The Hindu Business Line : On how balance-sheets weather global financial storms

THE Bank for International Settlements "fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability," informs www.bis.org. The site is a must-check for accountants, because it contains useful material in the field of finance. Take, for instance, a recent posting, the speech of the RBI Governor, Dr Y. V. Reddy, on Implications of global financial imbalances for the emerging market economies (EMEs).

Not all EMEs are alike, explains Reddy. There are the ones with large current account surpluses, as for example, China, the Russian Federation, South Korea, Venezuela, Malaysia, Taiwan and Brazil. Running current account deficits are Turkey, Hungary, South Africa, Mexico, and the Czech Republic, apart from India.

EMEs' current account balances "range from a deficit of $20 billion to a surplus of $69 billion"; and savings rates "range from nine per cent to 43 per cent of the GDP".

Russia is an EME with fiscal surplus; the opposite is true for Turkey, India, the Philippines, Argentina and so on. "While some of the EMEs such as India are largely domestic-demand driven, some others EMEs, particularly in the East Asia (Malaysia and the Philippines) are largely dependent on exports to sustain their growth, and their exports of goods and services range from 15 per cent to over 120 per cent of GDP... While some of the EMEs are net oil exporters, some others are net oil importers," elucidates Reddy, painting the big picture.

But first, why is it necessary to understand global developments in the world financial markets? Because they have `the most direct and serious impact on the financing conditions' in EMEs such as India. How? "An abrupt and sharp adjustment of the currencies may potentially lead to a significant portfolio rebalancing by the foreign investors, which could cause sharp changes in the long-term yields. This, in turn, could result in volatility in the level and cost of capital flows," says Reddy, in his inimitable and simple style.

The India that he presents is a bundle of about a dozen positives, such as: Improved investment climate, buoyant exports as the driver of demand, commitment to fiscal consolidation, decline in trend inflation, success in managing liquidity despite continuing capital flows, preferred destination for foreign investors, receipt of more than a quarter of the global portfolio flows to EMEs in 2004, forex reserves in excess of total outstanding external debt, improvement in corporate performance, deepening and widening of financial markets, robust institutional framework, healthier indicators of banking soundness, and the adopting of `international benchmarks for financial standards and best practice with suitable adaptations for Indian conditions'.

The core of Reddy's speech studies the impact of global financial imbalances on the government, RBI's balance-sheet, corporates, banking and the real sector. The Government could be affected "indirectly through the spill-over impact of external developments on domestic interest rates," he explains, because our fiscal deficit isn't financed out of resources raised from international capital markets. Monetary 101 that he imparts is that when domestic interest rates rise, cost of government borrowing goes up. However, "Since most of the outstanding debt is at fixed rates and not on floating rates, the rise in the borrowing cost will be incremental."

How is the RBI's balance-sheet impacted? Through the change in forex rates. "Volatility in the foreign exchange market exposes foreign exchange reserves to both operational and market risks," points out Reddy. "Depreciation in the value of any reserve currency vis-à-vis the domestic currency would result in an equivalent decline in the value of the reserves held, though the impact may be mitigated to some extent through appreciation of other currencies in which foreign exchange reserves are held." A redeeming feature is that the RBI follows `conservative accounting norms', so that "valuation gains/losses on foreign exchange reserves and gold are not taken to the profit and loss account, but instead, booked under a separate reserve head".

What about the companies that raise resources in the international capital markets? They will face the impact of `deterioration in global financial market conditions'. The fixed interest rate borrowing doesn't pose as much worry as the variable interest loans. And the RBI isn't unaware of this. Which is why it advises banks to monitor "the unhedged position of the corporates"; the RBI too exhorts companies to hedge their forex exposures. Thus, India's corporates could be affected "only to the extent they are not hedged either by foreign-currency cash flows in the normal course of business or through recourse to appropriate hedging products," assures Reddy. Valuable read.

A model of uncertainty

ANOTHER find from BIS is Money in an uncertain world, a dinner speech by Dr Hermann Remsperger, Member of the Executive Board of the Deutsche Bundesbank. Central bankers need models to structure their thoughts and to estimate the impact of their decisions, says Remsperger. But there is a problem? "There is no consensus about which model is the appropriate representation of the real world." So? Most central banks use a wide range of models, he explains.

Data are uncertain too, especially when they are about economic aggregates such as gross domestic product, which cannot be measured precisely and are therefore subject to revisions after they have been published for the first time, notes Remsperger. "Measurement problems become even more severe if certain model variables are unobservable as such," he adds, citing as examples `the output gap and the natural rate of interest'.

With such variables there is another severe problem! "The theoretical construct has to be translated into a statistical concept," says Remsperger. "And that is exactly the point where the problems of data and model uncertainty are closely connected: An empirical quantification of the output gap, for instance, is often based on more or less detailed assumptions about an underlying model structure." A heady dinner speech!

Positive note despite negative image

THE 3-page speech of Mr Ishrat Husain, Governor of the State Bank of Pakistan, at the Indian Business School, Hyderabad, focuses on `structural reforms' in his country. In the final paragraph of his speech, Husain discusses the `many difficult challenges' that Pakistan faces. These include the typical developing country problems such as one-third of the population still living below the poverty line, almost one in two being illiterate, high rates of infant and maternal mortality, limited access to quality education and healthcare, inequalities of income, high unemployment, infrastructure shortages and skill shortfall.

"Most worrying to me is that Pakistan's image abroad is quite negative," rues Husain. "Foreigners are reluctant to visit Pakistan as they perceive the country to be a dangerous place. The worldwide preoccupation with the large economies of China and India and the ever-increasing quest to enter these markets is also working to the disadvantage of countries such as Pakistan," he says.

Yet he is not diffident. "The lesson we have learned is that there is no point in complaining and whining about this but to get on with the job, to work even harder, to overcome these deficiencies and constraints and to hope for the best," he concludes, on a hopeful note.

Three-in-one workshop

AMONG the latest postings on the BIS site are papers presented at a workshop held in Basel between November 11 and 12, 2005, on `Accounting, risk management and prudential regulation'. M. D. Knight, BIS General Manager, mentioned in his opening remarks that the workshop focussed on a topic that lies at the intersection of three areas that do not always interact closely, despite the fact that they have quite a lot in common: `Financial reporting, risk management theory and practice, and prudential regulation of financial firms.'

All three areas are fundamentally concerned with fostering decision-making processes that, ultimately, support the efficient functioning of the financial system and its stability, he pointed out. "And all three have experienced the declining economic significance of national borders and have focused increasingly on developing best practices and norms with international applicability."

Knight was unhappy that except among specialists, accounting questions have not received the attention they deserve in economic discussions. "In particular, they have often been overlooked in discussions of the various elements that play a role in financial stability. This neglect can partly be blamed on today's very high degree of specialisation in individual academic and professional disciplines — a situation which can become a barrier to understanding the profound interrelationships among problems in the real world," he observed.

Financial reporting standards need to strike a balance between meaningfulness and verifiability of valuations, he insisted. The daunting task for standards, according to Knight, is to work against the incentives of `insiders' to misreport, and at the same time enhance the ability of all `outsiders' to discriminate between honest differences in opinion and intentional deception.

The workshop begins with Mary E. Barth's paper on Including Estimates of the Future in Today's Financial Statements. She explains why the question is how to incorporate estimates of the future in today's financial statements, not if! W.P. McCrossan of the International Actuarial Association presents a case for considering `a framework change towards behavioural economics'. Wayne R. Landsman's paper identifies issues that bank regulators need to consider if they are to use fair value accounting for determining bank regulatory capital and when making regulatory decisions.

"Cross-country institutional differences are likely to play an important role in determining the effectiveness of using mark-to-market accounting for financial reporting and bank regulation," Landsman concludes. The application of fair value accounting to financial instruments presents a huge opportunity to advance the quality of financial reporting by financial institutions, though the measurement problems are formidable, argues Ken Peasnell in a paper titled, Institution-specific Value. `Do accounting changes affect the economic behaviour of financial firms?' asks Anne Beatty, and Claudio Borio discusses `Risk in financial reporting: status, challenges and suggested directions.'

A `three-in-one' workshop, for continuing education.

AccountSpeak@TheHindu.co.in

D. Murali

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