## _op240 ## Source details **Canonical URL:** [_op240](https://www.imf.org/-/media/websites/imf/imported-publications/external/pubs/nft/op/240/_op240.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-publications/external/pubs/nft/op/240/_op240.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-publications/external/pubs/nft/op/240/_op240.pdf.json) --- ### The Balance Sheet Approach (BSA): purpose and scope - The paper describes the conceptual framework of the balance sheet approach (BSA) and its application to emerging market countries. - The BSA is increasingly used in the IMF’s analysis of debt-related vulnerabilities and as part of surveillance and risk assessments. - The study is derived from earlier work including “The Balance Sheet Approach to Financial Crisis” (IMF Working Paper No. 02/210). - Project team and acknowledgments: - Drafting led by Christoph Rosenberg and included Ioannis Halikias, Brett House, Christian Keller, Jens Nystedt, Alexander Pitt, and Brad Setser. - Initiated by Mark Allen, Director of the IMF’s Policy Development and Review Department; Juha Kähkönen provided general direction. - Contributions and inputs from numerous IMF departments, external seminars, and scholars (including Nouriel Roubini). - Esha Ray edited the paper; production by IMF Multimedia Services Division; typesetting by Alicia Etchebarne-Bourdin. - Publication metadata preserved: - Occasional Paper 240 - INTERNATIONAL MONETARY FUND, Washington DC, 2005 - ISBN 1-58906-425-9 - Price: US$25.00 (US$22.00 to full-time faculty members and students at universities and colleges) ### Four related purposes of the paper - To introduce the BSA and its application to emerging market economies, explaining basic concepts and their use in analyzing recent financial crises. - To provide an overview of salient balance sheet developments in emerging market economies, taking account of main balance sheet trends over the past decade and presenting case studies. - To demonstrate how the BSA can be used to identify vulnerabilities, highlighting the importance of systematically considering the level and structure of liabilities and assets and intersectoral linkages, including off-balance-sheet activities and contingent liabilities. - To prepare the ground for discussing surveillance and program-related policy issues, providing empirical backing for IMF Executive Board conclusions on policies to increase resilience, including appropriate liquidity management and design of debt-related conditionality and access to IMF resources. ### Why the paper focuses on emerging market countries - Emerging market countries have been subject to capital account crises in the last decade, often emanating from balance-sheet-related weaknesses. - Typical financing constraints in these countries: - Often unable to issue foreign debt in domestic currency. - Frequently forced to borrow at short maturities, leading to combined currency and maturity mismatches. - Fewer avenues to hedge or absorb financial losses. - IMF resource and surveillance considerations: - IMF’s budget constraints lead to a risk-oriented approach concentrating staff resources on members most likely to face crises and where the IMF could be financially exposed. - Relevance to mature markets: - BSA is also relevant to industrial countries; recent Article IV consultations for Australia, Ireland, the United Kingdom, and the United States focused on real estate, mortgage lending, and household debt. - Selected studies have examined banking and insurance international linkages (Germany, Portugal, Spain) and currency mismatches (Austria). - Full intersectoral balance sheet analysis is data intensive; some industrial country members (such as the United Kingdom) are progressing in this area. ### Academic and theoretical context (Box 1.1 highlights) - Crisis modeling evolution: - “First generation” models (Krugman, 1979; Flood and Garber, 1984) emphasized fiscal deficits and reserve depletion leading to peg abandonment. - “Second generation” models (post-1992 crisis literature) recognize balance sheet mismatches and endogenous policy choices that can trigger crises; multiple equilibria and self-fulfilling runs are key concepts. - “Third generation” models (post-1997–98 Asian crisis) incorporate private sector vulnerabilities, currency mismatches, and banking-sector weaknesses; these models explain twin crises and the amplification from currency depreciation to balance sheet deterioration. - Key theoretical contributions and phenomena referenced: - Self-fulfilling currency runs, debt rollover crises, bank runs. - Channels linking currency depreciation to increased real debt-service burden and output contraction. - Interpretation of crises as liquidity runs or variants of bank-run models (e.g., Diamond and Dybvig, 1983). - Literature cited includes Krugman (1999); Masson (1999); Corsetti, Pesenti, and Roubini (1999a and 1999b); Chang and Velasco (1999); Burnside, Eichenbaum, and Rebelo (1998); Schneider and Tornell (2000); and IMF Research Department work on international lender-of-last-resort roles (Jeanne and Wyplosz, 2001; Zettelmeyer and Jeanne, 2002). ### Structure of the paper - Section II: introduces general concepts underlying the BSA and shows how they help understand modern financial crises. - Section III: broad overview of trends in public and private balance sheets in emerging market countries; highlights deepening intersectoral linkages and vulnerabilities. - Section IV: case studies tracing balance sheet developments in recent crises and near-crisis episodes (Argentina, Turkey, Uruguay; Brazil, Lebanon, Peru). - Section V: concluding thoughts on policy implications, operationalizing the BSA, and further work. ### Debt intolerance and fiscal vulnerabilities - Developing countries historically run into problems at much lower debt-to-output ratios than advanced countries. - Weak revenue bases and lack of expenditure control are critical reasons why primary balances and hence sustainable public debt levels in an emerging market economy are fairly low. - Research in International Monetary Fund (2003a) suggests that, based on fiscal performance, the sustainable gross public debt level for a typical emerging market economy may only be about 25 percent of GDP; 50 percent of GDP is found to be a threshold level beyond which the risk of a sovereign debt crisis increases significantly. - Reinhart, Rogoff, and Savastano (2003a) find that external debt was less than 60 percent of GNP in 47 percent of the default cases they examined. - International Monetary Fund (2002b) and Manasse, Roubini, and Schimmelpfennig (2003) estimate external debt thresholds of 40 percent of GDP and 50 percent of GDP, respectively, beyond which countries are more likely to experience debt defaults. ### Liability-side vulnerabilities and original sin - Weaknesses on the liability side of the public sector’s balance sheet can reduce the level of debt that emerging market economies can sustain. - The literature on original sin—the inability to borrow (abroad, but also at home) long term in the local currency—highlights important differences between the debt structures of advanced economies and many emerging market economies. ### Dollarization, balance sheet mismatches, and amplification of crises - Financial crises, especially in Latin America, have inspired research on vulnerabilities associated with (partial) domestic dollarization in emerging market countries. - Households’ holdings of dollar deposits can leave the banking system and the overall economy vulnerable to a self-reinforcing deposit run if a shock to portfolio preferences prompts a shift out of domestic dollar deposits toward relatively safer international assets. - The need to match dollar deposits with domestic dollar loans can increase the overall stock of foreign-currency-denominated claims in the economy, aggravating the risk that a currency depreciation will result in financial distress. - Balance sheet mismatches in the financial, household, or corporate sectors can seriously limit the degree of exchange rate volatility that policymakers are willing to tolerate (fear of floating), as monetary authorities in practice often intervene to prevent large movements in the exchange rate. ### Measuring vulnerability: assets, liabilities, and foreign currency exposure - Recent work on currency mismatches highlights the need to take into account domestic foreign currency liabilities as well as external debt in assessing vulnerability. - An economy’s foreign currency debt should be assessed in light of both existing stocks of foreign assets and its ability to generate a flow of foreign currency receipts from exports and income. *Source: OCCASIONAL PAPER 240, Debt-Related Vulnerabilities and Financial Crises: An Application of the Balance Sheet Approach to Emerging Market Countries, International Monetary Fund, 2005.* ### Section 1 ### Overview ### The Balance Sheet Approach (BSA): purpose and scope - The paper describes the conceptual framework of the balance sheet approach (BSA) and its application to emerging market countries. - The BSA is increasingly used in the IMF’s analysis of debt-related vulnerabilities and as part of surveillance and risk assessments. - The study is derived from earlier work including “The Balance Sheet Approach to Financial Crisis” (IMF Working Paper No. 02/210). - Project team and acknowledgments: - Drafting led by Christoph Rosenberg and included Ioannis Halikias, Brett House, Christian Keller, Jens Nystedt, Alexander Pitt, and Brad Setser. - Initiated by Mark Allen, Director of the IMF’s Policy Development and Review Department; Juha Kähkönen provided general direction. - Contributions and inputs from numerous IMF departments, external seminars, and scholars (including Nouriel Roubini). - Esha Ray edited the paper; production by IMF Multimedia Services Division; typesetting by Alicia Etchebarne-Bourdin. - Publication metadata preserved: - Occasional Paper 240 - INTERNATIONAL MONETARY FUND, Washington DC, 2005 - ISBN 1-58906-425-9 - Price: US$25.00 (US$22.00 to full-time faculty members and students at universities and colleges) ### Four related purposes of the paper - To introduce the BSA and its application to emerging market economies, explaining basic concepts and their use in analyzing recent financial crises. - To provide an overview of salient balance sheet developments in emerging market economies, taking account of main balance sheet trends over the past decade and presenting case studies. - To demonstrate how the BSA can be used to identify vulnerabilities, highlighting the importance of systematically considering the level and structure of liabilities and assets and intersectoral linkages, including off-balance-sheet activities and contingent liabilities. - To prepare the ground for discussing surveillance and program-related policy issues, providing empirical backing for IMF Executive Board conclusions on policies to increase resilience, including appropriate liquidity management and design of debt-related conditionality and access to IMF resources. ### Why the paper focuses on emerging market countries - Emerging market countries have been subject to capital account crises in the last decade, often emanating from balance-sheet-related weaknesses. - Typical financing constraints in these countries: - Often unable to issue foreign debt in domestic currency. - Frequently forced to borrow at short maturities, leading to combined currency and maturity mismatches. - Fewer avenues to hedge or absorb financial losses. - IMF resource and surveillance considerations: - IMF’s budget constraints lead to a risk-oriented approach concentrating staff resources on members most likely to face crises and where the IMF could be financially exposed. - Relevance to mature markets: - BSA is also relevant to industrial countries; recent Article IV consultations for Australia, Ireland, the United Kingdom, and the United States focused on real estate, mortgage lending, and household debt. - Selected studies have examined banking and insurance international linkages (Germany, Portugal, Spain) and currency mismatches (Austria). - Full intersectoral balance sheet analysis is data intensive; some industrial country members (such as the United Kingdom) are progressing in this area. ### Academic and theoretical context (Box 1.1 highlights) - Crisis modeling evolution: - “First generation” models (Krugman, 1979; Flood and Garber, 1984) emphasized fiscal deficits and reserve depletion leading to peg abandonment. - “Second generation” models (post-1992 crisis literature) recognize balance sheet mismatches and endogenous policy choices that can trigger crises; multiple equilibria and self-fulfilling runs are key concepts. - “Third generation” models (post-1997–98 Asian crisis) incorporate private sector vulnerabilities, currency mismatches, and banking-sector weaknesses; these models explain twin crises and the amplification from currency depreciation to balance sheet deterioration. - Key theoretical contributions and phenomena referenced: - Self-fulfilling currency runs, debt rollover crises, bank runs. - Channels linking currency depreciation to increased real debt-service burden and output contraction. - Interpretation of crises as liquidity runs or variants of bank-run models (e.g., Diamond and Dybvig, 1983). - Literature cited includes Krugman (1999); Masson (1999); Corsetti, Pesenti, and Roubini (1999a and 1999b); Chang and Velasco (1999); Burnside, Eichenbaum, and Rebelo (1998); Schneider and Tornell (2000); and IMF Research Department work on international lender-of-last-resort roles (Jeanne and Wyplosz, 2001; Zettelmeyer and Jeanne, 2002). ### Structure of the paper - Section II: introduces general concepts underlying the BSA and shows how they help understand modern financial crises. - Section III: broad overview of trends in public and private balance sheets in emerging market countries; highlights deepening intersectoral linkages and vulnerabilities. - Section IV: case studies tracing balance sheet developments in recent crises and near-crisis episodes (Argentina, Turkey, Uruguay; Brazil, Lebanon, Peru). - Section V: concluding thoughts on policy implications, operationalizing the BSA, and further work. *Source: OCCASIONAL PAPER 240, Debt-Related Vulnerabilities and Financial Crises: An Application of the Balance Sheet Approach to Emerging Market Countries, International Monetary Fund, 2005.* ### Section 2 ### _op240 - Section 2 ### Debt intolerance and fiscal vulnerabilities - Developing countries historically run into problems at much lower debt-to-output ratios than advanced countries. - Weak revenue bases and lack of expenditure control are critical reasons why primary balances and hence sustainable public debt levels in an emerging market economy are fairly low. - Research in International Monetary Fund (2003a) suggests that, based on fiscal performance, the sustainable gross public debt level for a typical emerging market economy may only be about 25 percent of GDP; 50 percent of GDP is found to be a threshold level beyond which the risk of a sovereign debt crisis increases significantly. - Reinhart, Rogoff, and Savastano (2003a) find that external debt was less than 60 percent of GNP in 47 percent of the default cases they examined. - International Monetary Fund (2002b) and Manasse, Roubini, and Schimmelpfennig (2003) estimate external debt thresholds of 40 percent of GDP and 50 percent of GDP, respectively, beyond which countries are more likely to experience debt defaults. ### Liability-side vulnerabilities and original sin - Weaknesses on the liability side of the public sector’s balance sheet can reduce the level of debt that emerging market economies can sustain. - The literature on original sin—the inability to borrow (abroad, but also at home) long term in the local currency—highlights important differences between the debt structures of advanced economies and many emerging market economies. ### Dollarization, balance sheet mismatches, and amplification of crises - Financial crises, especially in Latin America, have inspired research on vulnerabilities associated with (partial) domestic dollarization in emerging market countries. - Households’ holdings of dollar deposits can leave the banking system and the overall economy vulnerable to a self-reinforcing deposit run if a shock to portfolio preferences prompts a shift out of domestic dollar deposits toward relatively safer international assets. - The need to match dollar deposits with domestic dollar loans can increase the overall stock of foreign-currency-denominated claims in the economy, aggravating the risk that a currency depreciation will result in financial distress. - Balance sheet mismatches in the financial, household, or corporate sectors can seriously limit the degree of exchange rate volatility that policymakers are willing to tolerate (fear of floating), as monetary authorities in practice often intervene to prevent large movements in the exchange rate. ### Measuring vulnerability: assets, liabilities, and foreign currency exposure - Recent work on currency mismatches highlights the need to take into account domestic foreign currency liabilities as well as external debt in assessing vulnerability. - An economy’s foreign currency debt should be assessed in light of both existing stocks of foreign assets and its ability to generate a flow of foreign currency receipts from exports and income. *Source: _op240 - Section 2* --- _Source: https://www.imf.org/-/media/websites/imf/imported-publications/external/pubs/nft/op/240/_op240.pdf_