ANALYZING FINANCIAL DEVELOPMENTS IN LDCS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP85T01058R000304120001-6
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 15
• Document Creation Date: December 22, 2016
• Document Release Date: November 13, 2009
• Sequence Number: 1
• Publication Date: March 12, 1985
• Content Type: MEMO

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w,^ t
12 '.S65`
Chief, Economics Division
SUBJECT Analyzing Financial Developments in LDCs
Attached is a primer done by two of our' analysts describing
an alternative methodology for analyzing financial developments
in debt-troubled LDCs. The methodology may be especially useful
to analysts newly assigned to LDC accounts. If you have any
questions or comments on the material, contact
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Attachment:
Analyzing Financial Developments in LDCs: 25X1
Mnnptnry Data as Early Warnin Si ns
GI M 85-1007 March 1985, 25X1
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%-,un 1 Linn 1 I t1L
SUBJECT: Analyzing Financial Developments in LDCs
OGI/ECD/FI
Robert H. Knickmeyer, State
Lauralee Peters, State
Gerald Lamberty, State
Ralph Lindstrom, State
David Konkel, State
Thomas Forbord, State
Peter Lande, State
Douglas Mulholland, Treasury
Byron Jackson, Commerce
SA/DDCI
- Executive Director
- DDI
- DDI/PES
- NIO Economics
CPAS / I SS
ALA/AF
ALA/MCD
ALA /SAD
OEA/CH
OEA/NA
OEA/SE
NESA/Al
NESA/PG
NESA/SO
EURA/EE
EURA/WE
EURA/EI
D/OGI, DD/OGI
OGI/PG/CH
OGI /PS
OGI/EXS/PG
OGI/ECD
OGI/ECD/FI
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Central Intelligence Agency
Analyzing Financial Developments in LDCs:
Monetary Data as Early Warning Signs
Summary
Since late 1982, the international financial conmunity has
had access to a substantial amount of financial data on countries
undertaking IMF programs, but financial information on other
LDCs, especially up-to-date balance of payments and fiscal
deficit data, is more limited. Central bank data, however,
including those showing trends in the monetary base and net
domestic and foreign assets of the central banks, are more
readily obtainable and can be used as early warnings of changes
in domestic and external financial conditions and as evidence of
policy behavior in financially troubled countries. In
particular, rapid increases in the monetary base can indicate
that a central bank is following an expansionary monetary policy,
while significant changes in net domestic and foreign asset
positions suggest that the country may be running large fiscal
and balance of payments deficits.
According to the indicators, Colombia's domestic and
external financial condition is deteriorating rapidly and, in the
absence of strong adjustment measures, probably will soon lead to
a rapid increase in inflation and a foreign exchange crisis. The
indicators also suggest that the deterioration in Algeria, India,
and Pakistan may warrant closer attention, particularly if trends
This memorandum was prepared byl
Office of Global Issues. Conments and queries
are welcome and may be directed to the Chief, Financial Issues
Branch, Office of Global Issues
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worsen. Some countries, however, are showing substantial
improvement in their financial conditions, in particular
Indonesia. The data do not indicate either a large deterioration
or significant improvement in the external and internal financial
conditions of Bangladesh, Egypt, Malaysia, South Korea, or
Thailand, although Egypt shows a consistent slow deterioration.
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Analyzing Financial Developments in LDCs_
Monetary Data as Early Warning Signs
Methodology
Data on central banks--contained in the International
Financial Statistics (IFS), a monthly publication of the IMF--can
be arranged into the monetary base, net domestic assets, and net
foreign assets. Changes in these categories can then serve as an
indication of developments in domestic and external economic
performance, especially for countries suspected of having
potential balance-of-payments problems. For example:
o a rapid increase in net domestic assets indicates the
central bank is heavily financing government deficits;
o rapid declines in net foreign assets may indicate a
balance-of-payments deficit;
o rapid rises in the monetary base suggests the central
bank is running an expansionary domestic policy that
will lead to a rapid increase in the money stocks and,
eventually, inflation.
On the other hand, a rise in net foreign assets and stability in
the monetary base and net domestic assets indicates a relatively
strong position such as would occur with a current account
surplus and low deficits.
Findings
We used the methodology to examine Algeria, Bangladesh,
Colombia, Egypt, India, Indonesia, Malaysia, Pakistan, Thailand,
and Venezuela, countries that do not have an IMF program but who
are potentially troubled debtors; in addition, South Korea was
included.
Financially Deteriorating Countries
According to the methodology, Colombia has experienced the
most serious deterioration of the 11 countries. Starting in
early 1983 net foreign assets of the central bank declined
rapidly while net domestic assets increased. The monetary base
also rose but at a less rapid rate. This information implies
that the Colombian government has been running a large fiscal
deficit that is being heavily financed by the central bank. The
* A fuller discussion of the methodology can be found in attached
appendix.
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data also indicate that the central bank was intervening heavily
in the foreign exchange market to reduce the inflationary growth
of the monetary base. If the central bank eventually exhausts
its foreign exchange reserves--and these declined sharply in
1984--any additional deficit financing by the central bank would
lead to a rapid increase in the monetary base, a subsequent rise
in the inflation rate, and a likely balance-of-payments crisis.
The data on India and Pakistan indicate that both countries
experienced a deterioration during late 1981 through the third
quarter of 1982. The deterioration in India then slowed until
the third quarter of 1983, while Pakistan's external and domestic
financial situation improved until fourth quarter 1983.
According to the indicators, however, financial deterioration in
both countries resumed in 1984.
The information on Algeria indicates that starting in mid-
1982 the government's budget deficit was heavily financed by the
central hank, causing the monetary base to grow rapidly. At the
same time, the central bank intervened in the foreign exchange
market through purchases of its own currency. The data indicate,
however, that Algeria undertook some adjustment measures in late
1983 which helped alleviate the necessity of central bank
purchases of government debt.
Financially Improving Countries
According to the indicators, Indonesia and Venezuela have
demonstrated substantial improvement in their domestic and
external finances over the past few years. Indonesia's
improvement was the most spectacular. Starting in early 1983
Indonesia implemented adjustment measures, including devaluing
its currency, reducing the public sector deficit, and enacting
more market oriented policies. These measures led to a rapid
inflow of foreign exchange. The central bank largely neutralized
the inflationary impact of central bank purchases of foreign
exchange through sales of government debt.
The data on Venezuela indicate an improvement in domestic
and external finances following some deterioration. During 1983
the government devalued the currency and substantially reduced
the public sector deficit which led to an inflow of foreign
exchange sufficient to alleviate the need for central bank
financing of the public sector deficit.
Other Country Situations
The economic indicators for Bangladesh, Egypt, Malaysia,
South Korea, and Thailand did not indicate any strong trend of
deterioration or improvement. The data on Bangladesh show that
the government was heavily financing its fiscal deficit through
the central bank during 1981 and early 1982; however, the
deterioration was halted in mid-1982. The monetary base and net
domestic assets of the central bank have been growing at a rapid
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rate in Egypt over the past three years, but net foreign assets
of the central bank have been fairly stable. The data on South
Korea and Thailand have fluctuated greatly over the past three
years, but no long-term trend is discernible. Conversely, the
indicators on Malaysia have fluctuated little.
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ALGERIA
COLOMBIA
r,
-100
P ,4 ,q
BANGLADESH
30 1 BILLIONS OF TAKA
101
EGYPT
V
7-
\g0, \\ \\\ \v14eti \\ \\\ \4 t D \\ \\\ \~ e- \\
110!!E'p1RY ~A3E
IET 001E3T1C ASSET!
~ FORtIGN A33[TS
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INDIA
MALAYSIA
10-
8
~
/
INDONESIA
-4000 -F=~r-~~-~
PAKISTAN
-20
,P ,roe ~
roNCn rf "m
r+cr T%Ro AAs
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/v
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SOUTH KOREA
THAILAND
60
.~
40-
\
20 /
\. ~~
`~.
VENEZUELA
40 - ,
~LV ~1 I I-~ 11TT-~ ~T7 r ~
MONELIRY SASE
NET DONESi1C ASSETS
NET FOPE70N ASSETS
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Methodology for Determining Domestic
and External Financial Developments
Economists responsible for analyzing financial developments
in developing countries examine closely changes in the level of
public sector deficits, money stocks, and developments in the
balance of payments. Often, however, public sector deficits and
balance of payments data appear only after a considerable lag and
monetary aggregates are distorted. The data on central banks in
the International Financial Statistics (IFS), a monthly
publication of the IMF, can serve as a more timely indicator of
the direction of fiscal and monetary policies and of the foreign
exchange operations of the central bank.
The IFS data on central banks can be arranged into three
categories under a balance sheet (see Figure A). Changes in
these categories can serve as an indicator of developments in
domestic and external economic policies. For example, if a
government decided to increase its public sector deficit without
immediately raising interest rates, it could sell its debt to the
central bank. This causes a rise in central bank loans on the
asset side and a rise in both deposits of banks and currency
outside banks on the liability side as the government disburses
its loan. These measures lead to an increase in domestic demand
including increased expenditures on foreign goods, services, and
securities. The net result is an increase in domestic inflation
and downward pressure on the exchange rate.
If the government decided to reduce the inflationary
pressures and prevent an exchange rate depreciation, the central
bank could purchase its own currency in the foreign exchange
market with its foreign assets or with foreign borrowings. This
would cause a reduction in the monetary base. The net result is
that the monetary base has changed little or none, while net
foreign assets have declined and net domestic assets have
increased. A government could continue the policy of running
large public sector deficits and indirectly financing them with
foreign exchange to suppress inflation and support the exchange
rate as long as the central bank possessed or was able to get
access to foreign exchange. Once the central bank exhausts its
foreign exchange holdings, government deficits financed by the
central bank would lead to a rise in domestic inflation and a
decline in the exchange rate.
For countries with potential balance-of-payments problems,
three scenarios with respect to changes in a central banks
balance sheet can serve as warnings:
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Wl~ 17 1 LF, 1'1 1 I t1L
Figure A
Central Bank
Balance Sheet
Assets Liabilities
Net foreign assets
Foreign Assets
Foreign liabilities
Net domestic assets
= Loans to government
+ Other loans
- Deposits of government
- Other deposits
- Capital and reserves
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Monetary base
= Currency outside banks
+ Deposits of banks
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o A rise in net domestic assets, a fall in net foreign
assets and little change in the monetary base would
indicate that the central bank is financing the public
sector deficit and is sterilizing the monetary effects
by intervention in the foreign exchange market.
o A rise in net domestic assets, a fall in net foreign
assets, and a rise in the monetary base would indicate
that the central bank is financing the public sector
deficit but is only partially offsetting the monetary
effect through intervention in the foreign exchange
market.
o A rise in net domestic assets, a rise in the monetary
base, and no change in net foreign assets following a
fall to a low level would indicate that the central bank
is financing the public sector deficit and is unable to
offset the monetary effect because the country has
exha t d
U0 a its foreign reserves.
Conversely, for a country that is undertaking adjustments
after experiencing or coming close to a balance-of-payments
crisis, three scenarios with respect to changes in the central
bank balance sheet can give an indication of its progress:
o A fall in net domestic assets, a fall in monetary base
and little or no change in net foreign assets would
indicate that adjustment policies are reducing the need
for the central bank to purchase its own currency in the
foreign exchange market.
o A fall in net domestic assets, a rise in the monetary
base, and a rise in net foreign assets would indicate
that adjustment policies are resulting in an overall
balance-of-payments surplus and that the central bank is
purchasing foreign exchange with its own currency.
o A fall is net domestic assets, a fall in the monetary
base, and a rise in net foreign assets would indicate
that adjustment policies are producing an overall
balance-of-payments surplus and the monetary effects of
central bank purchases of foreign exchange are more than
offset by centr l b
a
ank sales of government debt.
Mexico: A Test of the Methodology
To examine how the methodology performs, Mexico is used as a
test case (see Figure B). By early 1982, the central bank had
virtually exhausted its foreign exchange reserves and was having
difficulty borrowing. As a result, additional deficit financing
by the central bank lead to a rapid increase in both net domestic
assets and the monetary base. After adopting adjustment measures
in late 1982, including a substantial reduction in the public
sector deficit, the growth of net domestic assets delined
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FIGURE B
MEXICO*
NET FOREIGN ASSETS
1981 N NI IV 19x2 b Ii IV 1983 p 111 IV 1984 N
'LATEST NAII.ABLE DATA NOV 1984
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substantially. The lower public sector deficits along with
depreciation of the peso caused a substantial increase in net
foreign assets. The Mexican central bank, however, has not
neutralized the rapid increase in net foreign assets which is
causing the monetary base to still grow at an inflationary
rate.
Limitations to the Methodology
Financial analysts using this methodology need to be wary
about forming conclusions based only on these data. Other
information, such as the competitive value of the exchange rate
and major changes in foreign exchange and credit restrictions may
distort the indicators. Another drawback is that a few countries
submit their ral bank data only after a considerable lag.
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