by M Allen · 2002 · Cited by 520 — The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables in the aggregate
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© 2002 International Monetary Fund WP/02/210 IMF Working Paper Policy Development and Review Department A Balance Sheet Approach to Financial Crisis Prepared by Mark Allen, Christ oph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini 1 Authorized for distribution by Timothy Geithner December 2002 Abstract The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. The paper lays out an analytical framework fo r understanding crises in emerging markets based on examination of stock va riables in the aggregate balance sheet of a country and the balance sheets of its main sectors (assets and liabilities). It focuses on the risks created by maturity, currency, and capital structure mismatches. This framework draws attention to the vulnerabilities created by debts among residents, particularly those denominated in foreign currency, and it helps to explain how problems in one sector can spill over into other sectors, eventually triggering an external balance of payments crisis. The paper also discusses the potential of macroeconomic policies and official intervention to mitigate the cost of such a crisis. JEL Classification Numbers: E00, F02, F32, F33, F34, F42, G15, G18 Keywords: National balance sheets, financial crisis, IMF policy, emerging markets Authors™ E-Mail Addresses: firstname.lastname@example.org, crosenberg@ imf.org, email@example.com, firstname.lastname@example.org, email@example.com 1 The first four authors are Deputy Director, Deputy Division Chief, Economist and Consultant, respectively, in the Policy Review and Development Department of the IMF. Nouriel Roubini is a professor at New York University, who spent some months as a Visiting Scholar at the IMF. The authors would like to thank Anne Krueger, Timothy Geithner, Leslie Lipschitz, Charles Enoch, Alan MacArthur, Christian Mulder, Jeromin Zettelmeyer, Olivier Jeanne and reviewers in several departments of the Fund for extensive comments. All remaining errors are ours.
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– 2 – Contents Page Summary 4 I. Introduction. 9 II. The Anatomy of Ba lance Sheet Crises..12 A. Balance Sheet Concepts: A Primer with Examples.12 Maturity mismatch risk.15 Currency mismatch risk16 Capita l structure mismatches.17 Solvency risk ..18 Related risks 20 B. Characteristics of Recent Cap ital Account Crises from a Balance Sheet Perspective 20 III. Implications for Crisis Prevention and Fund Policy Advice During Crises.23 A. Crisis Prevention. .24 Public sector debt management..27 Foreign curren cy debt of the private sector..28 B. Policy Advice and Program Design in Crises29 Example 1. Exchange rate policy29 Example 2. Moneta ry policy and foreign exchange intervention after a devaluation 31 Example 3. Capital outflow controls32 Example 4. Fiscal policy.33 IV. The Role of Official External Financing33 A. The Need for External Financing.34 B. The Case for Official Extern al Financing or Offici al Support for a Debt Restructuring. .36 C. Limits on Use of External Official Financing to Address Balance Sheet Needs. ..39 D. Sustainability of Balance Sheets..41 V. Conclusion ..42 Annex I Estimating Balance Sheet Needs: Operational Issues..44 Annex II Calculating Balance Sheet Risks and Fina ncing Gaps: Thailand Before the Crisis.50 References ..60
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– 3 – Boxes 1. The Balance Sheet Approach in Recent Academic Literature10 2. How Balance Sheet Risks Apply to Different Sectors19 3. Balance Sheet Approach and Flow Analysis..24 4. Data Availability as Prerequisite for Balance Sheet Analysis25 Figure 1. Financial Interlinkages Between the Sectors in an Economy.14 Table 1. Indicators of Potential Financing N eeds in Recent Capita l Account Crises23 Annex I Figure 1. Matrix of an Economy™s Intersec toral Asset and Liability Positions.45 Annex II Figures 1. Thailand: Intersectoral Asset and Liability Position End of December 199651 2. Thailand: Intersectoral Asset a nd Liability Position End of June 1997.52 Annex II Tables 1. Thailand: External Foreign Curr ency Financing Gaps, December 1996..55 2. Thailand: External Foreign Curr ency Financing Gaps, June 1997..56 3. Average Corporate Debt-to-Equity Ratios in Selected Countries58 4. Financial Institutions™ Claims on the Privat e Sector in Selected Countries, End of 199658
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– 4 – SUMMARY Financial markets have become increasing ly integrated over the past ten years . In many countries, foreign borrowing has helped to finan ce higher levels of investment than would be possible with domestic savings alone and contribut ed to sustained periods of growth. But the opening of capital markets has also placed exceptional demands on financial and macroeconomic policies in emerging market economies. Private capital flows are sensitive to market conditions, perceived policy weaknesse s, and negative shocks. Flows of private capital have been more volatile than many ex pected. A number of major emerging economies have experienced sharp fi nancial crises since 1994. The financial structure of many emerging ma rkets economiesŠthe composition and size of the liabilities and assets on the country™s financial balance sheetŠhas been an important source of vulnerability to crises. Financial weaknesses, such as a high level of short-term debt, can be a trigger for domestic and external investors to reassess their willingness to finance a country. The composition of a country™s financial balance sh eets also helps to determine how much time a country might have to overcome doubts about the strength of its macroeconomic policy framework, and, more generally, how effectively a country can insulate itself from volatility stemming from changes in global market conditions. This paper seeks to lay out a systematic analytical framework for exploring how balance sheet weaknesses contribute to th e origin and propagation of modern-day financial crises. It draws on the growing body of academic work that emphasizes the importance of balance sheets. It pays particular attention to the balance sheets of key sectors of the economy and explores how weaknesses in one sector can cascade and ultimately generate a broader crisis. What Is the Balance Sheet Approach? Unlike traditional analysis, which is based on the examination of flow variables (such as current account and fiscal balance), the balance sheet approach focuses on the examination of stock variables in a country™s sectoral balance sheets and its aggregate balance sheet (assets and liabilities). From this perspective, a financial crisis occurs when there is a plunge in demand for financial assets of one or more sectors: creditors may lose confidence in a country™s ability to earn foreign exchange to service the external debt, in the government™s ability to service its debt, in the banking system ™s ability to meet deposit outflows, or in corporations™ ability to repay bank loans and other debt. An entire sector may be unable to attract new financing or roll over existing short-term liabilities. It must then either find the resources to pay off its debts or seek a restructuring. Ultimately, a plunge in demand for the country™s assets leads to a surge in demand for foreign assets and/or for assets denominated in foreign currency. Massive outfl ows of capital, a sharp depreciation of the exchange rate, a large current account surplu s, and a deep recession that reduces domestic absorption are often the necessary counterpart to a sudden adjustment in investors™ willingness to hold a country™s accumu lated stock of fi nancial assets.
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– 5 – An economy™s resilience to a range of shocks, including financial shocks, hinges in part on the composition of the count ry™s stock of liabilities and assets. The country™s aggregate balance sheetŠthe external liabilities and liquid external assets of all sectors of the economyŠis vital. But it is of ten equally important to l ook inside an economy and to examine the balance sheet of an economy™s key se ctors, such as the government, the financial sector, and the corporate sector. Our framework for assessing balance sheet risks focuses on four types of balance sheet mismatches, all of which help to determine a country™s ability to service debt in the face of shocks : (i) maturity mismatches, where a gap between liabilities due in the short term and liquid assets leaves a sector unable to honor its contractual commitments if the market declines to roll over debt, or creates exposure to the risk that interest rates will rise; (ii) currency mismatches , where a change in the exchange rate leads to a capital loss; (iii) capital structure problems, where a heavy reliance on debt rather than equity financing leaves a firm or bank less able to weather revenue shocks; and (iv) solvency problems , where assetsŠincluding the present value of future revenue streamsŠare insufficient to cover liabilities, including contingent liabilities. Maturity mismatches, currency mismatches, and a poor capital structure all can contribute to solvency risk, but solvency risk can also arise from simply borrowing too much or from investing in low-yielding assets. An analytical framework that examines the balance sheets of an economy™s major sectors for maturity, currency, and capital structure mismatches helps to highlight how balance sheet problems in one sector can spill over into other sectors, and eventually trigger an external balance of payments crisis. Indeed, one of the core arguments that emerges from this approach is that the debts among residents that create internal balance sheet mismatches also generate vulnerability to an external balance of payments crisis. The transmission mechanis m often works through the domestic banking system. For instance, broad concerns about th e government™s ability to service its debt, whether denominated in domestic or foreign currency, will quickly destabilize confidence in the banks holding this debt and may lead to a deposit run. Alternatively, a change in the exchange rate coupled with unhedged foreign ex change exposure in the corporate sector can undermine confidence in the banks that have le nt to that sector. The run on the banking system can take the form of a withdrawal of cross-border lending by nonresident creditors, or the withdrawal of deposits by domestic residents. Many of the characteristics of a capital account crisis derive from the adjustment in portfolios that follows from an initial shock. Underlying weaknesses in balance sheets can linger for years without trig gering a crisis. For example, a currency mismatch can be masked so long as conti nued capital inflows support the exchange rate. Consequently, the exact timing of a crisis is difficult to predict. However, should a shock undermine confidence, it can trigger a large and disorderly adjustment, as the initial shock reveals additional weaknesses and a broad range of investors, including local residents, seek to reduce their exposure to the country. Massive flows are the necessary counterpart of a sudden move toward a new equilibrium of asset holdings stemming from rapid stock adjustments. If these flows cannot be financed out of reserves, the relative price of foreign
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– 7 – An assessment of the relative scale of maturity and currency mismatches on sectoral balance sheets can help policymakers weigh the trade-off between an interest rate defense and a nominal exchange rate adjustment. In practice, policymakers are unlikely to be able to either direct mone tary policy solely at domestic macroeconomic conditions or to direct monetary policy solely at exchange rate stabilization: they will need to aim for the right balance between exchange rate adjustment and monetary tightening. There is obvious appeal in running a counter cyclical fiscal policy to limit the fall in output associated with a crisis that originates in the private sector. The scope to do so will depend critically on the strength of the government™s balance sheet and its ability to obtain the needed financing. Finally, the balance sheet approach can help the official sector to assess the case for financial intervention, and to better understand the scale of official support needed. Not all sectoral financial crises in emerging market economies call out for official intervention. In many cases, problems in the pr ivate sector™s balance sheet can and should be resolved by restructuring the private sector™s liabilities without any g overnment intervention or financing. In other cases, the national government will be able to use its own reserves and other elements of the strength of its own balance sheet to prevent a crisis in the private sector from spreading. Such intervention should be accompanied by steps to reinforce incentives for more prudent behavior in the future, including closing weak institutions. However, there are cases where the country™s authorities will l ack access to the resourcesŠnotably foreign exchange reservesŠon the scale needed to act to prevent a crisis on private sector balance sheets (for example, a run on foreign currency denominated bank deposits) from snowballing. And the government cannot interven e when it is the source of financial distress itself. Exceptional external financing from the official sector may be justified under some circumstances as part of a strategy to prevent a broader crisis . The genesis of recent financial crises points to the need to address sector balance sheet problems quickly and in a targeted manner, before they snowball into even larger problems that put severe pressure on a country™s balance of payments and trigger a deep crisis that results in a large fall in output. In times of stress, a country may need to quickly increase its holdings of gross reserves to be in a position to support the orde rly unwinding of balance sheet problems. Fund support can therefore play an important role in augmenting a country™s reserves so that it is better positioned to contain the crisis. The scale of the needed support can be quite large, as a country™s financing needs will be proportionate to the stock of ou tstanding claims of the sector in distress. All foreign currency denominated debtsŠeven if between residentsŠcan generate pressure on official reserves. Claims denominated in domestic currency can also be a source of pressure, as there are limits to the extent m onetary expansion can be used to address a domestic rollover crisis without ultimate ly putting pressure on reserves.
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– 8 – Yet even as the balance sheet approach highlights the case for official support to avoid a crisis that snowballs across sectors and becomes a generalized loss of confidence, it also underscores the limits on what official intervention can be expected to accomplish. Borrowing from the official sector does not transform either the country™s aggregate balance sheet or the government™s balance sheet for the better. Increased access to foreign exchange in the short run is offset by a new liability to preferred creditors. External borrowing from official creditors may help address a sectoral maturity mismatch, including a rollover crisis stemming from a maturity mismatch on the government™s own balance sheet. But official lending cannot resolve a country-wide currency mismatch. At best it can provide access to foreign exchange liquidity that allows the private sector to reduce its open foreign currency positionŠat the cost of increasing the government™s foreign currency exposure. The accumulation of additional senior debt will certainly increase capital structure risk. Official lending can temporarily cover a maturity mismatch and therefore provide time to make appropriate adjustmentsŠwhether to the exchange rate regime or to the fiscal accountŠto strengthen the country or the government™s lo ng-term sustainability. But official lending itself will not make an unsustainable balance sheet sustainable.
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– 9 – I. INTRODUCTION This paper sets out a framework for understanding financial and currency crises in emerging market economies. The framework is based on a so-called ﬁbalance sheet approachﬂ, which has gained prominence in the academic literature (Box 1). This paper is not intended to lay out the beginning of an opera tional framework, nor are many of the insights presented here new. Rather, this paper s eeks to lay out the balance sheet approach systematically and to pull together its various insights, with an emphasis on the policy choices that countries in crisis face and the case for external official financing. The data requirements needed for balance sheet analysis and the framework™s implications for crisis prevention are discussed more briefly. These topics have been treated more thoroughly elsewhere, including in recent board papers on data provision and vulnerability analysis. 2 Recent capital account crises have differed from earlier crises and balance of payments difficulties in several respects . First, financing needs erupted suddenly and on an unprecedented scale. Second, payments difficultie s were not limited to transactions between the sovereign and nonresident inve stors, but often had their origins in the private sector, both financial and corporate, as well as in transac tions between residents. Finally, the scale and pace of economic adjustment was sharp and dram atic, often driven by large capital outflows and substantial exchange rate ad justment. The analysis of these capital account crises and the ways in which financial difficulties are propagated across the different sectors of the economy, including spilling over into the external accounts, has been a major challenge to policy makers. 3 The balance sheet approach represents a useful way of thinking about these problems . Beyond improving the understanding of th e genesis of financ ial crises, it has implications for the Fund™s approach to crisis prevention and resolution. First, it can further strengthen the framework for Fund surveillance, especially in emerging market economies. Indeed, the Fund™s involvement in the developmen t of data sources and its surveillance work is already increasingly focused on balance sh eet vulnerabilities. Second, provided that the data are available, it can help to gauge ex ante the scale of potential sources of pressure on a country™s reserves, and the financial problems th at may develop if sufficient reserves are not available to meet these sources of pressure. Su ch analysis could help Fund staff make more 2 See International Monetary Fund (2002a, 2002b, 2002c); also Bussière and Mulder (1999); Johnston, Chai and Schumacher(2000); Gosh and Gosh (2002); Hemming, Kell and Schimmelpfennig (forthcoming). 3 See, for example, Ortiz (2002).
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– 10 – Box 1. The Balance Sheet Approach in Recent Academic Literature Recent experience has led to a thorough rethinking of economists™ views of the causes, genesis and resolution of currency and financial crises. Until the mid 1990s, the standard ﬁfirst generationﬂ model explained a currency crisis in macro economic terms, usually as a result of monetized fiscal deficits leading to reserve losses and eventually the abandonment of an exchange rate peg (Krugman (1979); Flood and Garber (1984)). This first generation literature also introduced additional factors that may help to explain the dynamics of a crisis, such as current account imbalances, real exchange rate misalignments, output effects of misalignments; effect on the debt- servicing costs of the government when expected devaluation occurs and implications of borrowing to defend a peg. The stress, however, was on fundamental factors and on the idea that a crisis would be triggered more or less mechanically once reserves had reached a critical level. 1 The ERM crisis of 1992 and, more importantly, the Mexican crisis of 1994-95 led to a ﬁsecond generationﬂ of crisis models. It was recognized that a crisis could be triggered by an endogenous policy response as the authorities decide whether to devalue based on tradeoff between the benefits and costs of floating. 2 Moreover, these currency crises added the insight that, in addition to fundamental weaknesses (such as an overvalued currency and an unsustainable current account deficit), some elements of se lf-fulfilling panic can also be at work. In Mexico, as a large amount of short-term foreign currency linked debt (tesobonos) was coming to maturity and foreign reserves were insufficient to service this debt, the risk of a self-f ulfilling rollover crisis driven by investors™ panic became evident. These features were captured in so-called ﬁsecond generationﬂ models of currency crises (Obstfeld, 1994; Drazen-Masson (1994); Cole and Kehoe (1996)). The possibility of multiple equilibria contained in many of these models can be re-interpreted in the context of the balance sheet approach as a product of liquidity mismatches, either in the government sector or in the private sector. Such mismatches may lead to a self-fulfilling currency run or debt rollover crisis or banking run crisis. So, many second-generation models can be seen as stressing one element of balance sheet vulnerabilities. The Asian crisis of 1997-98 confirmed the view that the private sector, rather than traditional first generation fiscal imbalances, could be at the core of a crisis. While the Asian crisis had some elements of a self-fulfilling ﬁliquidity runﬂ (see Sachs and Radelet (1998), Rodrik and Velasco (1999)) as in the case of the roll-off of the cross- border Korean interbank lines, this crisis brought to the open a number of additional vulnerabilities in the corporate and financial sector of these economies. The Asian crisis also highlighted that currency crises are often associated with banking crises (ﬁtwin crisesﬂ) and that the currency crises of the 1990s were driven by sharp and unexpected movements of the capital account (ﬁsudden stopsﬂ and ﬁreversals of capital inflowsﬂ) rather than traditional current account imbalances. A third generation of models, based on balance sheet analysis, was developed to understand how capital account movements drive currency and financial crises (see Dornbusch (2001)). __________________________ 1/ Harry Johnson and others have long emphasized that changes in demand for money (a stock) would result in balance of payments flows in the context of a fixed exchange rate regime. A fall in demand for monetary assets would lead to a flow of reserves out of the country, while an increase in demand for monetary assets would require either capital inflows or current account surpluses to generate the needed stock of reserve assets. Recent work has tended to put less emphasis on changes in demand for money and more emphasis on shifts in demand for financial assets. 2/ For example, in the ERM (Exchange Rate Mechanism) crisis in 1992 some governments chose suddenly to devalue when the costs of an overvalued exchange rate in terms of growth and unemployment became too great. (continued)
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