heavily dollarized banking systems may pass currency risk to borrowers; requiring banking sector currency matching can transfer excessive foreign currency risk to corporate balance sheets. - In liability-dollarized economies with limited export bases, natural hedges may be insufficient. - Floating exchange rates help discourage foreign currency borrowing but will not eliminate liability dollarization because residents and foreign investors may be unwilling to take local currency exposure; floating may sometimes increase demand for instruments hedging real depreciation risk. (Footnote 19.) - Prudential regulation options to limit foreign currency exposure: - higher reserve requirements for foreign currency liabilities to lower returns on foreign currency deposits relative to local currency deposits and force banks to hold more liquid assets, - policies to discourage short-term external borrowing by firms and banks (example: Chile’s encaje) may warrant consideration though implementation difficulties are significant. ### Policy advice and program design in crises — balance sheet approach applications - General point: balance sheet approach clarifies policy trade-offs during crises and highlights need to reestablish confidence in banking system and currency regime; accurate sectoral balance sheet information is crucial. - Example 1. Exchange rate policy - Overvaluation of the real exchange rate is usually best addressed by nominal depreciation; both nominal devaluation and deflation increase real burden of foreign currency debts. - Deflationary (sustained tight macro) policies may avoid exchange rate overshooting and give time for balance sheet adjustment but require very flexible labor markets and typically reduce real growth; can worsen public debt dynamics if fiscal sustainability is in doubt. - Governments should generally hesitate to use reserves to defend a currency peg under sustained pressure, because: - sale of reserves increases government’s maturity mismatch in foreign currency as it loses the key liquid asset, - intervening may result in runs on short-term foreign-currency government debt or financial sector liabilities, - a devaluation after reserve depletion sharply increases real net government debt, - transferring currency risk to government can create expectations of intervention encouraging future currency risk-taking, - exchange rate defenses via reserve sales have had mixed success in practice. - Only where official reserves are very high can reserves sensibly be used ex ante to minimize eventual balance sheet effects of nominal/real exchange rate adjustment. - In a carefully designed monetary program, sales of foreign exchange to meet surge in demand can: - have an immediate positive impact on private sector balance sheets if residents reduce open FX positions, - transfer currency risk to government to avoid massive bank and corporate bankruptcies; this must be balanced against risk of increasing net public debt as share of GDP, - risk supplying hedges to both those with and without pre-existing mismatches and may facilitate taking short positions against the government. - Example 2. Monetary policy and foreign exchange intervention after a devaluation - Trade-off: tightening monetary policy (raising interest rates) can prevent excessive real depreciation but can increase burden on sectors with maturity mismatches; both exchange rate adjustment and higher rates can cause substantial output losses. - Policymakers need accurate sectoral balance sheet information to choose policies; if both short-term debt and large open currency positions are present, the choice is particularly difficult. - Access to emergency external financing eases trade-offs between domestic and external stabilization. - Example 3. Capital outflow controls - Capital outflow restrictions might be considered to prevent exchange rate overshooting without sharp monetary contraction; can, in theory, allow low interest rates with more appreciated exchange rates. - In debt restructurings, controls can help enforce suspension of private external debt payments and prevent capital flight, but practical costs and enforcement challenges are significant. - Case evidence: - Thailand: brief attempt before adopting floating regime. - Malaysia: selective controls introduced later in crisis after ringgit depreciation and relatively strong macro policies. - Russia: controls used to prevent capital flight after default/devaluation announcement. - Argentina: controls with deposit freeze when exiting currency board and suspending sovereign debt payments. - Controls risk becoming substitutes for sound macro policy, create rent-seeking/evasion, and lose effectiveness over time. - Example 4. Fiscal policy - Countercyclical fiscal policy can offset balance sheet impacts of currency crises when private sector currency mismatches are pronounced. - Countercyclical spending supports aggregate demand while private sector adjusts to higher real debt burdens. - Scope for fiscal loosening depends on: - availability of financing, including official sources, - pre-crisis fiscal position and accumulated debt stock, - fiscal costs of supporting the financial system. - If public sector balance sheet weaknesses are central to the crisis, limiting government borrowing to avoid sovereign debt crisis must take precedence over demand management. - If imbalances are in private sector and public debt sustainability is not a concern, fiscal loosening can help stabilization (examples: Thailand and Korea). ### Role of official external financing — main themes - Two key themes: - reserves are both financial and monetary assets; they back currency and provide emergency liquidity to meet payment needs arising from sectoral maturity and currency mismatches, - timing and scale of official support matter: making financing available early can prevent sectoral difficulties from snowballing into broader crises. - With deeper financial integration, sectoral problems are more likely to generate balance of payments crises because domestic and foreign assets are close substitutes and reduced willingness to hold domestic claims increases demand for assets abroad. - Balance sheet weaknesses in individual private firms generally carry limited spillover risk if creditors can absorb restructuring; resilience of creditor balance sheets is first defense. Government intervention may be warranted if crisis originates in or threatens the financial sector. - Government financial difficulties carry high spillover risk due to government debt being a key financial asset for banks; government financing via domestic private sector borrowing can further risk domestic financial system integrity. ### The case for official external financing or support for debt restructuring - A government may seek exceptional external financing when it reaches limits of its capacity to draw on reserve assets and to borrow in foreign currency on terms consistent with medium-term sustainability. - Adjustment alone is unlikely to meet sudden surge in outflows in a capital account crisis and may exacerbate other problems; external finance or debt restructuring can be necessary to resolve trade-offs (e.g., exchange rate vs interest rate). - The Fund’s role: - provide official external financing when private markets and adjustment cannot meet foreign currency liquidity demands, - disburse large amounts of foreign exchange quickly and distinguish crises addressable by preferred lending from those that cannot, - early intervention can forestall larger capital outflows and loss of national prosperity, but unsuccessful programs increase debt service to preferred creditors at a time of higher foreign exchange demand. - Strengthening monetary authorities’ balance sheets can enable them to assist other sectors with foreign currency liquidity without undermining their own balance sheets; lending to central banks to maintain external reserve cushions can indirectly strengthen commercial banks’ balance sheets (example: Turkey in 2001). - Program design considerations: - NIR floors can limit authorities’ freedom of action and effectively require adjustment, debt restructuring, or both, when financing is constrained. *Source: Box 4. Data Availability as Prerequisite for Balance Sheet Analysis (extracted from the provided IMF document content).* ### Annex II), if there is a large stock of hard currency denominated short-term debt that ### _wp02210 - Annex II), if there is a large stock of hard currency denominated short-term debt that ### Approaches to providing official financing in the face of large potential financing needs - Four alternative official-sector approaches when a large stock of hard currency denominated short-term debt may not be rolled over: - (i) provide financing on a scale sufficient to cover at least a large fraction of the potential financing need; - (ii) provide a more limited amount of financing in the hope that this financing, along with the policy adjustments, will reassure the country’s creditors and thus catalyze the provision of the additional financing needed; - (iii) seek a commitment for the private sector to roll over claims and extend maturities rather than an outright debt reduction; - (iv) condition official financing on concerted efforts to restructure the country’s external liabilities or limit capital outflows. - Intermediate approaches between catalytic and concerted private sector involvement have proven increasingly elusive. - Voluntary approaches can be very expensive because creditors demand a high spread during a crisis to compensate for the risk of holding longer-term claims. - Non-voluntary restructuring of private debts risks shattering market confidence and triggering sudden balance sheet adjustments. - Official external support and debt restructuring can be complementary if debts are disaggregated at the sectoral level: restructure troubled sector debts while using official support for other sectors, or undertake comprehensive restructuring when aggregate external debt reduction is needed. - Official external financing can meet emergency financing needs. ### The balance sheet approach: use and limits - The balance sheet approach helps assess potential sources of demand for foreign currency liquidity by: - gauging potential demand for foreign exchange arising from existing resident debts; - specifying assumptions about rollover rates underlying expected financing need calculations; - identifying whether balance sheet needs require monetary authorities to hold a higher level of gross reserves, which could inform size of access to Fund resources. - The approach provides tests (not mechanistic rules) to help judge the case for official financing. Official financing is strongest if: - the identified balance sheet problem cannot be remedied with domestic resources and policy adjustment alone; - official financing can help address the relevant balance sheet imbalance (e.g., cover a maturity mismatch temporarily or transfer currency risk from a weak sector to a stronger sector); - the financial position of both the country and the government are sustainable under reasonable assumptions with appropriate policy adjustments. - The balance sheet approach does not mechanistically identify the scale of need or whether debt restructuring or lending is preferable; it informs judgments and provides tests. ### Limits on use of external official financing to address balance sheet needs - Official financing is best suited to addressing maturity mismatches. - Two types of maturity mismatches: - Difficulty rolling over existing foreign currency debts (domestic and external). Official lending pays off maturing debts by temporarily replacing existing foreign currency debts with new official debt; foreign currency debt remains unchanged but preferred debt increases, worsening capital structure. Examples: Mexico (end of 1994 tesobonos), Korea (end of 1997 short-term bank lines). - Difficulty refinancing local currency denominated debts or obtaining domestic financing on sustainable terms. Domestic lender-of-last-resort actions (monetary expansion) may be constrained by sectoral currency mismatches; in such cases foreign currency lending from official external sector can take pressure off domestic market but increases government exposure to currency risk and may increase aggregate external liabilities depending on holders of domestic currency debt. - Nonconcessional official lending cannot reduce the currency mismatch on the country’s balance sheet as a whole because it creates a foreign exchange denominated external liability. - Official financing can transfer currency risk from private sector to government by having government borrow externally and supply foreign exchange to banks/firms; currency risk migrates to government. - Official lending cannot improve capital structure or make large contributions to reducing solvency risk unless extended as grants; preferred creditor loans create more rigid debt and capital structure and only provide time to adjust. - Adding preferred loans weakens government and country capital structure and does not improve aggregate currency position. ### Sustainability requirements for official lending - For official lending to help meet balance sheet needs, both government and country balance sheets need to be sustainable and strong enough (with needed adjustments) to support additional preferred debt to the official sector. - The government’s balance sheet matters even when the underlying problem is private sector balance sheets; a weak government balance sheet cannot help other sectors. - Long-term sustainability (in simplest definition) requires assets exceed liabilities; major assets are: - government: long-term capacity to generate primary surpluses; - country: future capacity to generate surpluses in the non-interest bearing current account. - Valuation of these assets depends on future growth, government capacity to raise revenues/reduce expenditures/sustain fiscal adjustment, capacity of residents to sell goods and services abroad, willingness to devote future resources to debt service, and willingness of the country to run current account surpluses. - Major assets are illiquid and hard to value; government contingent liabilities (e.g., assuming liabilities of banking system) matter. - External official sector should only lend in absence of private debt restructuring when it believes there is a sufficiently high probability that government and country are sustainable provided needed adjustments are made; otherwise restructuring to reduce debts is appropriate. ### Key conclusions from the balance sheet framework - The currency and maturity structure of the outstanding debt stock is almost as important as total debt size. - Liabilities among residents can be a source of pressure on reserves, particularly if denominated in foreign currency. - Sectoral balance sheets matter; domestic crises (debts between residents) are particularly likely to snowball due to interlinkages among government, financial system, and firms. - Private actors should hedge currency risk, but if government is primary hedger the mismatch is passed to the government. - A domestic balance sheet crisis will not stay domestic long with open capital accounts; residents and non-residents will seek foreign assets. - Combination of short-term debt and foreign currency debt is extremely dangerous—even if mismatches are split across sectors—because any currency mismatch constrains government’s capacity to act as domestic lender of last resort. - Prompt action to contain crisis before cross-sector propagation can prevent larger crises. - Financing need must be assessed relative to outstanding relevant claims; effective scale may be large and vary from a single sector to entire country as crisis evolves. - External official sector has a role in providing reserves to meet demands for hard currency liquidity from domestic sectors; in a surge in demand, country needs higher level of gross reserves to intervene while maintaining prudent cushion. - Official intervention’s ability to offer viable long-run solutions to problems rooted in poor balance sheets is limited; preferred lending cannot radically transform balance sheets and adding new senior debt intrinsically weakens capital structure. ### Annex I — Operational issues in estimating balance sheet needs - Sectoral and aggregate balance sheet information on size, maturity, and currency composition is the first step to calculate sectoral foreign currency liquidity needs; actual financing need requires behavioral assumptions (rollover willingness, deposit behavior) and identification of which sectoral needs generate reserve/BOP pressure. - A matrix of intersectoral asset and liability positions (rows: liabilities by issuing sector and maturity/currency; columns: holders/creditors) highlights interlinkages and mismatches; diagonal (intrasectoral holdings) is empty due to consolidation. - Valuation and data issues: - state enterprises and private nonfinancial assets (fixed assets, goodwill) are difficult to value; - assessing risks associated with balance sheet components and asset availability during crisis is challenging; - data quality and availability vary; balance sheet approach must be applied flexibly. - Data availability constraints: - balance sheet information has not been routinely produced by national authorities due to resource and confidentiality constraints, though availability has improved (SDDS, Fund staff focus). - IFS provides monthly information on monetary authorities’ international liquidity; Money and Banking section provides domestic currency claims/liabilities; 78 countries’ IFS includes International Investment Position (IIP) with sector and maturity information. - BIS international banking statistics provide quarterly creditor-side statistics for reporting countries, disaggregating claims into bank and nonbank; maturity breakdown is by residual maturity but only on aggregated country basis. - Together IFS and BIS provide reasonable coverage of public sector liabilities and aggregate external liabilities, but white spots remain for sectoral residual maturities and foreign currency items not involving nonresidents. - Lack of corporate balance sheet data is a major concern because corporate exposures can generate systemic risk via bank claims on corporations; stress testing banks without corporate data must be interpreted with caution. - International guidance: External Debt Statistics: Guide for Compilers and Users emphasizes stock data and external debt measures (remaining maturity basis, currency of denomination, external debt service schedule, net external debt position) and recommends sectoral presentation. ### Annex II — Thailand before the 1997 crisis: stylized calculations and sensitivity to assumptions - Choice of Thailand (end-1996 and mid-1997 data) exploits relatively detailed data and a private-sector-originated crisis; the original program substantially underestimated capital account adjustment. - End-December 1996 headline sectoral positions (assumptions: 1US$=25.6 baht): - short-term liabilities to rest of world: government sector less than $0.04 billion; commercial banks almost $29 billion; nonbank sector almost $19 billion — aggregate roughly $48 billion short-term foreign currency debt. - Bank of Thailand (BOT) foreign reserve assets: close to $39 billion. - commercial banks’ foreign assets: somewhat over $7 billion, of which $2.6 billion are liquid (cash and deposits with nonresident banks). - commercial banks’ claims on domestic nonbank sector: about $207 billion; about $0.5 billion are liquid deposits with other financial institutions. - assumed practically all lending to residents was in foreign currency, implying commercial banks had additional $32 billion foreign currency assets as claims against domestic nonbank sector. - nonbank foreign currency deposits with resident commercial banks: $0.48 billion. - December 1996 stylized financing-gap accounting (Table 1): - Scenario A (only banks’ foreign deposits liquid; zero rollover of short-term liabilities): - Liquid assets: Government sector 39; Commercial Banks 2.6; Nonbank Sector ?; Country as Aggregate 41. - Short-term liabilities: Government sector 0; Commercial Banks 29; Nonbank Sector 19; Country as Aggregate 48. - Net (including outstanding swaps and forwards (-5)): - Government sector: 39 - Commercial Banks: 34 and -26 (two columns in table reflecting inclusion of swaps/forwards) - Nonbank Sector: -19 - Country as Aggregate: -7 and -11 (reflecting inclusion of swaps/forwards) - Reported potential financing gap about $7 billion (country aggregate) under pessimistic assumptions. - Scenario B (all banks’ foreign assets liquid; 50 Percent rollover of short-term liabilities): - Liquid assets: Government sector 39; Commercial Banks 7; Country as Aggregate 46. - Short-term liabilities: Government sector 0; Commercial Banks 15; Nonbank Sector 19; Country as Aggregate 34. - Net (including outstanding swaps and forwards (-5)): - Country as Aggregate: 12 and 7 (reflecting inclusion of swaps/forwards). - Under optimistic assumptions, a $12 billion surplus for country aggregate (December) becomes $7 billion when accounting for swaps/forwards. - Key December 1996 balance-sheet conclusions: - A potential financing gap of about $10 billion existed between government sector foreign reserves and the country’s total external foreign currency liabilities falling due over the short term; with banks’ liquid foreign assets less than $3 billion, the nonbank sector would have had to hold $7 billion liquid foreign assets to close aggregate gap. - Commercial banks’ total liabilities about $200 billion; about one-fourth ($49 billion) foreign currency denominated, 60 percent of which ($29 billion) fell due in the short term; after accounting for liquid foreign assets ($2.6 billion), more than $26 billion could be the sector’s short-term financing need. - Nonbank sector liabilities about $268 billion; almost one-quarter ($62 billion) owed to nonresidents in foreign currency — close to one-third ($19 billion) due in short term. - Commercial banks onlent domestically in foreign currency (claims ~ $32 billion) effectively hedging currency mismatch vis-à-vis nonresidents but transferring currency risk to domestic nonbank sector. - Nonbank sector total liabilities about $269 billion and equity about $137 billion imply average debt-to-equity ratio close to 200 percent at end-1996 (exchange rate 25.6 baht per U.S. dollar); over a third of total debt ($94 billion) was foreign currency debt (including foreign currency debt owed to domestic banks). - For commercial banking sector: liabilities close to 850 percent of sector’s capital and total capital to total asset ratio over 10.5 percent at end-December 1996. - By end-June 1997: - BOT had lost almost $7 billion of its foreign reserves (reserves still over $32 billion). - BOT outstanding forward and swap obligations increased from about $5 billion to some $29 billion. - June 1997 stylized financing-gap accounting (Table 2): - Scenario A (only banks’ foreign deposits liquid; zero rollover): - Liquid assets: Government sector 32; Commercial Banks 3.2; Country as Aggregate 35. - Short-term liabilities: Government sector 0; Commercial Banks 30; Nonbank Sector 19; Country as Aggregate 49. - Net (including outstanding swaps and forwards (-29)): - Country as Aggregate: -14 and -41 (reflecting inclusion of swaps/forwards). - Reported potential financing gap about $14 billion (country aggregate) under pessimistic assumptions, and $41 billion when including swaps/forwards. - Scenario B (all banks’ foreign assets liquid; 50 Percent rollover): - Liquid assets: Government sector 32; Commercial Banks 7; Country as Aggregate 39. - Short-term liabilities: Government sector 0; Commercial Banks 15; Nonbank Sector 19; Country as Aggregate 34. - Net (including outstanding swaps and forwards (-29)): - Country as Aggregate: 5 and -24 (reflecting inclusion of swaps/forwards). - Under optimistic assumptions a $5 billion surplus becomes a $-24 billion aggregate gap when subtracting outstanding swaps/forwards. - Sensitivity of financing-gap estimates: - Financing-gap calculations are highly sensitive to behavioral assumptions (rollover rates, liquidity of bank foreign assets) and to inclusion of outstanding swaps/forwards. - Example outcomes: - December 1996: pessimistic scenario yields $7 billion gap; optimistic scenario yields $12 billion surplus; subtracting $24 billion in swaps/forwards reverses outcomes. - June 1997: pessimistic scenario yields $14 billion gap; optimistic scenario yields $5 billion surplus; subtracting $41 billion in swaps/forwards reverses outcomes. - Observations on Thailand case and operational implications: - Potential financing needs were concentrated in sectoral private balance sheets rather than government sector. - The quality and liquidity of domestic foreign-currency claims (the banks’ onlending) were critical to the true exposure. - BOT off-balance-sheet exposures (swaps/forwards) substantially increased aggregate vulnerability when counterparties were nonresident. - Any financing need assessment must carefully consider off-balance-sheet items and the residence of counterparties. - Current account adjustment also matters for financing needs; there was scope for current account adjustment in Thailand’s case. - Estimating financing gaps accurately is difficult even with hindsight. *Italic source attribution: IMF working paper (excerpted content provided).* ### 9.8 percent, respectively. This said, the ratio of 9.8 percent is not directly comparable to the ### _wp02210 - 9.8 percent, respectively. This said, the ratio of 9.8 percent is not directly comparable to the ### Swaps, counterparties, and implications for foreign assets - Had only resident commercial banks been the counterparts to all the $29 billion of swaps, they would have—also without being recorded on their balance sheets—entirely hedged their short-term foreign liabilities. - In that case the swaps would have represented a (future) shift of foreign assets from government sector to commercial banking sector, but not a loss of these foreign assets for the country as a whole. - To the extent the swap and forward positions took place with offshore entities, however, they constituted an outflow. - If resident commercial banks had been the counterparts, the assets would ultimately have flowed out too, but in the form of a repayment of their foreign liabilities. ### Corporate leverage metrics (Table 3) - Average Corporate Debt-to-Equity Ratios in Selected Countries (In percent): - Thailand: 196 - Taiwan Province of China: 90 - United States: 106 - Germany: 144 - Malaysia: 160 - Japan: 194 - Korea: 317 - BIS minimum capital asset ratio of 8.5 percent (for local banks) noted as not weighting assets by risk. ### Solvency risk observations (template-based, not comprehensive) - Commercial banks - High solvency risk through large exposure to the nonfinancial private sector. - Claims of over $206 billion on nonfinancial private sector versus claims a little above $5.5 billion on the government sector. - Total claims on nonbanks amounted to over 115 percent of GDP. - Government sector - Government sector debt about $14 billion, equivalent to only about 6 percent of GDP and only about one-half of annual tax revenue collected by the central government. - Adding contingent liabilities in the form of $12 billion government guarantees for state enterprise debt would about double those ratios. - Even in the extreme case of adding the BOT’s $29 billion forward obligations (which nevertheless were fully covered by the BOT’s own reserves), total public debt would still only reach 28 percent of GDP. - Aggregate country solvency when combining private and public external debt - Thailand’s total external debt ($115 billion) reached over 60 percent of GDP and over 200 percent of the exports of goods and services. ### Financial institutions’ claims on the private sector (Table 4, end of 1996) - Financial Institutions’ Claims on the Private Sector in Selected Countries (In percent of GDP): - Thailand: 142 - Mexico: 22 - Turkey: 24 - Philippines: 48 - Indonesia: 55 - Brazil: 31 - Malaysia: 144 - Korea: 66 - Note: Ratio for financial institutions (incl. Thai finance companies) used for international comparison; see Radelet and Sachs (1998), Table 14. ### References (selected items from source) - Aghion, Philippe, Philippe Bacchetta, and Abhijit Banerjee, 2000, “Currency Crises and Monetary Policy with Credit Constraints” (unpublished; Cambridge, Massachusetts: Harvard University). - Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo, 1998, “Prospective Deficits and the Asian Currency Crisis,” NBER Working Paper No. 6758. - Bussière, Matthieu and Christian Mulder, 1999, “External Vulnerability in Emerging Market Economies: How High Liquidity Can Offset Weak Fundamentals and the Effects of Contagion,” IMF Working Paper 99/88. - Calvo, Guillermo, 1998, “Capital Flows and Capital-Market Crises: The Simple Economics of Sudden Stops,” Journal of Applied Economics, Vol.1, November, pp. 35–54. - (Additional references follow in the source text.) *Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2002/_wp02210.pdf* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2002/_wp02210.pdf_