Balance Sheet Approach to crisis identification/prevention

A team of economists developed an excellent way to analyse and understand economic crisis in emerging economies. It is popularly called as the balance sheet approach

The paper lays out an analytical framework for understanding crises in emerging markets based on examination of stock variables 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.

I am re-reading the paper for more insights.

I came across an excellent paper (which is also much shorter) from Atish Ghosh of IMF that helps understand the approach with some excellent examples. (The paper was presented in this IMF conference. (I covered a paper presented in this conference on Korean 1997-98 crisis; this paper also pointed to mismatches in Korean balance sheet).

It points that causes of emerging market crisis are different:

The financial crises that struck a number of emerging market countries in the 1990s and early twenty-first century were characterized by sudden reversals of capital flows that had pervasive macroeconomic consequences, including abrupt current account adjustment and collapsing real exchange rates and economic activity (Figure 1). But while the consequences of these crises were broadly similar, their causes  appear to be bewilderingly different. Turkey (1993), Mexico (1994), and Russia (1998) were public sector funding crises. By contrast, the 1997 East Asian crises were mainly private sector phenomena. In Brazil (1998-99), Turkey (2000-01) and Argentina (2002) public sector debt dynamics played a key role—in the latter two cases, accompanied by a banking crisis. On the other hand, Uruguay (2002) was a banking crisis—caused by withdrawals of Argentine deposits—that spilled into a public sector debt problem and a balance of payments crisis.

Interesting. It also says economies can live with mismatches for quite a few years and what is needed is a crisis trigger which could really be anything:

Much like a bomb that requires both an explosive material and a detonator to cause an explosion, neither the balance sheet weakness nor the crisis trigger on its own is likely to cause (as much) mischief. Thus an economy can live with currency and maturity mismatches in private or public sectoral balance sheets for years if, serendipitously, nothing triggers a crisis. Yet there are many possible crisis triggers, both external—contagion, a terms of trade shock, a deterioration in market conditions—and domestic, such as an inconsistent macroeconomic policy stance (see Table 1 for a summary of vulnerabilities and crisis triggers in selected emerging market countries).

Table 1 is quite interesting as it summarises causes and triggers for each of the crisis. 

Further, the paper presents balance sheet approach for three crisis- Thailand (1997), Argentina (2001) and Turkey (2000-01). In each of the crisis we understand though overall picture might look favorable, when we disaggregate the country’s balance sheet into say government, banks and non-banks we get some idea of the risks (mismatches to be precise).  Each one is an excellent case study and a must read.  

I think it will be very useful to do this analysis in each of the economies (atleast main ones) to identify what went wrong in this crisis.

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8 Responses to “Balance Sheet Approach to crisis identification/prevention”

  1. Tirath Says:

    This paper was written in 2006 – and something very minutely scribbled is FX off-balance sheet exposure through derivatives. It is just noteworthy, how much focus is on derivative exposure now.
    Also, I wonder how many countries would be added to the list as a result of the present crisis.
    Another thought – what sort of a FX related crisis would a USA face => Too much cash pouring back into the country if assets are liquidated. Hope there is something you can enlighten me / us with Amol.

    • Amol Agrawal Says:

      As of now one can use this approach to analyse problems of large number of economies. I had written a paper where I tried to show how crisis imapcted various economies. http://amol.agr.googlepages.com/HowtheUSoriginatedcrisisimpactedothe.pdf

      The paper was largely qualitative and this BS approach can be used to quantify it. I am sure the econs that are in trouble (apart from US) have much more problems than they admit. As crisis hit, all said in unison that it would not hurt us as we are safe etc. THis is all false now.

      USD case is special. USD is still the defacto currency for the world and would not really face a USD crisis. Infact, it has appreciated against most currencies despite such large crisis in US. US is still the safest bet in this global crisis and as a result would not face a USD crisis. Yeah. if it had not been a global crisis, then it would have been interesting.

      However, you never know. Anything can happen in this crisis. I may be completely wrong.

  2. Tirath Says:

    Will read your paper for sure –
    reg. the US case; thanks for adding the last 2 lines!

  3. Balance Sheet Debt | Finance Blogg Says:

    [...] Balance Sheet Approach to crisis identification/prevention … [...]

  4. Tirath Says:

    Thanks for the report – was a good read.

  5. A Balance Sheet crisis in India?? « Mostly Economics Says:

    [...] paper is written by Nouriel Roubini and Richard Hemming. Roubini along with other economists pioneered balance sheet approach (see this paper as well)  to understanding crisis in emerging economies (though the most imp [...]

  6. What lessons did IMF learn from South East Asian crisis? « Mostly Economics Says:

    [...] balance sheets as loans were mostly in dollars. IMF has now developed a very important tool – balance sheet approach (see India case study as well), which helps it assess the currency and maturity mismatches of the [...]

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