In almost every country, the institutions that manage the assets of a sovereign are different than the bodies that oversee the liabilities, often with mandates to optimize their specific deliverables. But the sound macroeconomic management requires many entities with different mandates to coordinate seamlessly, to deliver economic growth and to provide resiliency against economic shocks. Having a holistic view of the sovereign balance sheet paints a complete picture for analyzing and managing the potential risks and opportunities for the government.
What is sovereign asset and liability management approach?
Sovereign asset and liability management is the process of managing the use of assets and cash flows to meet the government’s financial obligations at the lowest possible cost with a prudent level of risk. This approach requires analyzing the mismatches in currency and interest rate composition, for natural hedges and duration of the cash flows, and over time, choosing the assets and liabilities with matching characteristics and/or employing financial derivatives to enable sovereigns to more effectively manage their risk to achieve identified, desired risk levels.
What should be in a sovereign's balance sheet?
Assets and liabilities in a sovereign’s balance sheet, very much depend on the country context. Among the assets, governments may account for stocks such as cash reserves (domestic and international), sovereign wealth funds, equity in state-owned enterprises and subnational entities as well as other fixed financial assets. They may account for inflows such as tax revenues and non-tax revenues, onlending flows, receivables, even the present value of future income. Among the liabilities, they may include sovereign debt, government expenditures, pensions, government guarantees, legal claims, deposits in commercial banks, currency in circulation and other commitments. There is no cookie cutter approach to look at a sovereign's balance sheet and managing the associated risks.
What are sovereign balance sheet risks?
Balance sheet vulnerabilities stem from mismatches between the financial characteristics of assets and liabilities. The most often experienced mismatches are currency composition, interest rate basis and duration between assets held by the government and its liabilities. Mismatches in the inflows and outflows are particularly significant and can lead to a higher probability of financial crisis.
Foreign currency mismatches have resulted in financial crises in numerous countries, including Mexico in 1994, Brazil in 1999, Russia in 1998, and Argentina in 1998-2002. Following the global financial crisis, sovereign balance sheets became more complicated; constraints in external markets, issuance of short-term debt and increase of foreign reserves have all contributed to sovereigns carrying higher risks.
How to manage sovereign balance sheet risks?
After analyzing the mismatches between assets and liabilities, the financial characteristics of the current and future cash flows can be hedged, using financial derivatives to help smooth the budgetary impact of shocks on debt servicing costs, while ensuring return optimization.