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Sovereign Asset and Liability Management: An E-Learning Training Course
I. Balance Sheet Risks
I.i. Currency Matching
I.ii. Interest Rate Matching
I.iii. Maturity Matching
I.iv.Derivatives
II. Methodologies
II.i. Initial Methodologies
II.ii. Advanced Methodologies
Conclusion
Bibliography
Glossary
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Balance Sheet Risks

“As the SALM objectives are frequently specified based on a narrow set of the balance sheet items, the risk management considerations from an asset management perspective naturally involve minimizing liquidity and credit risk and, in some cases, interest rate risk.  From a liability management perspective, considerations for minimizing interest rate risk, refinancing risk, and currency risk prevail among debt managers” (Das et al., 2012). 

“Government balance sheet policies differ between countries, reflecting different market conditions and possibly suggesting differences in assessment of policy trade-offs and conflicts.  In addition to the above trade-offs, a number of issues continue to shape balance sheet management:

  • The composition of government liabilities and assets can be adjusted to hedge against fluctuations in overall government revenues and spending in response to business cycles, which might help alleviate the need for discretionary adjustments in fiscal policy (e.g. in tax rates) and minimize the associated negative effects on long-term growth.

  • Liquid government bond markets aid in the pricing of private sector credit and derivatives and in providing liquidity buffers, regulatory capital and hedging assets to financial institutions.

  • Financial reserves might be built for purposes such as prefunding future temporary spending or transferring wealth to future generations.  However, there is a risk that funds will be used for current spending or tax reductions” (Rawdanowicz et al., 2011).

"Financial and non-financial assets impact, together with liabilities, on the costs, yields and risks of the public sector balance sheet... For example assetyields might be correlated with the business cycle and fall pro-cyclically along with tax receipts, and asset prices might fall in the presence of adverse economic shocks” (Rawdanowicz et al., 2011).  This demonstrates the need for each country to develop a risk management framework that accounts for the factors of its specific economy. 

“Typically, emerging market sovereigns face increased market exposure of their asset and debt portfolios, especially as they expand access to domestic and international capital markets.  Many frontier market sovereigns are exposed to risks arising from terms-of-trade shocks and changes in debt refinancing terms, and tend to be more vulnerable to exogenous shocks than other countries” (Das et al., 2012).  Commodity rich developing nations have additional issues related to fiscal stability and the investment of revenues from finite resources.  How to allocate capital in a manner that will maximize the long-term return on investment must be determined.  Challenges to budget stability are constant as commodity prices are susceptible to boom and bust periods.  Additionally, commodity prices change daily making balance sheet management ongoing and in need of constant attention.  In periods of high commodity prices, commodity rich developing nations must resist the urge to use windfall profits to finance unsustainable social programs.  Commodity rich developing nations must also confront issues of Dutch Disease, accurately estimating commodity revenues, appropriate reserve management, and developing a framework for equitable wealth transfer prior to the resource(s) being depleted.  Overestimating commodity prices and consequent revenues is far more damaging than underestimating these revenues (Leigh and Olters, 2006).  As such, reliable commodity pricing and budgeting practices are of paramount importance. 

One of the primary threats to developing nations is depreciation of the exchange rate in which assets are likely to be denominated in local currency and liabilities held in foreign currency.  This is due to a lack of a developed domestic capital market to finance long-term debt.  In commodity exporting nations, it may be prudent to pursue policies that hedge debt service to the price of the primary commodity.  This will prevent the debt (liabilities) from increasing as commodity (asset) prices fall.  This employs the same principle as currency matching assets and liabilities.  As many developed countries do not hold any foreign currency debt or a negligible amount, currency matching is not an issue.  The primary threat to developed countries will likely be off balance sheet items related to CL and structural problems with pensions, retirement systems, and healthcare costs due to aging populations that could result in these programs becoming insolvent.

For more, see the International Monetary Fund’s “Guiding Principles for Managing Sovereign Risk and High Levels of Public Debt”.

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