Foundations of Balance Sheet Economics

From  A Balance Sheet Approach to Financial Crisis

Financial markets have become increasingly integrated over the past ten years. In many countries, foreign borrowing has helped to finance higher levels of investment than would be possible with domestic savings alone and contributed 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 weaknesses, and negative shocks. Flows of private capital have been more volatile than many expected. A number of major emerging economies have experienced sharp financial crises since 1994.

The financial structure of many emerging markets economies—the composition and size of the liabilities and assets on the country’s financial balance sheet—has 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 sheets 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 the 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 outflows of capital, a sharp depreciation of the exchange rate, a large current account surplus, and a deep recession that reduces domestic absorption are often the necessary counterpart to a sudden adjustment in investors’ willingness to hold a country’s accumulated stock of financial assets.

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

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

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

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

Policy Implications

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

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

 

There are five strands in development of Balance sheet Economics.

A) Work of Prof. K Tsujimura and Prof. Mizoshita and Prof. M Tsujimura on asset-liabilities Matrices (ALM).

B) IMF’s Balance sheet Approach (BSA)

C) Prof. N Zhang’s work on the Global Flow of Funds accounts

D) Post Keynesian Economists – Mark Lavoie, Dirk Bezemer, Wynne Godley, Hyman Minsky, Steve Keen

E) Money View – Perry Mehrling, Zoltan Pozsar

 

 

 

Key sources for Research:

Compilation and Application of Asset-Liability Matrices: A Flow-of-Funds Analysis of the Japanese Economy 1954-1999.
(2004).
 Tsujimura, Kazusuke, and Masako Mizoshita.

 

http://koara.lib.keio.ac.jp/xoonips/modules/xoonips/download.php/AA10715861-00000093-0001.pdf?file_id=9761

 

 

Tsujimura, Masako, and Kazusuke Tsujimura.

“Balance sheet economics of the subprime mortgage crisis.”

Economic Systems Research 23.1 (2011): 1-25.

http://www.cfsp.org/sites/default/files/tsujimura_-_balance_sheet_economics_presentation.pdf

 

 

Civil Law, Quadruple Entry System and the Presentation Format of

National Accounts

Kazusuke Tsujimura Masako Tsujimura

July 20, 2008 ver.4.1 September 11, 2007 ver.1.1

http://aries.sanken.keio.ac.jp/publication/KEO-dp/109/DP109.pdf

 

 

Foundations of Balance Sheet Economics

Kazusuke Tsujimura and Masako Tsujimura

2012

http://www.iariw.org/papers/2012/TsujimuraPaper.pdf

 

 

Asset-Liability-Matrix Analysis Derived from the Flow-of –Funds Accounts: the Bank of Japan’s Quantitative Monetary Policy Examined

 

Kazusuke Tsujimura

Masako Mizoshita

2004

http://www.iariw.org/papers/2004/ALM.pdf

 

 

Compilation and Application of Asset-Liability Matrices:

A Flow-of-Funds Analysis of the Japanese Economy 1954-1999

Kazusuke Tsujimura Masako Mizoshita

November 3, 2004 ver.1.1 October 15, 2004 ver.1.0

http://www.sanken.keio.ac.jp/publication/KEO-dp/93/fulltext.pdf

 

 

Tsujimura, Kazusuke, and Masako Mizoshita.

“Flow of Funds Analysis.”

(2002).

http://koara.lib.keio.ac.jp/xoonips/modules/xoonips/download.php/AA10715861-00000069-0001.pdf?file_id=9751

 

 

Does Monetary Policy Work under Zero-Interest Rate?

Kazusuke Tsujimura Masako Mizoshita

October 2003 ver.1.0 January 2004 ver.1.2

 

https://www.sanken.keio.ac.jp/publication/KEO-dp/87/fulltext.pdf

 

 

Tsujimura, Kazusuke, and Masako Mizoshita.

“How to Become a Big Player.”

(2003).

http://koara.lib.keio.ac.jp/xoonips/modules/xoonips/download.php/AA10715861-00000084-0001.pdf?file_id=9779

 

 

Tsujimura, Kazusuke, and Masako Mizoshita.

“European Financial Integration.”

(2002).

http://koara.lib.keio.ac.jp/xoonips/modules/xoonips/download.php/AA10715861-00000072-0001.pdf?file_id=9719

 

 

Mizoshita, Kazusuke Tsujimura Masako.

“Flow of Funds Analysis: BOJ Quantitative Monetary Policy Examined.”

(2001).

 

 

 

Measuring Global Flow of Funds and Integrating Real and Financial Accounts: Concepts, Data Sources and Approaches

Nan Zhang (Stanford University)

Paper Prepared for the IARIW-OECD Special Conference

2015

http://iariw.org/papers/2015/zhang.pdf

 

 

An Integrated Framework for Financial Positions and Flows on a From-Whom-to-Whom Basis: Concepts, Current Status, and Prospects1

Prepared by Manik Shrestha, Reimund Mink,2 and Segismundo Fassler

2012

 

https://www.imf.org/external/pubs/ft/wp/2012/wp1257.pdf

 

 

 

Global-Flow-of-Funds Analysis in a Theoretical Model -What Happened in China’s External Flow of Funds 

 

Nan Zhang

 

http://ns1.shudo-u.ac.jp/~zhang/08GFOF.pdf

 

 

Simultaneous-Equations Model for Global-Flow-Funds Analysis

Nan Zhang

https://www.bis.org/ifc/events/2011_dublin_48_01_zhang.pdf

 

 

Global Flow of Funds: Mapping Bilateral Geographic Flows

Authors1: Luca Errico, Richard Walton, Alicia Hierro, Hanan AbuShanab, Goran Amidzic

 

http://www.statistics.gov.hk/wsc/STS083-P1-S.pdf

 

 

 

The Composition of The Global Flow of Funds in East Asia

Nan Zhang Hiroshima Shudo University

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.565.4984&rep=rep1&type=pdf

 

 

 

What Happened in China’s External Flow of Funds?

-Global-Flow-of-Funds Analysis in a Theoretical Model

Nan Zhang

 

http://www.rcie-cn.org/conferences/2010/papers/zhang_nan.pdf

 

 

Quantitative Evaluation of Foreign Exchange Intervention and Sterilization in Japan ―A Flow-of-Funds Approach

 

Kazusuke Tsujimura

Masako Mizoshita

April 04, 2004 March 21, 2005

http://aries.sanken.keio.ac.jp/publication/KEO-dp/92/fulltext.pdf

 

 

 

Using the Balance Sheet Approach in Surveillance: Framework, Data Sources, and Data Availability
Johan Mathisen  Anthony J. Pellechio

April 2006

http://papers.ssrn.com/Sol3/papers.cfm?abstract_id=902754

 

 

A Balance Sheet Approach to Financial Crisis

Mark Allen, Christoph Rosenberg, Christian Keller, Brad Setser, and Nouriel Roubini

 

https://www.imf.org/external/pubs/ft/wp/2002/wp02210.pdf

 

 

A New Framework for Analyzing and Managing Macrofinancial Risks of an Economy

Dale F. Gray, Robert C. Merton and Zvi Bodie

September 25, 2006

http://www.nber.org/papers/w12637.pdf

 

 

Contingent Claims Approach to Measuring and Managing Sovereign Credit Risk

Dale F. Gray, Robert C. Merton and Zvi Bodie

July 3, 2007

 

http://www.people.hbs.edu/rmerton/contingentclaimsapproachfinal7-3-07.pdf

 

 

 

Hofer, Andrea.

“The International Monetary Fund’s Balance Sheet Approach to Financial Crisis Prevention and Resolution.”

 

 

USING THE BALANCE SHEET APPROACH IN FINANCIAL STABILITY SURVEILLANCE:
Analyzing the Israeli economy’s resilience to exchange rate risk

Yair Haim, Roee Levy

January 2007

http://www.boi.org.il/deptdata/stability/papers/dp0701e.pdf

 

 

THE BALANCE SHEET APPROACH TO FINANCIAL CRISES IN EMERGING MARKETS

Giovanni Cozzi and
Jan Toporowski

December 2006

http://www.levyinstitute.org/pubs/wp_485.pdf

 

 

Debt-Related Vulnerabilities and Financial Crises An Application of the Balance Sheet Approach to Emerging Market Countries

Christoph Rosenberg, Ioannis Halikias, Brett House, Christian Keller, Jens Nystedt, Alexander Pitt, and Brad Setser

2004

https://www.imf.org/external/np/pdr/bal/2004/eng/070104.pdf

 

 

The Balance Sheet Approach and the Public Debt Stock Analysis: the Case of Lebanon

Souaid, Sana

2011

https://www.bis.org/ifc/events/2011_dublin_111_05_souaid.pdf

 

 

 

Balance Sheet Analysis: A New Approach to Financial Stability

Surveillance

By Jean Christine A. Armas

2016

http://www.bsp.gov.ph/downloads/EcoNews/EN16-01.pdf

 

 

Balance-Sheets: A Financial/Liability Approach

A Concise Macro-Financial Framework: SNA Theory and Concepts Rapid Estimates of Market Valued Non-Financial Assets and National Wealth

Bo Bergman

http://iariw.org/papers/2015/bergman_paper.pdf

 

 

Macro Financial Balance Sheets. Alternative Approach. 1980 – 2011. Sweden

Bo Bergman

2012

http://www.iariw.org/papers/2012/Bergmanpaper.pdf

 

 

BALANCE SHEET ANALYSIS IN FUND SURVEILLANCE

IMF

June 2015

https://www.imf.org/external/np/pp/eng/2015/061215.pdf

 

 

BALANCE SHEET ANALYSIS IN FUND SURVEILLANCE

REFERENCE NOTE

IMF

July 2015

https://www.imf.org/external/np/pp/eng/2015/071315.pdf

 

 

Sectoral interlinkages in balance sheet approach

28-29 August 2012

Ryoichi Okuma

https://www.bis.org/ifc/events/6ifcconf/okuma.pdf

 

 

Growing fragilities? Balance sheets in The Great Moderation

Richard Barwell and Oliver Burrows

2011

http://www.bankofengland.co.uk/financialstability/Documents/fpc/fspapers/fs_paper10.pdf

 

 

Balance Sheets. A financial approach

Bo Bergman

2010

http://www.iariw.org/papers/2010/poster1Bergman.pdf

 

 

A Closer Look at Sectoral Financial Linkages in Brazil I: Corporations’ Financial Statements

Prepared by Izabela Karpowicz, Fabian Lipinsky and Jongho Park

March 2016

https://www.imf.org/external/pubs/ft/wp/2016/wp1645.pdf

 

 

2014 TRIENNIAL SURVEILLANCE REVIEW—OVERVIEW PAPER

IMF

http://www.imf.org/external/np/pp/eng/2014/073014.pdf

 

 

The IMF’s ‘Surveillance’: How Has It Changed since the Global Financial Crisis?

Emily Poole

2015

http://www.rba.gov.au/publications/bulletin/2015/mar/pdf/bu-0315-9.pdf

 

 

 

Mapping the Shadow Banking System through a Global Flow of Funds Analysis

 

Hanan AbuShanab Goran Amidzic Luca Errico Artak Harutyunyan Yevgeniya Korniyenko Elena Loukoianova Hyun Song Shin Richard Walton

 

First IMF Statistical Forum Washington DC, November 12-13, 2013

 

https://www.imf.org/external/np/seminars/eng/2013/sta/forum/pdf/Hyun-Song-Shin2.pdf

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