Quasi-Fiscal Operations of Public Financial Institutions · 2020. 4. 1. · Price: US$15.00 (US$12.00 to full-time faculty members and ... these "quasi-fiscal" operations or activities

OCCASIONAL PAPER 142

Quasi-Fiscal Operationsof Public Financial Institutions

G. A. Mackenzie and Peter Stella

INTERNATIONAL MONETARY FUNDWashington DC

October 1996

©International Monetary Fund. Not for Redistribution

© 1996 International Monetary Fund

Library of Congress Cataloging-in-Publication Data

Mackenzie, G.A. (George A.), 1950-Quasi-fiscal operations of public financial institutions / G.A. Macken-

zie and Peter Stella.p. cm. — (Occasional paper ; 142)

Includes bibliographic references.ISBN 1-55775-583-31. Budget deficits. 2. Fiscal policy. 3. Banks and banking, Central.

4. Government financial institutions. I. Stella, Peter, 1957- .II. International Monetary Fund. III. Title. IV. Series: Occasionalpaper (International Monetary Fund) ; no. 142.HJ2005.M217 1996 96-36350339.5'23—DC20 CIP

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Contents

Page

Glossary v

Preface vii

I Overview I

Basic Features of QFAs 1Policy Toward QFAs 2

II Basic Issues 3

Why QFAs Are a Matter of Concern 3General Issues 4

Institutional and Regulatory Sources of QFAs 4Motives and Rationale for QFAs 5Problems of Quantification 5

III Varieties and Economic Effects of Quasi-Fiscal Activities 7

QFAs Associated with the Exchange System 7MER Practices 7Exchange Rate Guarantees and Assumption of Exchange Rate Risk 8

QFAs Associated with the Financial System 9Subsidized Lending 9Reserve Requirements and Credit Ceilings 10Rescue Operations 11

Sterilization Operations 12

IV Implications for Policy 14

Traditional Approaches 14More Sophisticated Approaches 14Structural Reform 15

Appendices

I Measurement and Accounting Issues 17

Definitional Issues 17Problems Resulting from the Use of Cash Versus Accrual Accounting 18Particular Problems Resulting from Foreign Exchange Transactions

and MER Systems 19Reserve Requirements 20Contingent Liabilities 22Inflation Adjustment 22

iii


CONTENTS

II Varieties of Country Experience 24

MER Practices 24Exchange Rate Guarantees and Assumption of Exchange Rate Risk 25Subsidized Lending 26Selective Reserve Requirements and Credit Ceilings 26Rescue Operations 27

III Five Country Case Studies 28

Uruguay 28Jamaica 28Ghana 30Poland 31Romania 32

References 35

BoxesSection

IV 1. Calculating the Value of Quasi-Fiscal Activities: Two Examples 152. The Treatment of Quasi-Fiscal Activity in a Common Currency Area 16

TablesSection

II 1. A Schematic Typology of Quasi-Fiscal Activities 4

Appendix

I 2. Impact of an MER System on the Central Bank's Balance Sheet:With No Change in Reserves 20

3. Impact of an MER System on the Central Bank's Balance Sheet:With Change in Reserves 21

III 4. Uruguay: Operating Losses of the Public Financial Sector 295. Jamaica: Operating Balance of the Bank of Jamaica 306. Ghana: Quasi-Fiscal Operations of the Bank of Ghana 317. Poland: Transfer of Profits by PFIs to the State Budget 32

The following symbols have been used throughout this paper:

. . . to indicate that data are not available;

— to indicate that the figure is zero or less than half the final digit shown, or that the itemdoes not exist;

- between years or months (for example, 1991-92 or January-June) to indicate the yearsor months covered, including the beginning and ending years or months;

/ between years (for example, 1991/92) to indicate a crop or fiscal (financial) year.

"Billion" means a thousand million.

Minor discrepancies between constituent figures and totals are due to rounding.

The term "country," as used in this paper, does not in all cases refer to a territorial entity thatis a state as understood by international law and practice; the term also covers some territor-ial entities that are not states, but for which statistical data are maintained and provided in-ternationally on a separate and independent basis.

iv


Glossary

CD Certificate of depositECCU East Caribbean Currency UnionECU European currency unitFIFO First in, first out (inventory accounting term)LCU Local currency unitLIBOR London interbank offered rateMER Multiple exchange rateNBP National Bank of PolandNBR National Bank of RomaniaNBY National Bank of [former] YugoslaviaNFA Net foreign assetsNFPE Nonfinancial public sector enterpriseNFPS Nonfinancial public sectorOIN Other items netPFI Public financial institutionQFA Quasi-fiscal operation or activity

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Preface

Central banks and other public financial institutions often carry out operations thatare fiscal in all but name. Despite their potential macroeconomic and financial signif-icance, these "quasi-fiscal" operations or activities have not received a great deal ofattention from economists. This Occasional Paper aims to fill this gap by providing acomprehensive analysis of the macroeconomic and financial aspects of quasi-fiscalactivity. It examines problems related to the measurement and allocative impact ofsuch operations, the implications of their exclusion from conventional budgets, andpossible policy responses.

The paper is a revised version of a paper prepared for a seminar in the ExecutiveBoard of the IMF in May 1995.

The authors are indebted to numerous colleagues throughout the IMF—particularlythose who reviewed the individual country experience discussed in the paper. Theywish especially to thank Peter Heller, George Kopits, Vito Tanzi, and Manuel Guitianfor guidance and support. Thanks are also due to Rifaat Basanti, Ales Bulir, GustavoCanonero, John Dalton, Jorge Guzman, Juha Kahkonen, Claire Liuksila, DavidMarston, Caryl McNeilly, Reza Moghadam, Robert Rennhack, Gerd Schwartz, andGopal Yadav for useful suggestions; Chris Wu and Scott Anderson for research assis-tance; and Ahwerah Vichailak, Randa Sab, and Pearl Acquaah for secretarial assis-tance. Jim McEuen of the External Relations Department edited the paper for publi-cation and coordinated production.

The opinions expressed in the paper are those of the authors and should not be con-strued as representing the views of the IMF or of its Executive Directors.

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I Overview

Central banks and other public financial institu-tions (PFIs) play an important role as agents of

fiscal policy in many IMF member countries. Theiractivities in this guise can affect the overall publicsector balance (the balance of both the nonfinancialand the financial public sectors), without affectingthe budget deficit as conventionally measured.These activities, which are often referred to as quasi-fiscal operations or activities (QFAs), may also haveimportant allocative effects.1 Moreover, they entailan increase in the effective role and size of the pub-lic sector.

Standard measures of the nonfinancial public sec-tor (NFPS) borrowing requirement normally takeaccount of the explicit contribution to the budget ofthe central bank or other PFIs (typically, their profittransfers).2 In countries where QFAs have been im-portant, however, a more comprehensive definitionof the public sector financial balance may be a su-perior index of the impact of the government's fi-nancial operations on the economy. Thus, the IMF,in its surveillance and program activities, has some-times relied on a broader measure of the public sec-tor's financial requirements, in which the NFPS bal-ance is augmented to include the net income (or netlosses) of the central bank and sometimes that ofother PFIs.

The principal goal of this paper is to analyze themacroeconomic and financial aspects of QFA.There is an important microeconomic dimension toQFA, however, since it effectively introduces taxes,subsidies, or other expenditures outside the frame-work of the budget. The many forms that QFA takesmake it imperative that the analysis address notonly the overall impact of QFA on public sector bal-ances, but also the impact of particular QFAs on re-source allocation. The paper addresses these alloca-tive concerns. It also deals with the implications ofthe exclusion of QFA from normal budgetary proce-dures. Finally, the paper deals with some of the spe-

'The acronym QFA will be used both for quasi-fiscal activity ingeneral and for a specific quasi-fiscal activity.

2These revenues are normally included in the nontax revenueof the central government.

cial measurement and accounting issues that QFAentails.3

The rest of the paper presents an analysis of theeffects and implications of QFA, and makes recom-mendations about what should or should not be doneabout it. Specifically, Section II begins by definingQFAs and explaining why their identification andanalysis should be a matter of concern for fiscal pol-icy analysis. It then briefly reviews the factors thatgive rise to QFAs and some basic problems that arisein quantifying them. Section III provides a more de-tailed survey of the macroeconomic, financial, andallocative effects of specific QFAs. Section IV thenaddresses policy toward QFA.

The paper has three appendices. Appendix I ana-lyzes a number of measurement and accounting is-sues. Appendix II presents some country-specific ex-amples of the practices discussed in Section III ofthe text, and Appendix III presents five country casestudies.

Basic Features of QFAs

The QFAs of central banks and other PFIs aremany and varied. In the case of a central bank, mostQFAs stem either from its role as regulator of the fi-nancial system or from its role as regulator of the ex-change system. Subsidized lending, sectoral creditceilings, and central bank rescue operations fall inthe first group; multiple exchange rate (MER)regimes and exchange guarantees fall in the second.Central bank lending to the central government atbelow-market rates is also a relatively commonpractice. The QFAs of other PFIs often derive fromrestrictions on financial markets or from govern-ment-mandated special treatment for certain classesof borrowers and lenders. All of these operationsmay entail implicit or explicit taxation or subsidiza-tion of particular groups or activities, but they all falloutside the budget.

3For a more condensed and informal treatment of these issues,see Mackenzie (1994).

I


I OVERVIEW

QFAs are a matter of concern for several reasons:• Most important, in many countries, it has be-

come clear that central bank and PFI losses stem-ming from QFAs may be large and may be an impor-tant factor contributing to financial instability.

• The existence of QFAs means that conventionalmeasures of the government's financial balance maygive a misleading indication of the extent and role offiscal activity in the economy and of its macroeco-nomic impact.

• The taxes and subsidies that result from QFAscan be highly distortionary in their impact on re-source allocation.

• QFAs may take the form of unfunded or contin-gent liabilities, which may be potentially sizable,highly uncertain, and especially difficult to control.Certain forms of contingent liabilities—for example,exchange rate guarantees—may have significantmacroeconomic effects that precede their impact onthe cash flows of the PFIs that extend them.

Three characteristics of QFAs are important in un-derstanding their macroeconomic and financial ef-fects: the size and timing of their impact on the cashincome position of the public sector; the feasibilityof their quantification (that is, the measurability ofthe quasi-fiscal taxes or subsidies that they entail);and the extent to which they entail a contingent lia-bility, for which adequate financial provision needsto be made.

Some QFAs are much more difficult to quantifythan others. The implicit taxes and subsidies entailedby an appreciated exchange rate applied to particularclasses of traded goods can be measured and ex-tracted from the financial accounts of the centralbank. In contrast, such practices as credit ceilings,although they clearly have a fiscal component, are inpractice impossible to quantify and cannot be incor-porated in an alternative measure of the fiscaldeficit. Even when it is not possible to quantify fullythe impact of specific QFAs, it is nevertheless im-portant that they are at least qualitatively flagged inany analysis of the fiscal situation.

Exchange rate guarantees provide a good exampleof a potentially very costly contingent liability. Con-sider a guarantee that ensures the convertibility ofthe local-currency counterpart of foreign-currencydebt at the exchange rate prevailing when the debtwas contracted. In a high-inflation country, this canentail a huge subsidy for foreign borrowing, and thestimulatory effect on aggregate demand is likely totake place well before the losses are realized. Thepotential impact of such contingent liabilities pointsto the shortcomings of purely cash-flow measures of

fiscal activity, even where they extend beyond theNFPS to encompass the QFAs of the central bankand other PFIs.

Policy Toward QFAs

QFAs, if not properly monitored and controlled,can obviously undermine the achievement and main-tenance of financial stability. If the central bank isused as a conduit to extend what is really a bud-getary subsidy, both the deficit of the NFPS and netbank credit to the NFPS will be understated.4 Thesubsidy shows up in the form of a reduction in thecentral bank's income. The traditional measures ofthe fiscal stance are thus rendered unreliable byQFA. However, an enlarged measure of the deficit—consisting of the sum of the NFPS and net income ofthe central bank and any other PFIs engaged inQFA—will capture the aggregate impact of such ac-tivity. When QFA is prevalent, it is a superior gaugeof the fiscal stance.

To the extent feasible, quasi-fiscal operationsshould be quantified, extracted from the books of thecentral bank and PFIs, and included in a measure ofthe NFPS deficit used for programming or analyticalpurposes. This procedure will give a truer picture ofthe size of the public sector and the relative impor-tance of different taxes and expenditures. Even apartial measure of the QFAs of the central bank andother PFIs is superior to concentrating simply on theoverall balance. Moreover, such a separate analysiswill prove useful even for the purpose of assessingand projecting developments in the accounts of cen-tral banks and PFIs for which QFAs are significant.5

Structural measures are likely to be necessary toaddress the root cause of QFAs. Troubled financialinstitutions may have to be closed, exchange rate sys-tems unified, or the treasury required to pay a mar-ket-related rate of interest on its debt. Similarly, thelegal authority of the central bank may need to be re-vised to limit the extent to which QFAs can be car-ried out. Such reforms can have major implicationsfor the way a country's financial system operates.

4Only if the cost were fully and promptly passed on to the trea-sury—that is, only if a reduction in central bank income entailedan equal and contemporaneous reduction in profit transfers fromthe central bank to the treasury—would this not be the case.

5Such QFAs often figure as important determinants in themovement of the "other items net" (OIN) account in the monetarysurvey for the country. Extraction of QFAs can reduce the extentto which financial programming relies on highly aggregative pro-jections of OIN movements.

2


II Basic Issues

In many countries, some of the activities in whichcentral banks and PFIs engage, as well as some of

the regulatory requirements of central banks, can besaid to take on a fiscal character. These quasi-fiscalactions could, in principle, be duplicated by specificbudgetary measures in the form of an explicit tax,subsidy, or other direct expenditure.6 Such activities,operations, and regulations are often used by gov-ernments to carry out specific budgetary or fiscal ob-jectives outside the budget, and often in ways thatare not transparent. Table 1 gives a sense of therange of QFAs in which central banks and otherPFIs engage.

Apart from strictly quasi-fiscal actions, opera-tions of a less obviously fiscal—and more obvi-ously monetary—character, such as sterilization oropen market operations, are commonly referred toas QFAs because the large losses they can entailsooner or later affect the budget. Although a nar-rower definition that excludes such operations has aconceptual appeal, the paper acknowledges thebroader connotation—and more common use—ofthe term QFA and will include these monetary oper-ations in its definition.

Why QFAs Are a Matter of Concern

QFAs should be a matter of concern for macro-economic policy and structural adjustment for sev-eral reasons. First and foremost, in many countriessuch operations have given rise to losses (or dimin-ished profits) by the central bank or other PFIs thathave been sufficiently large to be an important con-tributor to monetary expansion. Indeed, there arecases in which the appearance of fiscal discipline inthe central government accounts is belied by "indis-cipline" in the financial sector that arises from bank-ing institutions carrying out QFAs at the behest ofthe government. For the purposes of macroeconomicanalysis, it is critical to have an accurate estimate ofthe magnitude of the budget deficit and its financing.

6These definitional issues are explored further in Appendix I.

This implies the need to take account of the mone-tary financing of government policies that may beeffectively hidden in the accounts of the central bankor PFIs.

Some sense of the macroeconomic impact ofQFAs can be gleaned by reference to the size of cen-tral bank losses in some countries in recent years. InJamaica, central bank losses, which are essentiallythe legacy of past exchange guarantee operations,exceeded 5 percent of GDP in the early 1990s.Quasi-fiscal losses in the Philippines approached 2percent of GDP in 1989-92; their elimination was amajor objective of the recent reform of the centralbank. Uruguay has also experienced sizable quasi-fiscal losses from a variety of QFAs; these have de-clined from the mid-1980s but in 1990 still exceeded4 percent of GDP.

Second, in analyzing any economy, it is importantto have an accurate idea of the size of government.Although the net operating position of the centralbank may take account of the net financial effect ofsome of the different QFAs, more analysis is likelyto be needed to identify clearly and separately theimplicit taxes and subsidies that the QFAs entail.Without this analysis, the magnitude of revenues andexpenditure of the government is likely to be under-stated. Sometimes an estimate of the magnitude ofsuch fiscal actions can be readily obtained from thefinancial accounts of the financial institution; inmost cases, however, the tax or subsidy is not at alltransparent (for example, as would be the case whena central bank lends at a concessional rate).

Third, quasi-fiscal taxes and subsidies, like someexplicit taxes and subsidies, can have seriously dis-tortive effects on resource allocation.

Bringing such measures out into the open and ana-lyzing their allocative impact are obvious prerequi-sites for determining whether their eliminationshould receive a high priority in the policy agenda.

Last, QFAs may entail the creation of contingent,often unfunded, liabilities. Such operations are farfrom uncommon in the central government itself, butwhen undertaken by the central bank or other PFIsthey are arguably less subject to scrutiny and moredifficult to monitor and control. A loan or exchange

3


II BASIC ISSUES

Table I. A Schematic Typology of Quasi-Fiscal Activities

Timing of Impacton Cash Position1 Ease of Quantifiability

Operations related to the exchange systemMERs I Variable; easiest with single

preferential rateImport deposits I VariableDeposits on foreign asset purchases I VariableExchange rate guarantees D VariableSubsidized exchange risk insurance D Variable

Operations related to the financial systemSubsidized lending

Administered lending rates I Relatively easyPreferential rediscounting practices I DifficultPoorly secured and sub-par loans D Very difficultLoan guarantees D Very difficult

Reserve requirements I VariableCredit ceilings I Very difficultRescue operations I/D Variable

'I, immediate; D, delayed.

rate guarantee may have no immediate effects on thecash flow of PFIs, but it is likely to have immediatemacroeconomic consequences that may be over-looked. Effective management of macroeconomicpolicy must ensure that unfunded and implicit liabil-ities incurred through financial operations are ex-plicitly recognized and funded.

For these reasons, QFAs warrant a close examina-tion. Nevertheless, there are also clear limits to thedegree of scrutiny that they can or should receive.First, as the subsequent discussion will explain,monetary operations such as sterilization of capitalinflows, which, as already noted, are commonly re-ferred to as QFAs, cannot be treated in the same wayas operations that are obviously akin to taxes andsubsidies. Second, and perhaps more important,QFAs are often very difficult to quantify. Significanttime and effort may be required to estimate the costof specific QFAs even when the resulting figure re-mains quite imprecise. The subsequent discussionwill also clearly illustrate some of the conceptualand practical issues that arise in quantification.

These considerations argue strongly for a prag-matic approach to the analysis of QFAs, given thelimited resources that both countries and interna-tional organizations can devote to this pursuit, im-portant though it is. Analytical and empirical workon QFAs should concentrate on those operations thatare either suspected of accounting for large financiallosses (or reduced profits) in the public financialsector or are thought to be the source of major dis-

tortions in resource allocation. Such a pragmaticfocus would also extend to the analysis of the impli-cations that the QFAs pose for economic policy.

General Issues

Institutional and Regulatory Sources of QFAs

As regulator of the monetary system, a centralbank has at its disposal a large number of instru-ments. Among the most basic are reserve require-ments, requirements for rediscounting operations,criteria for collateral for various classes of loans,credit allocation criteria, and interest rate ceilingsand floors. These instruments can be used to favoror to discourage—to subsidize or to tax—the lend-ing or borrowing of particular economic sectors.Significant opportunities for QFAs are also createdby the central bank's role as regulator of the ex-change rate regime. In addition to the fiscal roleplayed by MER regimes, exchange rate guaranteeson external borrowing can be used to subsidize bor-rowing, as can exchange risk insurance that is of-fered at excessively low rates. Similarly, import de-posit schemes and the like have effects akin tocustoms duties.

The central bank's special relationship as bankerto the government is another source of QFAs. Thetreasury often enjoys a below-market rate of intereston its overdrafts with the central bank, with the re-

4


General Issues

suit that the true level of the NFPS's interest expen-diture is understated.7

Although other PFIs are not presented with thesame potential opportunities for QFAs as centralbanks, they are public sector entities and may beused for fiscal policy ends. Common practices in-clude the extension of credit on subsidized terms orthe provision of credit to borrowers who would notnormally qualify in competitive credit markets. Onecrucial difference between the QFAs of these PFIsand those of a central bank is that the former, unlessthey enjoy a monopoly or monopsony position aslenders or borrowers, are typically not in a positionto levy quasi-fiscal taxes. Their QFAs, on balance,tend to reduce their potential profits if not to entailoutright losses.

Central banks and other PFIs are not the only pub-lic sector entities engaged in quasi-fiscal activity.Nonfinancial public enterprises are also often re-quired to undertake QFAs, particularly commoditysubsidies. Even though activities of this sort do notaffect the overall balance of the NFPS, they do meanthat the standard presentation of the public sectorbalance may understate the role of subsidies and cer-tain other expenditures in the economy.8 In easternEurope, for example, state-owned enterprises havebeen expected to provide an array of social servicesthat elsewhere would be provided by the govern-ment. A more accurate characterization of the roleplayed by such quasi-fiscal expenditure would begained by including it, at least for analytical pur-poses, in the accounts of the central government. Itis not always clear how such activities are financed.Presumably, implicit taxes on the production andsales of the enterprises concerned must play a majorrole.

Motives and Rationale for QFAs

Various aspects of a country's financial historyand institutional fabric might be cited to explain theexistence of QFAs. One essential consequence oftheir use is that QFAs hide what are essentially bud-getary activities in the accounts of PFIs. For exam-ple, obliging mineral exporters to surrender their for-

7An overdraft with a below-market rate of interest has no effecton the treasury's deficit when the marginal rate of transfer of cen-tral bank net income is 100 percent. In this case, the decline in thetreasury's interest bill will be exactly offset by a decline in trans-fers from the central bank (a part of nontax income) or an in-crease in transfers from the treasury to cover a loss. The trea-sury's overall balance is affected when the marginal rate oftransfer is less than 100 percent. But even in the first case, thepractice of interest-free overdrafts results in an understatement ofthe opportunity costs of central bank lending.

8Tanzi (1993) has discussed the QFAs of state-owned enter-prises of economies in transition.

eign exchange at an artificially overvalued exchangerate is tantamount to an export tax. It reducesrecorded royalties and profit tax collections, but iteffectively increases the real tax burden of the min-ing sector. An exchange rate guarantee on foreigndebt is similar to an interest subsidy, but initially itaffects neither the cash flow of the central bank northat of the government. The hidden nature of theseoperations may also make them more acceptable po-litically in many countries.9 Contingent QFAs are ina sense doubly hidden—their cash-flow impact isdelayed, and because they are granted by financialinstitutions they do not necessarily receive legisla-tive or parliamentary scrutiny.

One possible rationale for some QFAs is that theyare seen as more convenient to administer than con-ventional budgetary operations. For example, if acentral bank is used to operating an MER system, itmay seem easier to rely on it than on the budget toextend a new subsidy to an imported good.

Some of the QFAs of central banks—notably res-cue operations for troubled financial institutions—may also reflect an assumption that such support forthe financial sector is properly in the domain of thecentral bank. In some countries, the central bankmay be able to act more quickly than the treasury inthis regard. In consequence, these operations, de-spite their fiscal character, may be seen as an inte-gral part of a central bank's responsibility for sus-taining the financial system during a crisis.

Problems of Quantification

All of the basic reasons for concern over QFAspoint to the importance of quantifying them, or atleast of quantifying the most significant ones. Al-though reliable information on the net income or netlosses of the central bank and any other PFIs engagingin QFAs is clearly valuable in its own right, the lossesof a central bank or other PFI may be the result of thecombined effect of the institution's regular operationsand several QFAs. To have an idea of the true role andmagnitude of the taxes levied and the subsidies pro-vided by the central government in the economy, it isnecessary to be able to break down the aggregate netloss figure into its quasi-fiscal components. More-over, predicting the evolution of such losses is clearlyeasier when it is possible to identify and measure theimpact of the separate activities that give rise to them.But this is much easier said than done.

9Tanzi (1995, page 5) made a similar point when he wrote that". . . often, governments that cannot raise a desired level of taxrevenue do not scale down their role in the economy, but, rather,they attempt to pursue that role through nonfiscal instruments. . . largely, but not exclusively, quasi-fiscal activities and quasi-fiscal regulations."

5


II BASIC ISSUES

In some cases, estimation of the financial impactof a QFA is relatively straightforward. For example,with MERs, as Section III discusses, ready quantifi-cation is feasible in certain cases.10 Similarly, thesubsidy element in a loan extended at a preferentialinterest rate can be readily quantified, although anassumption has to be made about the evolution of

l0Appendix I discusses a variety of measurement issues inmore detail.

the market rate of interest on loans of equivalentquality, and such assumptions are obviously subjectto some judgmental element. In contrast, the estima-tion of the subsidy or tax that results from credit al-location ceilings poses formidable problems thatstem mainly from the difficulty of determiningwhether, and to what extent, the ceiling "bites." Sim-ilarly, it may be very difficult to assign a hard valueto the financial cost of contingent liabilities, owingto the difficulty of predicting the likelihood of theirbeing incurred.

6


Ill Varieties and Economic Effectsof Quasi-Fiscal Activities

The quasi-fiscal activities of a central bank stemfrom its roles as regulator of the exchange sys-

tem and regulator of the financial system. The QFAof other PFIs takes the form of interventions in thefinancial markets.

QFAs Associated with theExchange System

QFAs associated with the exchange system can bedivided into two groups: those that result from the useof MERs, and those that result from the assumption ofexchange risk by the central bank (see Table 1). Oper-ations such as required import deposits can be assimi-lated to the first group because they effectively estab-lish a special exchange rate for certain classes ofimports. Similarly, regulations that require zero-yielddeposits at the central bank as a condition for purchas-ing foreign assets effectively establish a separate ex-change rate for the transactions to which they apply.

MER Practices

MER practices, or practices with similar effects,are very common. As of December 31, 1994, some40 IMF member countries had at least two exchangerates or an advance import deposit requirement.Nearly all of these required the surrender or repatria-tion of export proceeds, a practice tantamount to atax when the surrender rate differs from the marketrate.11 The fiscal character of MERs is apparent inthe case of an exchange rate regime where a specialrate applies to particular categories of exports andimports. As an example, consider a regime in whichcertain mineral exports and imports of medicines areboth subject to appreciated rates, all other tradebeing carried out at the standard rate.12

"See International Monetary Fund (1995). This figure comesfrom the table entitled "Summary Features of Exchange andTrade Systems in Member Countries." These statistics reflect theexistence of multiple official exchange rates, not necessarily par-allel exchange rates.

I2A regime like this applied in Egypt before the exchange sys-tem reforms of 1991 (see Appendix II).

It is clear that recourse to this form of MER prac-tice is tantamount to imposing a tax on the mineralexports and a subsidy on imports of medicine, andthat the value of the taxes and subsidies imposed canbe accurately estimated.13 These estimates can thenbe used to produce an adjusted measure of the net in-come of the central bank, and an adjusted measure(on a gross basis) of the financial operations of theNFPS. These revised estimates of public sector ac-tivity may then be used for purposes of analysis orprogramming.

The net effect on the budget of such an MER sys-tem can be calculated relatively straightforwardly.When the amount of foreign exchange purchasedfrom the taxed mining sector does not equal theamount sold for subsidized imports, the impact onthe central bank's accounts will depend on the valu-ation procedures used for foreign exchange (seeAppendix I).14

The calculation of the fiscal impact of MERregimes is less straightforward when the specialrates affect a number of the major sectors of theeconomy. It should still, in principle, be possible toeliminate the special rates and replace them by ex-plicit ad valorem taxes or subsidies, but it may notalways be clear which rate is the central rate.15

Another set of problems arises when the ex-change rate, whether a single rate or the central ratein an MER system, is so grossly overvalued thatforeign exchange sales are rationed by the centralbank. In this case, every transaction involves a

l3The fiscal character of MERs was analyzed in two early con-tributions to the IMF's economic journal, Staff Papers; see Bern-stein (1950) and Sherwood (1956).

l4If the central rate is 10 local currency units (LCUs) per U.S.dollar, the mining sector rate is LCU 6 per dollar, and the specialimport rate is LCU 7 per dollar, then the central bank has netincome from the purchase and resale of $1 million of (7 - 6) x$1 million, or LCU 1 million. Alternatively, with reference to thecentral rate, the bank makes a profit of LCU 4 on each purchaseof foreign currency from the mining sector, and a loss of LCU 3on each sale to the privileged import sector.

15The fiscal costs entailed by the unification of the exchangerate regime (that is, devaluation of the official rate to eliminate aparallel exchange market) are very carefully analyzed in Agenorand Ucer (1995).

7


Ill VARIETIES AND ECONOMIC EFFECTS OF QUASI-FISCAL ACTIVITIES

simultaneous tax (of the exporter, who is forcedto surrender earnings at an unrealistically appre-ciated rate) and subsidy (for the importer, whobenefits from the same unrealistically appreciatedrate). Quantification in such cases is problematicbecause it requires the estimation of a shadow ex-change rate.

MERs, like tariff systems, can be highly distor-tionary in their allocative effects. They can entailwide variations in effective rates of protection—which can be positive or negative—for different in-dustries. Even when a system with more than onerate might conceivably serve some useful purpose—for example, a special exchange rate on agriculturalexports, which might serve as a proxy for a tax onagricultural income in an economy where it is notfeasible to administer an income tax—their lack oftransparency makes them a distinctly inferior substi-tute for explicit budgetary levies.

One potentially serious consequence of MERs istheir distortive impact on conventional measures ofthe relative importance of different sectors and dif-ferent revenue sources in the economy. For example,in Venezuela in the mid-1980s the appreciated rateapplying to oil exports meant that the conventionalrevenue measures understated the role of the state oilcompany in the generation of revenue. The appreci-ated rate applying to coffee exports in Uganda in thelate 1980s had a similar effect on the conventionalmeasure of revenues from coffee taxation. In addi-tion, because it applied to imports of materials usedby the local excisable goods producers, it led to anoverstatement of the role of excise taxation.16

Exchange Rate Guarantees and Assumptionof Exchange Rate Risk

The second major avenue for QFAs associatedwith the exchange system is the assumption by thecentral bank and other PFIs of exchange rate risk.This typically takes the form of an exchange rateguarantee, but it also may arise when the centralbank subsidizes exchange risk insurance.

Unlike the operations of MER systems, the issueof exchange rate guarantees and the like establishesa contingent liability, although the rate at whichlosses are realized can vary greatly. When domesticinflation is significantly above international levels,and the domestic currency is expected to depreciateat a significant rate, a guarantee at the current ex-change rate can create a strong incentive for foreignborrowing. It allows the domestic borrower to payan international rate of interest on an obligation de-

l6These and most of the other country examples mentioned inthis section are discussed at greater length in Appendix II.

nominated in local currency. This can create a verylarge subsidy in high-inflation countries. A similarsubsidy is created when a central bank or other PFIguarantees the rate applying to foreign currency de-posits of the banking system. Public enterprisesoften benefit from the adoption of a policy of ex-change rate guarantees, as has been the case inGhana and the Philippines.

If the guarantee extended by the central bank orPFIs on foreign-currency-denominated debt extendsto both interest payments and principal repayments,then a loss is realized with every payment everytime the exchange rate depreciates. It should be pos-sible to calculate ex post the value of such realizedlosses as they occur. Calculating ex ante the ex-pected value of the subsidy that is extended by thispractice is considerably more complicated, ofcourse, and depends inevitably on somewhat arbi-trary assumptions.17

Although the difficulties involved in such calcula-tions should not be downplayed, developing a mea-sure of the subsidy nevertheless could play a veryimportant role in supplementing or qualifying theconventional measure of the budget deficit. Even in-formation on the stock of outstanding guaranteeswould permit a more accurate picture of the size andimpact of the public sector's fiscal operations. Itmust be recognized, nonetheless, that quasi-fiscalcontingent liabilities are a part of a much larger, andoft-neglected, problem—namely, the inadequate ac-counting of contingent liabilities entailed by bothbudgetary and extrabudgetary programs of the gov-ernment and other public sector entities.18

A fundamental point to be made about exchangerate guarantees and similar operations is that, re-gardless of the pace at which losses are realized,their macroeconomic effects are likely to material-ize from the start of the operation. The subsidycreated by borrowing has its effect on expenditureimmediately, not when the losses are realized. Only

17In the case of a guarantee that fixes the exchange rate at therate prevailing at the time the loan was contracted, an estimate ofthe total value of the subsidy could be made by discounting thestream of loan repayments by a rate of interest on a long-termlocal-currency-denominated security, and subtracting the resultfrom the initial value of the loan. If the local rate equals the inter-est rate on the loan, there is no subsidy element (because the ini-tial value of the loan will by definition be equal to the present dis-counted value of the repayments stream using the rate of interestat which the loan was contracted). The higher the local rate, thegreater is the subsidy element.

l8The Federal Credit Reform Act of 1990 now requires that theU.S. budget include allocations to cover the present value of ex-pected net cash outflows from loan and loan guarantee programs(see U.S. Office of Management and Budget, 1995). In NewZealand, there is a requirement that all fiscal risks facing theoverall government be disclosed in the budget and quantifiedwhere possible.

8


QFAs Associated with the Financial System

the monetary effect coincides with the realizationof the loss. Concentrating on the cash-flow impactof these operations can, therefore, be seriouslymisleading.

QFAs Associated with theFinancial System

Subsidized Lending

Subsidized lending can take a variety of forms,ranging from the relatively direct practice of lendingat administered rates set below market, to the moreindirect subsidies entailed by preferential discountprocedures, lending to poor credit risks, and lendingwithout adequate collateral.

Administered Lending Rates

Perhaps the easiest operation to analyze is lendingat administered rates. When PFIs are obliged to lendat below-market interest rates, there is an obviousfiscal subsidy in their operations. An estimate of thesubsidy can be made, if data on market rates of inter-est are available, and can be taken into account in as-sessing the financial operations of the NFPS.

When PFIs are obliged to make loans at below-market rates, and are not compensated directly or in-directly by the government, their profits are lowerthan they otherwise would be. It is not uncommon,however, for such practices to be effectively fi-nanced by other entities in the public sector. For ex-ample, nonfinancial public sector enterprises(NFPEs) can be obliged to maintain deposits withPFIs at unremunerative rates. Until recently, part ofthe operations of the agricultural bank in Turkeywere financed in this manner.

The central government, in the end, may pay forthe subsidy through transfers to the NFPE involved,although the burden of the operation can fall on theNFPE for a time. Central banks can also financedirectly the subsidized lending operations of spe-cialized banks, as was the case with the NationalMortgage Bank in Argentina. When the financialsystem is controlled by the government and re-pressed as well, below-market lending rates can befinanced by artificially reduced deposit rates.19 The

l9In this case, it may be private financial institutions, ratherthan PFIs, that are effectively obliged to act as fiscal agents.Moreover, there may be no direct effect on the financial opera-tions of PFIs. Even for the private financial institutions in thecase just described, the implicit tax imposed on their depositors isoffset by the subsidy the private institutions are obliged to grantto their borrowers. That said, their profitability may be affectedby the impact of the interest rate regulations on the volume oftheir business.

lower lending rates can reduce a government'sinterest payments below what the payments wouldbe in a liberalized financial system. In effect, a taxon holders of deposits with the financial system isused to extend an interest subsidy to the centralgovernment.

The government is not the only beneficiary ofbelow-market interest rates. Any borrower who cangain access to this privileged form of borrowing alsobenefits. Although these kinds of implicit subsidiesand taxes cannot be quantified as rigorously as thoseemanating from an MER regime, rough estimatescan still be made. A recent comparative study esti-mated that the tax entailed by financial repression ofthis sort exceeded 4 percent of GDP in a number ofcountries during the 1980s (Giovannini and DeMelo, 1993). The estimates of the cost of implicittaxation in an earlier study are even higher (Cham-ley, 1991).

Direct central bank lending to the governmentcan take place through the use of overdrafts, bymeans of fixed-term loans and advances, or by thedirect purchase of government securities. In aneffort to promote central bank independence, manycountries have restricted or prohibited such lend-ing; nonetheless, direct lending, albeit not neces-sarily at below-market rates, is still common. Ofa sample of 57 countries compiled for a recentstudy, only 4 prohibited all three forms of lending(Cottarelli, 1993).

Even when direct lending to the government bythe central bank is formally prohibited, there aremeans of circumventing the prohibition when otherfinancial intermediaries are owned or controlled bythe public sector. For example, the central bank canlend to these intermediaries, who then can onlend tothe government. Indeed, loans from the central bankcan finance directly QFAs by other public sectorentities.

The impact on the central bank's net income ofsubsidized lending to the government, like the im-pact of other QFAs, can in some circumstances beneutralized if the bank does not pay interest on re-quired reserves. However, the scope for this tacticnarrows as the share of credit going to the govern-ment increases; it narrows further when inflation ishigh, because the central bank must then start pay-ing interest on the reserves that commercial bankshold with it. Indeed, paying significantly less thanthe market rate will weaken the profitability ofcommercial banks and encourage financial disinter-mediation and capital flight, thereby diminishingthe base of the inflation tax. Consequently, a largedeficit, high inflation, and interest-free lending tothe government can result in large central banklosses. Another consequence may well be controlson capital.

9



Preferential Rediscounting Practices

Whereas administered lending rates are a subsidyto consumers (that is, borrowers), typically paid forin the first instance by the producer, preferential re-discounts are effectively producer subsidies thatmight or might not be passed on to the consumer.For example, if a sectoral development bank is al-lowed to sell its own paper at a subsidized rate to thecentral bank or other PFIs, that rate could be passedon to the final borrower; however, it might also sim-ply result in greater profits for the developmentbank. In the latter case, it merely subsidizes lendingthat would have taken place anyway. Thus, it maynot be obvious who the ultimate beneficiary of pref-erential rediscounting would be. As is the case withadministered lending, however, it should be possibleto make an estimate of the size of the subsidy in-volved if it is possible to measure market-related in-terest rates.

Poorly Secured and Below-Par Loans

In many countries, public sector banks have hadextensive problems with loan recovery. Loans byPFIs that are either extended at standard market-related interest rates without adequate collateral, ormade to borrowers who are not creditworthy, clearlyhave a subsidy element. Indeed, at times such loansare actually implicit grants to favored client groups.As a practical matter, however, it is very difficult toestablish ex ante the value of the subsidy such loansentail.20

These operations only affect the cash flow—andpossibly the financial viability of the PFI that makesthem—if and when the loan is not serviced. Ulti-mately, and as noted below, the effects of such poorcredits entail quasi or direct fiscal outlays associatedwith rescue efforts. Like exchange rate guarantees,the macroeconomic effects of such activities, interms of the expenditures to which they give rise, re-ally precede their impact on a PFI's cash flow and theemergence of a possible need for recapitalization. Al-though the extension of high-risk loans by PFIs mayhave quite serious macroeconomic consequences,their effects are thus both hidden and delayed.21

20If loans of a similar degree of risk are extended by the privatefinancial system, a measure of the subsidy element of loans fromPFIs can be derived from the relationship between the interestrate charged by the private sector and that charged by the govern-ment. Appendix I discusses a way of calculating the subsidy ele-ment entailed by a loan guarantee that also can be applied topoorly secured and below-par loans.

2'See Watanagase (1990) for a description of how poor creditpractices associated with directed lending created a "latent" bank-ing crisis in Bangladesh. This case is also discussed briefly inAppendix II.

The Fund's framework for government financialstatistics (International Monetary Fund, 1986) clas-sifies net lending for policy purposes—as opposedto net lending to earn a return—as a deficit-deter-mining item and places it "above the line." The sametreatment could be accorded noncommercial netlending by PFIs, thus ensuring that these operations,which undoubtedly have a fiscal element, are treatedcomparably with similar operations carried out bythe government. Nonetheless, the isolation of thesubsidy element of poorly secured and below-parloans, and its inclusion in the standard presentationof the financial operations of the NFPS, is in generalnot feasible.

Loan Guarantees

This practice is typically associated more withgovernments than central banks and other PFIs.Nonetheless, PFIs do guarantee loans. The practiceentails a subsidy because, absent the element of risk,the lender is willing to charge a lower rate of inter-est. If one can measure the market rate of interest onregular loans to borrowers in the same risk category,it is possible to measure the value of the subsidy en-tailed by the provision of loan guarantees.22

Reserve Requirements and Credit Ceilings

If QFAs can be characterized on a continuum run-ning from indirect to direct, selective reserve re-quirements and credit ceilings would be at the indi-rect end of the scale. Both credit ceilings andadjustments to required reserve ratios can be engi-neered to encourage banks to allocate their loanportfolios in one direction or another.

The fiscal impact of reserve requirements is moreamenable to quantification than that of credit ceil-ings. The fiscal element in reserve ratios arises whenthe assets that comprise them do not earn a market-related rate of return. Provided that an assumptioncan be made about the rate of return that these assetswould enjoy if they could be invested freely, it ispossible to estimate the revenue the central bankearns by virtue of the requirement. What is very dif-ficult is determining who ultimately bears the bur-den of this quasi-fiscal tax.23

The fiscal element of reserve requirements can atleast be made transparent, even if it cannot be elimi-

22Appendix I describes one method of calculation.23That burden should be shared by the banks (that is, their

shareholders), their depositors, and their borrowers. By makingcertain assumptions about the loan and deposit markets it is possi-ble to estimate each group's share. But these assumptions will in-evitably be somewhat arbitrary. Molho (1992) presented an illu-minating discussion of this issue; see also Appendix I.

10


QFAs Associated with the Financial System

nated, by making an explicit transfer of the value ofthe implicit tax involved to the treasury, and by label-ing it as tax revenue in the government's accounts. Amore fundamental reform would be to ensure thatbanks obliged to hold reserves with the central bankcan earn a market-related rate of interest.24

In contrast, credit ceilings, to have an effect, haveto "bite," and it is not possible to know just from thedimensions of the ceilings whether they do. Thiscomplicates the task of estimating the size of theQFA. The determination of the impact of credit ceil-ings on the income statements of PFIs and their im-portance as subsidies or taxes can be understoodonly if it is possible to determine how credit and sav-ing would have been allocated in their absence. Thiswill not generally be feasible.

The use of reserve requirements as a fiscal policyinstrument can have profound effects on the econ-omy. Artificially high requirements can be used tocrowd out the private sector, by channeling all thecommercial banks' assets into the central bank,which then lends them to the government. A less ex-treme measure might take the form of a requirementfor the banks to hold a minimum part of their liquidassets in government paper, as has been the case inKenya. Such a policy can also artificially reduce thecost of government borrowing. A policy that controlsbank lending to the private sector can have a similareffect.25

Credit ceilings can result in a distribution of credittotally different from the distribution that wouldemerge if lending were governed by market criteria.The role of credit in a centrally planned economy,where credit norms are set simply to ensure the ful-fillment of the plan, is perhaps the most extreme ex-ample of this phenomenon.

Rescue Operations

Central bank rescue operations of troubled finan-cial institutions have at times been the most visibleand also the most expensive of QFAs. They can takea variety of forms—from a simple infusion of capi-tal, to an assumption of nonperforming loans, to anafter-the-fact exchange rate guarantee. A fairlycommon form is the purchase of all or part of thenonperforming loan portfolio of the institutions indifficulty. Operations of this sort took place inUruguay and Chile in the early 1980s, and more re-cently in some eastern European countries.

Sometimes, rescue operations are the inevitablesequel of the burden governments impose on PFIs

24The treatment of the implicit tax revenue generated by re-serve requirements is discussed in Appendix I.

25Bruni, Penati, and Porta (1989) have discussed the role of ad-ministrative controls in sustaining demand for public sectorbonds in Italy at various times.

to perform functions that properly fall to the bud-get. The obligation to make substandard or low-interest loans pushes a PFI to insolvency, and thegovernment—typically via the central bank—has tostep in.

A straightforward infusion of capital to a troubledfinancial institution by the central bank is no differ-ent in principle from a budgetary capital transfer.The treatment of the latter in the IMF's governmentfinance statistics is to include it in government ex-penditure and net lending, so that parallel treatmentof a transfer from the central bank would lead to anincrease in the financial deficit of the NFPS.

Nonetheless, the macroeconomic impact of suchtransfers depends on the circumstances in whichthey take place. If the government has alreadybeen paying compensation for the interest notpaid to a PFI on its portfolio of nonperformingloans, the transfer of capital and the write-off of theloans are simply bookkeeping operations.26 Simi-larly, if a lender was tacitly encouraged by the gov-ernment to offer an exchange rate guarantee, the in-fusion of capital that takes place when the exchangerate collapses occurs after the policy has had its ef-fects on the economy, at least to the extent that thelender expected to be fully bailed out if pushed tothe wall.

A complete understanding of the impact of a fi-nancial rescue operation thus depends on whatwould have happened in its absence. In the first ex-ample, the infusion simply formalizes an alreadyexisting arrangement—in effect, a subsidy is capi-talized. In the second case, a decision not to offerthe guarantee would certainly affect the economy.Even if the financial system as a whole were not af-fected by the collapse of certain institutions, therewould clearly be a depressing influence on theeconomy as a result of their bankruptcy and thelosses suffered by their depositors and creditors.That said, the extra expenditure of the bailout oper-ation is essentially a transfer payment from the tax-payer at large to the creditors and depositors of thetroubled institutions. It takes place after the infor-mal exchange rate guarantee has had its impact onthe economy.

Bank rescue operations can be likened to a formof implicit deposit insurance system.27 Formal, orexplicit, deposit insurance systems come in manyvarieties and are far more common in industrial thanin developing countries (Kyei, 1995). There are twobasic similarities between bank rescue operationsand a deposit insurance system: both can protect de-

26These operations would, nonetheless, give the PFI more as-surance that its operations would not be wound up in the nearfuture.

27This analogy was drawn by Talley and Mas (1990).

11



positors from the risk of loss; and both lessen incen-tives for depositors to exercise oversight over banks,and thereby increase the banks' opportunity to en-gage in risky lending practices. Explicit deposit in-surance institutions have been seen as a basic socialinstitution because of their potential role as sustainerof the financial system during crises. Recently, themoral hazard problem they can create has receivedmore emphasis.28

Does a deposit insurance system entail QFA? Ifthe insurance premiums are set at an adequate level,there will presumably be no need for the government(through the central bank) to intervene. The insur-ance system would be self-financing, and the im-plicit tax or subsidy element is not obvious.

In practice, it is very difficult to know what theappropriate level for premiums should be, and veryfew countries base premiums on the perceived riski-ness of different banks. The introduction of depositinsurance systems can also change the rate—andcost—of bank failures in an unpredictable way, mak-ing it difficult to set premiums ex ante. Conse-quently, a situation can easily arise of a deposit in-surance system exhausting its reserves and beingunable to meet its obligations. The quasi-fiscal ele-ment in a deposit insurance system, if there is one,results from the government's intervention when thereserves of the scheme are insufficient to compen-sate depositors. Explicit deposit insurance may alsohave a quasi-fiscal element to it to the extent that theinsurance fund is subsidized by the government, orwhen the system is used to promote a particular classor classes of financial institution.29

Sterilization Operations

As already noted, operations to sterilize capital in-flows by using open market operations and othermarket-based monetary instruments have recentlyentailed sizable losses for the central banks of somecountries. The role of these kinds of operations hasbeen enhanced by an increase in international capitalmobility and by the growing attractiveness of invest-ment in emerging financial markets. Central banklosses from this source also reflect the trend to indi-rect rather than direct methods of monetary policy.The conduct of monetary policy through open mar-ket operations and the like can increase the explicit

28See, for example, Merton and Bodie (1993) for a discussionof possible reforms of deposit insurance schemes in the UnitedStates.

29The use of a deposit insurance system to promote a particularclass of institution (for instance, savings banks) has been dis-cussed by Kyei (1995).

costs of monetary control even as it does away withmore distortive and direct methods of control.

Capital inflows must be sterilized if a governmentis unwilling to permit either an exchange rate appre-ciation or an induced and possibly inflationary in-crease in base money. If the exchange rate is allowedto float freely, capital inflows have no impact on thedomestic monetary base, and hence there is no sup-ply disturbance to sterilize. Similarly, if the centralbank is willing to accept an endogenously deter-mined supply of base money, then it need notsterilize.

Sterilization through such market-based means asthe sale of a government or central bank security hasa fiscal cost if the interest on the security sold by thecentral bank provides a higher rate of return than theforeign security purchased by the central bank withthe foreign exchange obtained through the sale ofthe security. In most cases, the motivation for thecapital inflow is that rates of return in the domesticcurrency exceed those available abroad, and thus therate of return that must be offered in domestic cur-rency by the central bank exceeds the rate that it canobtain abroad. Even if the central bank chooses tosell foreign-currency-denominated securities, inorder to eliminate the inflationary component of theinterest differential between domestic and foreignsecurities, the risk premium most central bankswould have to pay would exceed that offered by theintervention currency's "home country" authorities.Consequently, sterilization through market-basedmeans is usually a losing proposition.

Sterilization can be seen as altering directly mar-ket prices both in the foreign exchange market andthe money market. The exchange rate will be lessappreciated than otherwise, domestic interest rateswill be higher, and the quantity of the monetary basewill be unchanged (assuming that no exchange rateappreciation is permitted and all inflows are steril-ized). The direct fiscal cost of the policy choice isclear—the difference between the interest cost paidby the central bank or treasury and the interestearned on the foreign assets acquired with the for-eign exchange purchased. The indirect aspects arealso worthy of note, although they are less transpar-ent. Earners of foreign exchange obtain more localcurrency for their income than otherwise is the case,and spenders of foreign exchange need to pay morelocal currency than they would otherwise. Holdersof domestic debt are rewarded with a higher interestrate than they otherwise would obtain, although theyare denied the capital gain, measured in foreign cur-rency terms, that would accrue to them were the ex-change rate to appreciate. Holders of foreign assetsfind that they are spared the capital loss, measured inlocal currency terms, that would occur were the do-mestic currency allowed to appreciate.

12©International Monetary Fund. Not for Redistribution

Sterilization Operations

An important aspect of a sterilization operation isthat all of the transactions it involves are voluntary,and thus the key aspect of a tax—that a payment isexacted without compensation—is absent. Unlikethe case with a dual exchange system, where im-porters and exporters have an incentive to evade thesystem and deal directly with each other, there is noelement of coercion. There is, however, a myriad ofimplicit transfers of income that take place at thegovernment-influenced constellation of relative

prices. In this respect, the activity can be seen assimilar to that of a government policy to stabilize theprice of a commodity through purchases and sales atmarket prices. The direct government cost of thepolicy is the cost of carrying an inventory of thecommodity that is the object of intervention. Theindirect aspects are again less transparent becauseconsumers and producers of the product will, atvarying times, receive implicit transfers and payimplicit taxes.

13


IV Implications for Policy

W hen quasi-fiscal activity is prevalent, theconventional measures of fiscal activity,

such as the NFPS borrowing requirement or thedeficit of the central government, are misleading in-dicators of the stance of fiscal policy and of the de-mands the government makes on credit availability.

Traditional Approaches

For example, if the central bank is used as a con-duit for subsidies to PFIs or NFPEs, both the truebudget deficit and credit to the government are un-derstated by the budgetary accounts. In these cases, itis preferable to rely on an enlarged measure of the fi-nancial operations of the NFPS, one that is extendedto incorporate the net income of the central bank andother PFIs that engage in QFA.30 Central bank lossesare often included in the definition of the public sec-tor used in IMF-supported programs (see Bennett,Carkovic, and Dicks-Mireaux, 1995). Since the oper-ations of the NFPS will be measured generally on amodified cash basis, while central banks normallywould use an accruals-based measure, the amalgama-tion of the results for the central bank and the NFPSnormally requires that adjustments be made to thecentral bank's income statement.31

30The true budget deficit is not understated if the cost of QFA isborne by the budget, as it is if transfers from the central bank to thebudget are automatically adjusted to reflect quasi-fiscal losses. Putanother way, the budget deficit will not be misrepresented by theconventional measure when the central bank engages in QFA if themarginal rate of transfer of profits (and losses) is 100 percent. Typ-ically, the marginal rate of transfer is not 100 percent.

3'One of the exceptions to the cash-based measurement of thefinancial operations of the NFPS is interest payments, which forthe NFPS are normally measured on an accrual basis. To avoid ar-tificial increases in a central bank's cash income and to ensureconsistency with the accounting of interest payments in theNFPS, the central bank's interest earnings would have to be mea-sured on an accrual basis as well. In addition to the adjustmentsnoted above, adjustments may also be necessary to compensatefor deficiencies in the accruals-based accounting of central bankoperations. That said, the accounts of the central bank are nor-mally in better shape than those of the central government and, afortiori, those of the NFPS. These issues are explored at greaterlength in Appendix I. On general issues in amalgamating centralbank and fiscal deficits, see Robinson and Stella (1993).

This approach makes no attempt to distinguish be-tween the fiscal and the financial operations of thecentral bank or PFIs. Instead, it assumes that QFAswill be fully reflected in the profit and loss accountsof the PFIs that engage in them. Given the difficultyof disentangling the fiscal from the monetary and fi-nancial operations of the public financial sector, thistreatment of QFAs has the considerable merit ofbeing relatively simple.

More Sophisticated ApproachesWhen QFAs are recognized as a problem, the cal-

culation of an enlarged measure of the NFPS bal-ance that incorporates the net income (or losses) ofthe central bank and other PFIs will provide a bettermeasure of the true fiscal stance than the conven-tional measure. That said, more ambitious ap-proaches should be considered in cases where QFAsare deemed to have a significant macroeconomic im-pact and are readily quantifiable.

A range of analytic options may be considered, allof which would supplement reliance on the enlargedmeasure of the financial balance of the public sector.Least ambitious, and most appropriate where quan-tification is difficult or subject to significant impre-cision, would be to make a qualitative analysis ofthose QFAs that give rise to significant distortions inresource allocation or whose macroeconomic impactwould appear significant (and for which only arough order of magnitude can be estimated). Forsome of the QFAs cited above, the number of as-sumptions required to quantify them may simplymake quantification unfeasible. Among others, un-funded or contingent liabilities may require a quali-tative rather than a quantitative approach.

In other cases, the implicit taxes or subsidies en-tailed by QFAs may be more readily quantifiable.To make these estimates, those QFAs that can bemeasured relatively easily would effectively be ex-tracted from the accounts of the central bank orother PFIs (see Box 1). The estimates could be in-cluded in an analysis of the fiscal stance—albeitshown separately—and used to calculate alternative

14


Structural Reform

Box I. Calculating the Value of Quasi-Fiscal Activities: Two Examples

1. A country has a central exchange rate of LCU 3to the dollar. A special, appreciated exchange rate ofLCU 2.5/dollar applies to exports of mineral products;the same exchange rate applies to imports of medicinesand certain foodstuffs. Mineral exports in 1995 were$1,200 million; imports at the special rate amounted to$400 million.

The quasi-fiscal tax on exports is calculated as:

(3.0 - 2.5)LCU/$ x ($ 1,200 million) = LCU 600 million.

The quasi-fiscal subsidy to imports is calculated as:

(3.0 - 2.5)LCU/$ x ($400 million) = LCU 200 million.

The central bank was thus a net gainer from thisparticular QFA in 1995, to the extent of LCU 400 mil-lion. Under the procedure proposed in the text forfinancial programming and analytical purposes, exporttaxes of the central government would be increasedby LCU 600 million, and commodity subsidies byLCU 200 million. Central bank credit to the govern-ment could be adjusted downward by the amount of thenet tax (LCU 400). The net income of the central bankafter adjustment for the QFA would be reduced byLCU 400 million, so that the combined public sectordeficit would not change.

2. A central bank extends a loan at an interest rate of10 percent a year to the agricultural development bank;the current annual rate of inflation is 15 percent; loansof comparable maturities have rates of interest rangingfrom 20 to 25 percent. If the outstanding balance of theloan is LCU 200 million, a reasonable estimate of therange of the annual subsidy extended to the agriculturaldevelopment bank would be:

Lower bound:(20 - I0)/l00 x (LCU 200 million) = LCU 20 million.

Upper bound:(25 - 10)/100 x (LCU 200 million) = LCU 30 million.

The degree of uncertainty surrounding the size of thesubsidy may make it inappropriate to enter an estimatein the accounts of the central government even for pro-gramming or analytical purposes. Nonetheless, this in-formation could enter the standard presentation of thepublic finances as a memorandum item. When the esti-mate has a lower variance, however, it could be enteredas a subsidy in the accounts of the central governmentand financed by additional credit from the central bank.The central bank's net income would be correspond-ingly adjusted.

measures of the fiscal contribution to monetary ex-pansion.32 This analysis would highlight the impactof QFAs and the dangers they pose to macroeco-nomic policy. The quantification of QFA in commoncurrency areas poses other problems (see Box 2).

Where feasible, the most desirable option wouldbe to classify such QFAs as any other conventionalNFPS operation. This treatment would then allowthem to be incorporated on a gross basis—that is,quasi-fiscal taxes with budgetary revenue and quasi-fiscal subsidies with expenditure—in the conven-tional presentation of public sector operations; a cor-responding adjustment of the estimated net incomeof the affected PFIs would be made.

The adoption of these alternative approacheswould simply mean that QFAs, instead of beingburied in the accounts of the central bank and otherPFIs, would, to the maximum extent possible, bebrought out into the open and included as part of theanalysis of fiscal policy. This procedure would notrequire a change in established procedures for statis-tical compilation, since the proposed estimates ofquasi-fiscal taxes and subsidies would be used onlyfor analytical and financial programming purposes.

32This approach changes the distribution of the financial bal-ance of the overall public sector between the NFPS and the publicfinancial sector, although not its total.

Proposals to consolidate central bank budgetswith the government's budget have been opposed bysome on the grounds that consolidation would pre-commit monetary policy to an unacceptable degree;that it would circumscribe the central bank's flexi-bility to act as provider of liquidity and lender of lastresort. Even if this view is accepted, there is littlereason not to isolate those central bank activities thatare obviously fiscal in character. Thus, the centralbank could produce a budget that would differentiatebetween items for which a specific expenditure allo-cation is made, and those for which the outcome isneither predetermined nor publicly predicted.33

Structural Reform

Beyond the exercise of accurately measuring andilluminating the scope and magnitude of QFAs, the

33As an example, a budget consisting of those items for whichspecific allocations will be made could be constructed, includingthe central bank's own operating expenditures as well as expendi-tures for subsidized lending and any other QFAs. Separate projec-tions could be made for monetary operations, which would notneed to be published. Nonetheless, it would be expected that theresults of such operations would be reflected in the transfer ofcentral bank profits or budgetary provision for losses.

15


IV IMPLICATIONS FOR POLICY

Box 2. The Treatment of Quasi-FiscalActivity in a Common Currency Area

The issue arises whether the proposed treatmentof QFA might pose problems for a common cur-rency area such as the CFA franc zone of West andCentral Africa, or the East Caribbean CurrencyUnion (ECCU). In the CFA franc zone, monetarypolicy is largely conducted on a regional basis, withthe national central banks in the two regions actingessentially as agents for the two regional centralbanks. In such a setting, it is not obvious how to al-locate the cost of any QFA across governments.

However, a rule for the division of the losses fromQFA has to be worked out if the procedures advo-cated in this paper for incorporation of QFA in thebudget can be applied. If QFA can be quantified andhas not already been reflected in reduced transfersfrom the central bank, one criterion consistent withthat used in the paper would be to divide its costamong the member countries according to theirstipulated share in the profits (that is, their share ofthe capital) of the regional bank. Consequently, anytransfer made by the central bank to a member coun-try would, for analytical purposes, be reduced by theamount of the prorated loss incurred from QFA.

issue then remains whether such activities should bemore formally recognized as fiscal activities (thusreducing their impact on the net income and balancesheets of PFIs). One possibility would be for govern-ments to include QFAs explicitly in the budget, toexecute them through the normal budgetary chan-nels, and to subject them to the same scrutiny asother budgetary operations. A second and less radi-cal alternative would be to require the budget tomake explicit compensation to PFIs for the lossesentailed by any QFAs they are obliged to perform.The latter approach has been used by Ghana and Bo-livia in recent IMF-supported programs, but for par-ticular QFAs.

The first of these alternatives, if it could be imple-mented, would make QFAs more transparent andwould subject them to greater scrutiny than wouldthe second. Both alternatives, however, have draw-backs. First, some types of QFAs would normallyhave to remain within the accounts of the centralbank, simply because they would defy efforts to esti-mate them. As a consequence, it will not generallybe possible to apply either of the two approaches—at least not in a thoroughgoing way.

Second, and more fundamental, neither approachdeals with the problem of QFAs with distortive ef-fects on the allocation of resources. For example,converting an MER system into a set of explicit

taxes on trade, or converting a complex scheme ofdifferentiated reserve requirements into budgetarytaxes, only makes the practices more transparent.Their distortive effects on production and consump-tion decisions remain, although their presence in thebudget may make it more likely that the political willto eliminate them can be mustered.34

The ultimate solution to the truly harmful quasi-fiscal practices will often lie in measures outside thebudgetary realm. With reference to the two examplesjust given, the solution to the distortive effects of anMER system that on balance is a net tax on the econ-omy may be the adoption of a unified exchange ratesystem and a broadening of the base of a relativelyneutral levy such as the value-added tax. A perma-nent solution to distortive QFAs in PFIs will requirebasic reform of the banking system, rather than theinclusion in the budget of any subsidies or taxes tocompensate for those losses or gains resulting fromsuch quasi-fiscal instruments as selective credit con-trols and reserve requirements.

The importance of structural reform may be espe-cially great for economies in transition, where the fi-nancial system has long been expected, as a matterof course, to bail out loss-making establishments. Insuch conditions, it is particularly difficult to draw aline between the functions of the NFPS and PFIs.Here, reform has to extend beyond even the financialsystem, so that the systemic pressure on banks to fa-cilitate the violation of the hard budget constraint iseliminated at its source. Indeed, QFAs in the settingof a formerly centrally planned economy are, in asense, only a symptom of a far greater problem: thelack of incentives in the public enterprise sector forfinancial discipline.

The measures taken by Uruguay in mid-1992 inits IMF-supported adjustment program illustratehow these various approaches can be combined toaddress the problem of QFAs. To deal with the short-run macroeconomic and financial consequences ofQFAs, the central bank's net losses, the losses ofbanks that had received assistance from it, and thelosses of the state-owned mortgage bank were in-cluded in the measure of the overall public sectordeficit. At the same time, the authorities made acommitment to privatize the commercial banks thatremained in the public sector and to transfer part ofthe central bank's external debt to the treasury.Clearly, the solution to the problems posed by quasi-fiscal measures requires both a modification of tradi-tional definitions of public sector activity and struc-tural reforms.

34The implicit taxes and subsidies entailed by QFAs are notnecessarily undesirable—as taxes and subsidies. The subsidy cre-ated by an appreciated exchange rate could conceivably play arole in a social safety net, for example.

16


Appendix I Measurement andAccounting Issues

V arious problems that arise in defining QFA,and in measuring the quasi-fiscal component

of the operations of central banks and other PFIs,were briefly discussed in the text, as were the diffi-culties that can arise in consolidating the financialoperations of central banks with those of the NFPS.This appendix will address these issues at greaterlength.

Definitional Issues

A good starting point for the discussion is a mod-ified version of the narrow definition of QFA set outin Section II: an operation or measure carried outby a central bank or other PFI with an effect thatcan, in principle, be duplicated by budgetary mea-sures in the form of an explicit tax, subsidy, or di-rect expenditure and that has or may have an impacton the financial operations of the central bank orother PFIs.

This definition merits a number of observations:• It excludes certain activities that in some coun-

tries have entailed large losses for the central bank.One topical and important example is the losses thathave been incurred by policies to sterilize capital in-flows; another is the impact on a central bank's in-come statement generated by a restrictive open mar-ket operation.35 There is a sense in which theselosses—or any central bank loss—are fiscal, inas-much as they ultimately have to be covered by thegovernment. Although they do not have to entail atax or subsidy element, they are commonly referredto as QFAs.

• Consistent application of the definition may re-quire that certain activities normally consideredmonetary in character be recognized as having a fis-cal element. For example, most central banks im-pose a reserve requirement, and many of these donot pay a market-related rate of interest on their re-

35The central bank's income declines when it engages in openmarket operations selling bonds because it exchanges interest-bearing assets (bonds) for non-interest-bearing liabilities(money).

serves. If a reserve requirement results in banksholding a greater share of their assets in reservesthan they would in the absence of that requirement,it imposes a tax, as discussed in Section II.36 Yet thispractice may be seen by some as an integral part ofmonetary policy.

• The definition would also exclude some gov-ernment regulations and other acts of public policythat have little or nothing to do with either thebudget or monetary policy but that can have effectsakin to those of taxes and subsidies. For example, aregulation restricting the use of property can inflicta capital loss on the owner, and in this respect it issimilar to a tax on wealth. The definition excludesthese practices from the ambit of QFA, because theydo not directly affect the financial operations ofPFIs.37

• It would not include tax expenditures, whichare already covered by the budget and in principleare subject to budgetary scrutiny. This exclusiondoes not mean that a government should not beconcerned about the fiscal cost of special de-ductions from taxable income and the like. Theseare clearly important, but they are rather differentfrom the quasi-fiscal activity pursued by PFIs. Sim-ilarly, the definition excludes the estimated cost ofloan guarantee programs created by the governmentand other programs entailing contingent liabilities.As the paper stresses, these operations are poten-tially very costly, whether conducted by the govern-ment or by a PFI. See Towe (1993) for furtherdiscussion.

• The definition would exclude the inflation tax,in view of the following considerations:

—The inflation tax is not really an "operation" ora measure, but the end result of a particular

36It can be argued that to the extent that a depositary institutionhas access to central bank borrowing at more favorable termsthan it could obtain from the market, the institution receives asubsidy that compensates it in some measure for the reserverequirement.

37Regulations can, in principle, have macroeconomic conse-quences that public policy should take into account; a significantwealth effect, for example, could depress consumption.

17


APPENDIX I MEASUREMENT AND ACCOUNTING ISSUES

combination of monetary and fiscal policies.The term "tax" is, consequently, somewhatmisleading.

—The replacement of an explicit tax on moneybalances by the inflation tax entails a wholesalechange in the macroeconomic environment(that is, an increase in the rate of inflation). Re-placing an export tax by an MER practice has,by contrast, no such effect.

—The rate of the inflation tax will not typicallyequal any given rate of an explicit tax on moneybalances.

Another implication of the definition is that itsstrict application would exclude certain types of op-erations that entail the creation of taxes and subsi-dies through the financial system when these haveno direct impact on the net income of the centralbank or other PFIs. As discussed in Section II, thecentral bank may establish regulations setting maxi-mum lending rates and deposit rates for commercialbanks, both privately and publicly owned. Artifi-cially low deposit rates are like a tax on savers, andlow interest rates are a subsidy to borrowers. Yet thenet income of PFIs may be entirely unaffected by theregulations (that is, if there are no publicly ownedcommercial banks). These kinds of regulations beara certain resemblance to employer-mandated benefitplans. Nonetheless, these operations do affect the fi-nancial operations of the government, as previouslydiscussed, because they artificially lower the cost ofborrowing.

Since the spirit of these regulations is the same aspreferential interest rates and other QFAs, and sincethey impose a tax that ultimately benefits thegovernment, the definition could be expanded to in-clude them. The modified definition would be as fol-lows: an operation or measure carried out by a cen-tral bank or other PFI with an effect that can, inprinciple, be duplicated by budgetary measures inthe form of an explicit tax, subsidy, or direct expen-diture and that has or may have an impact on the fi-nancial operations of the central bank, other PFIs, orgovernment.

In practice, QFA is defined even more broadly,since it can refer to any operation that has a sig-nificant impact on the net income of a PFI.That said, there is some merit to distinguishingbetween such practices as MERs or subsidizedinterest rates, which clearly entail taxes andsubsidies, and practices such as open marketoperations, which have fiscal implications but can-not be so obviously duplicated by explicitly bud-getary operations. The paper has relied on a defini-tion of QFAs broad enough to encompass thesekinds of operations, while paying special attentionto those operations of a more obviously fiscalcharacter.

Problems Resulting from theUse of Cash Versus AccrualAccounting

Most Fund member countries measure the fi-nancial operations of the NFPS or central govern-ment on what might be called a modified cashbasis—taxes and other revenues are recorded ascollected, and expenditures when they are paid,with interest recorded when due, and sometimeswith an adjustment for changes in arrears. Financialinstitutions, and central banks in particular, will typ-ically use accruals-based accounting. To take a fewexamples: interest on loans is recorded when it isdue, not when it is paid; provisions for doubtfulloans, loss write-offs, or loss reserves will be madethat have no counterpart in a cash transaction; de-preciation of physical assets is recorded as an ex-pense; expenditure on capital assets is recorded inthe capital account and does not affect the net in-come position. For all these reasons, it cannot be as-sumed that the cash transfer made by the centralbank to the budget in a given period will equal itscash income for that period, measured in the sameway as the operations of the NFPS, even if it trans-fers 100 percent of its accrued income to the centralgovernment.

To derive the enlarged public sector balance de-scribed earlier—to amalgamate central bank orother PFI income (losses) with the balance of theNFPS in a consistent way—requires that somefairly major adjustments be made. However, sincethe operations of the NFPS or the central govern-ment are not measured entirely on a cash basis, nei-ther should the operations of the PFIs. For example,if interest paid to the central bank by the centralgovernment is measured on an accrual basis thebank's receipts should be measured in the same wayto avoid inconsistency. There is also a potentialproblem with a cash-based measure of central bankincome: it has happened that borrowers in arrears ontheir interest obligations to public sector banks haveobtained fresh loans to pay off their arrears. Thiskind of operation can be used to reduce artificiallythe overall public sector deficit. To avoid this kindof manipulation, appropriate bank supervisory regu-lations prohibiting such recapitalization of interestshould be put in place.

The accounting treatment of net lending by thecentral bank for policy purposes deserves particularattention. Such operations, if conducted through thebudget, are recorded as above-the-line transactionsin the framework of the IMF's government financestatistics (International Monetary Fund, 1986).Hence, they increase the deficit. Typically, theywould not be treated this way in the accounts of thecentral bank.

18


Problems Resulting from Foreign Exchange Transactions and MER Systems

Particular Problems Resulting fromForeign Exchange Transactions andMER Systems

This section begins with a brief discussion of ac-counting procedures for spot foreign exchange trans-actions without the added complication of the quasi-fiscal taxes and subsidies entailed by MERs.38 Itthen takes up the special problems posed by MERs.

In its role as custodian of a country's foreign ex-change reserves, a central bank is constantly accru-ing or realizing losses or gains in its foreign ex-change transactions. Considering first losses or gainsthat are not realized—those that result from a changein the value of the stock of foreign exchange—thestandard treatment, whatever the precise rule used tovalue foreign exchange, is to make a counterpartentry in the revaluation account. If central banksmake a daily valuation of their reserves based on theaverage daily rate, then the revaluation account isalso changed on a daily basis. These accrued gainsor losses, however, are not reflected in the centralbank's income and loss statement.39 This treatmentof accrued losses or gains is consistent with the stan-dard presentation of the financial operations of theNFPS. The same conclusion holds true when valua-tions are less frequent, provided that a counterpartentry is made in the revaluation account.

This use of the revaluation account makes no dis-tinction between nominal and real gains and losses.Thus, for example, the central bank's foreign ex-change reserves can actually increase or decrease inreal terms without there being any effect on the in-come and loss statement. Such accrued losses orgains, however, do affect the strength of a country'sreserve position and cannot be entirely ignored.

In general, recommended accounting practicecalls for only realized gains on foreign exchangetransactions to be brought to the profit and loss ac-count. A number of central banks (perhaps mostprominently the U.S. Federal Reserve System), how-ever, include both realized and unrealized gains andlosses in the profit and loss statement; that is, theyinclude the valuation change on the stock of net for-eign assets (NFA). In such cases it is clear that, inorder to ensure consistency with government ac-counts, the central bank operating result would needto be adjusted before amalgamating it with NFPSoperations.

38The issues this section discusses are also addressed by Leone(1994).

39The preferred accounting treatment requires that if the bal-ance of the revaluation account becomes negative (if accumulatedlosses exceed accumulated gains), the loss should be chargedagainst the profit and loss account.

Given the way realized gains are frequently mea-sured, their inclusion could be problematic. To take aconcrete example, suppose a central bank had ac-quired its target level of foreign exchange reserves atan average rate of LCU 1 per U.S. dollar, and thatthe exchange rate had subsequently been devalued toLCU 2 per dollar. At the time of the devaluation, arevaluation gain of LCU 1 million for each $1 mil-lion of reserves would have been recorded. Withoutany sales of foreign exchange, this gain would nothave affected the profit and loss account.

If the bank now sells $1 million at LCU 2 per U.S.dollar, the monetary base and NFA each decline byLCU 2 million. If it subsequently repurchases theforeign exchange with monetary base at the samerate—LCU 2 per dollar—the earlier transaction isreversed. In determining profits and losses for theyear, however, the bank's accountant would debit therevaluation account by the amount of profit deemedto be realized from the sale of foreign exchange. Ifthe foreign exchange sold was valued at LCU 1 perdollar, the sale is recorded as generating a profit ofLCU 1 million, which is added to the profit and lossaccount and subtracted from the revaluationaccount.

The economic justification for distinguishing thisas realized "profit" is rather dubious, however. In theexample given, the balance sheet would have beenidentical had the central bank undertaken no inter-vention (presuming the final exchange rate was un-affected by the intervention). The only differencewould be that in the latter case the accountant wouldnot have debited the revaluation account and addedthe amount to the profit and loss statement, since notransactions had taken place.

An analogy could be made with the use of first in,first out (FIFO) accounting by any enterprise withinventories in an inflationary period. Historic costpricing means that accounting profits are artificiallyoverstated; the cost to the enterprise of replacing itsinventories has risen, and once it has replaced themit is in the same position as before with the exceptionthat the value of its inventory has risen. The profit is"locked up" in the inventory, however, and the enter-prise does not realize this gain unless it reduces itsstock of inventory. The same is true of the centralbank. If it maintains an unchanged target for NFA, itwill not effectively realize a gain on its foreign ex-change holdings despite gross sales and purchases inthe market.

We now consider the valuation and classificationproblems posed by MERs. Two cases should be dis-tinguished: when the central bank's NFA do notchange, and when they do. As a simple example,take a three-rate MER system in which the officiallydesignated central rate is LCU 2 per dollar, with aspecial appreciated rate of LCU 1 per dollar apply-

19



Table 2. Impact of an MER System on the Central Bank's Balance SheetWith No Change in Reserves

A. Foreign Exchange Transactions and Their Monetary Impact

Exchange Rates (LCUs per dollar) At

I 2 3 All Rates

Net sales (net purchases - )(in millions of dollars) -1,000 1,000

Monetary impact(in millions of LCUs) 1,000 -3,000 -2,000

B. Impact on the Central Bank's Balance Sheet(in millions of LCUs)

Monetary impact -2,000Change in NFA —Change OIN

(central bank profits) 2,000

Note: LCUs, local currency units; NFA, net foreign assets; OIN, other items net.

ing to certain exports, and a depreciated rate ofLCU 3 per dollar applying to certain imports.

In the first case, where net sales at the central rateare zero, the sale of $1,000 million to importers atthe special rate and the purchase of $ 1,000 millionfrom exporters at their special rate entail no changein NFA, a reduction in the monetary base (or nega-tive monetary impact) of LCU 2,000 million, and anincrease in OIN (other items net) of LCU 2,000 mil-lion, reflecting the central bank's profits from theoperation (Table 2). These calculations are not af-fected by the choice of the central rate, even if thatchoice is to some extent arbitrary, because there isno change in NFA.

What would be affected by the choice of the cen-tral rate, however, is the classification of the quasi-taxes or subsidies entailed by the MER system. If, inthe example just presented, the officially designatedcentral exchange rate applies to most transactions,then this may not be an issue. However, the structureof a multiple rate system might be such that therewere at least two plausible candidates for the centralrate. In this case, any measure of the tax or subsidyequivalent of special exchange rates will inevitablybe arbitrary.

When the level of international reserves changes,the choice of the central exchange rate does matterfor the calculation of central bank income. To returnto the earlier example, now augmented by a fourthexchange rate of LCU 2.5 to the dollar, let us sup-pose that net sales of foreign exchange at the rates ofLCU 2 and LCU 2.5 are zero, but that sales of for-

eign exchange to importers at the rate of LCU 3 tothe dollar are now $500 million, not $1,000 million.

The monetary base is reduced by LCU 500 mil-lion, but the measured impact on OIN clearly variesdepending on which exchange rate is used to valuethe change in reserves (Table 3). This result is a sim-ple illustration of the inventory valuation problem,but it does illustrate how different accounting con-ventions will affect the measure of central bankincome.

The conventional approach to the valuation of re-serve gains and losses—the use of the rate at whichmost official transactions take place—becomes evenmore problematic when none of the official ex-change rates is close to the free-market rate. In sucha case, the use of any official exchange rate for valu-ation purposes can be quite misleading. To take anextreme example, suppose that the free-market ratein the example above is LCU 10 to the dollar. If thisrate, rather than an official rate, is used to value thereserve gain, the calculated impact on central bankincome is substantially different. Even when there isno change in NFA, the use of official exchange ratesin such a situation to measure the relative size of theimplicit taxes and subsidies created by the exchangesystem will be seriously misleading.

Reserve Requirements

Section III discussed the role of reserve require-ments as quasi-fiscal taxes. When banks are obliged

20


Reserve Requirements

Table 3. Impact of an MER System on the Central Bank's Balance Sheet:With Change in Reserves

A. Foreign Exchange Transactions and Their Monetary Impact

Exchange Rates (LCUs per dollar) At

_ J 2 ^5 3 All Rates

Net sales (net purchases —)(in millions of dollars) -1,000 — — 500 -500

Monetary impact(in millions of LCUs) 1,000 — — -1,500 -500

B. Impact on the Central Bank's Balance Sheet(in millions of LCUs)

With Exchange Rate With Exchange Rateofl_CU2 = $l of LCU2.5 = $I

Monetary impact -500 -500Change in NFA 1,000 1,250Change in O IN (central bank profits) 1,500 1,750

Note: OIN, other items net.

to hold reserves and are paid a lower rate of interestthan they would earn on an alternative and equallyattractive investment, they are in effect being subjectto a tax. If banks' reserves are lent to the govern-ment, and if this lending is a substitute for sales ofgovernment securities to the private sector, then thegovernment is in effect given an interest subsidy thatequals the difference between the rate of interest ongovernment bonds (ib) and the rate of interest paidto banks on their reserves (ir) times the stock of re-serves (R). The amount of the subsidy (S) is thusgiven by

S = (ib - ir)R.

If reserves are a certain fraction (k) of deposits(D), the subsidy may be re-expressed as:

S = (ib - ir)(kD).

This subsidy can affect the financial operations ofthe government in one or a combination of twoways. If the central bank does not charge interest onits loans to the government, its net income is reducedby the imposition of—or increase in—a reserve re-quirement, since it may pay interest on the bank re-serves. This means that transfers of central bankprofits to the government will be lower than other-wise.40 However, this negative impact on the gov-

40This will be the case if the marginal rate of transfer of centralbank profits is positive.

ernment's accounts will be more than offset bylower explicit interest payments by the government,since ib exceeds ir. Although government borrowingis subsidized, the explicit rate of interest on govern-ment securities is not reduced; instead, the amountof borrowing by this means is reduced.

If the central bank does charge a market rate of in-terest on its loans to the government, the govern-ment's interest expenditures will not be affected.The central bank's net income will be affected, how-ever, and the increase in its transfer to the govern-ment will reduce the budget deficit. Despite the factthat interest expenditure is not affected, the imposi-tion of a reserve requirement where reserves arecompensated at a rate below the market effectivelylowers the government's cost of borrowing.

The reserves tax does not have to be used to subsi-dize lending to the government; it can be used to fi-nance any expenditure. Nonetheless, the use of arti-ficially high reserve requirements to channel creditto the government is certainly not uncommon.

The quasi-fiscal tax on reserves can be madetransparent by including it—for analytical purposesat least—in government tax revenue, which willthen increase by the value S. If the central bank hasnot been charging the government interest on theloans that are financed by the increase in reserves,this should be offset by an increase in interest pay-ments of the same amount. When the central bankhas been charging interest, the increase in tax rev-enue should be offset by a decline in central bank

21



income—if a marginal rate of transfer of centralbank profits of 100 percent is assumed, then thegovernment's property income is reduced by theamount of the tax.

This discussion has focused on how the tax en-tailed by reserve requirements is determined, and onthe way it shows up in the public sector's financialaccounts. The incidence of the tax is another matter.To the extent that reserve requirements lower de-posit rates, for example, then depositors bear part ofthe cost; higher lending rates mean that borrowerspay part of it as well. These issues have been dis-cussed at some length in Molho (1992).

Contingent Liabilities

The problems posed for the contingent liabilitiesentailed by a central bank's quasi-fiscal operationsare essentially the same as those posed by similaroperations of the central government. Both centralbanks and central governments can guarantee loans,for example. In both cases the size of the operationscan be very large, but it will have no impact on acash-based measure of the financial operations ofthe government until money is actually paid out for aloss. The inadequacies of a cash measure of the pub-lic sector's operations, when contingent liabilitiesare important, have been the subject of some com-mentary (see Towe, 1993, for example). At a mini-mum, cash-based measures of the deficit should besupplemented with a measure of the outstandingvalue of contingent liabilities.

Substantial valuation problems may arise withcontingent liabilities; these problems are not uniqueto the operations of central banks and other financialpublic institutions. To take the case of loan guaran-tees, should one seek data on the total stock of loansthat are guaranteed or just that part of the stock thatis deemed to be at risk of nonperforming? Often theinformation that would permit the calculation of theexpected value of realized losses entailed by a con-tingent liability program may not be available.41

Towe (1993) has described one method for calcu-lating the capitalized subsidy element created by aloan guarantee. This is the present value of the re-duction in interest payments that results from theguarantee and is given by the following formula,where L is the loan principal, iw is the interest ratethat would have been obtained without the guaran-tee, and is is the guaranteed rate:

4'The valuation of the cost of a loan guarantee was discussedby Fries (1992). The issue of the treatment of loan guarantees andother contingent liabilities in the budgetary accounts was also dis-cussed in U.S. Congress (1990).

5 > _ y (**' - is) L L (l+lH ' )wJ

i=i (1 + iw)r iw

Inflation Adjustment

The adjustment of the conventional measure ofthe financial balance of the NFPS to take account ofthe impact of inflation on the real value of net pub-lic debt is a controversial issue.42 Nevertheless,inflation-adjusted deficits can play a useful comple-mentary analytical role to traditional indicators ofthe fiscal stance. The basic rationale for the adjust-ment is that the inflationary component of the gov-ernment's interest expenditure is really a form ofamortization. It compensates the holders of publicsector debt for the decline in the real value of theirassets; therefore it should not be classified as a cur-rent expense of the government or as income in thehands of the recipient.43

The income statements of central banks are alsoaffected by inflation, and the issue arises whether theconventional results need to be adjusted for infla-tion. This section briefly discusses some of the con-sequences of using the standard inflation adjustment,with the aid of this highly simplified central bankbalance sheet:

Assets Liabilities

Net foreign assets (NFA) Monetary base (MB)Net credit to government (DCG)Net credit to private sector (DCP) Net worth (NW)

It is assumed, for simplicity, that the bank has nooperating costs and no physical assets. Also for sim-plicity, net worth includes the valuation adjustmentfor changes in the nominal value of foreign ex-change; hence, it reflects not only nominal increasesin the bank's net credit position, other things beingequal, but also increases in the nominal (local cur-rency) value of foreign exchange.44

If the real rate of interest, r, on domestic and for-eign assets is the same, the real exchange rate is con-stant, and no interest is paid on the monetary base(MB) then nominal profits can be expressed as

42Interesting discussions of this subject can be found in Teijeiro(1989) and Fry (1993).

43On the general issue of the impact of inflation on the fiscaldeficit, see Tanzi, Blejer, and Teijeiro (1993).

44Conventional accounting would place nominal revaluationgains in a revaluation account. This is, in effect, an inflation ad-justment for foreign assets. Here the adjustment applies to thewhole of the bank's operations, and it is therefore acceptable toinclude nominal revaluation gains in the rest of the bank's nomi-nal income.

22


Inflation Adjustment

NFA(r + pw + d) + (DCP + DCG)(r + pd),

where r is the real rate of interest, d is the rate of de-preciation of the local currency, and pw and pd arethe international and domestic inflation rates.45 Thiscan be reexpressed as

NFA(r + pd) + (DCP + DCG)(r + pd).

Adjusted for inflation in the usual way, centralbank income would then become

NFA(r + pd) + (DCP + DCG)(r + pd) - pdNW

or

r(NFA + DCP + DCG) + pdMB.

But this would include a measure of the inflationtax, pdMB, in the real income of the central bank.Thus, if the "real" component of the central bank'sincome were transferred to the government, revenuefrom the inflation tax would be counted above the

45 A constant real exchange rate requires that pw + d = pd.

line. This suggests that the standard approach to ad-justing deficits for inflation is not appropriate in thecase of the central bank. Eliminating the inflation taxterm from the preceding equation would simplyleave:

r(NFA + DCP + DCG).

If, for the sake of argument, it is assumed that thecentral bank were paying the market rate of intereston the entire monetary base, then the conventionaladjustment would result in the following statementof real income:

r(NFA + DCP + DCG - MB).

In this case, however, the central bank would becompensating holders of the MB by paying amarket-related rate of interest on its liabilities. Thecentral bank is—by assumption—not exploiting itsmonopoly over money creation, and it is earn-ing simply the market-related return on its networth (the expression in parentheses equals NW). Inthis case, the conventional adjustment would beappropriate.

23©International Monetary Fund. Not for Redistribution

Appendix II Varieties of Country Experience

T his appendix describes a variety of QFAs thathave been practiced in IMF member countries.

Its intent is to give a flavor of the many forms thatsuch practices can take; the countries whose experi-ence is cited here are not the only ones where suchpractices may be found. The experience of quasi-fiscal practices in IMF member countries is veryrich, and an exhaustive treatment would requiremany pages.

MER Practices

An example of the subsidy entailed by a preferen-tial exchange rate can be drawn from the experienceof Costa Rica, where the central bank, during the pe-riod 1979—82, sold foreign exchange at lower ratesin domestic currency than those at which the foreignexchange had been purchased. These subsidies weremainly for imports of certain medicines, medicalequipment, and petroleum products, and for publicexternal debt service. In 1981, the subsidiesamounted to 41/2 percent of GDP (United Nations,1991a).

A second subsidy arrangement in Costa Rica in-volved a broader set of beneficiaries. In 1981, duringa foreign exchange crisis, a large backlog of requestsfor foreign exchange accumulated at the centralbank. Unable to satisfy the demand, the central bankcompensated importers who purchased foreign ex-change in the parallel market by issuing foreign-exchange-denominated bonds paying the six-monthLondon interbank offered rate (LIBOR) and equiva-lent to the difference between the official exchangerate and the rate importers had to pay in the parallelmarket.46 The face value of these bonds issuedamounted to 12.7 percent of GDP and accrued an an-nual interest cost of 2 percent of GDP (United Na-tions, 1991a).

46For the purposes of the subsidy, a maximum of C 15 per U.S.dollar was set on the parallel market rate deemed to have beenpaid by importers without access to foreign exchange at the offi-cial rate, which was C 8.60 per U.S. dollar.

A good example of a simultaneous implicit taxand subsidy scheme operated through the foreignexchange market is provided by Egypt, where, be-fore the exchange system reforms of 1991, a sepa-rate foreign exchange pool was established for cer-tain transactions. Implicit taxes were imposed onexports of petroleum and cotton and Suez Canaldues. Foreign exchange was provided at a subsi-dized rate for certain foodstuffs and external publicsector debt-service payments. Net foreign exchangepurchases by the central bank at the more appreci-ated rate—and, consequently, net profits or lossesobtained from the operation of the system—variedover time, reflecting, among other influences, move-ments in international oil prices and the impact ofarrears, rescheduling, and forgiveness on actual pay-ments of external public debt service.

In Venezuela, in the period from 1983 up to theadoption of a unified freely floating exchange ratesystem in March 1989, the most important quasi-fiscal operation of the central bank related to theoperation of an MER system. In December 1986, thecentral bank rate applying to most imports wasBs 14.5 per U.S. dollar, compared with a free marketrate of about Bs 22 per dollar. Imports of food-stuffs and certain other items were permitted a rateof Bs 7.5 per dollar, and certain debt-servicepayments were transacted at Bs 4.3 per dollar.Petroleum export receipts, which accounted forapproximately 90 percent of Venezuela's foreigncurrency earnings, were converted at Bs 7.5 dollaruntil mid-1987, when the rate was changed toBs 14.5 per dollar.

The net outcome of the system was to generateprofits for the central bank until the devaluation ofthe rate applied to oil exports, whereupon the bal-ance shifted to a deficit. The resulting decline inprofitability of the central bank was exactly offset bythe increased profitability of the state oil company,so that the combined balance of the central bank andthe NFPS was not affected by the change to the ex-change rate. The recourse to the overvalued rate forpetroleum transactions did, however, obscure theimportant role played by the state oil company in thegeneration of public sector revenues.

24


Exchange Rate Guarantees and Assumption of Exchange Rate Risk

A further example of the way in which the lack oftransparency that results from the implicit taxes andsubsidies of an MER regime can extend beyond theimpact on the central bank's accounts is furnished bythe experience of Uganda in 1987-88. The officialrate of U Sh 60 per U.S. dollar was in sharp contrastto the parallel market rate of U Sh 200-400 per dol-lar. The Coffee Marketing Board was surrenderingits foreign exchange earnings at the official rate tothe Bank of Uganda, which was selling, in part, toparastatal enterprises at approximately the samerate.

Because the revenue from the coffee export taxwas determined by the difference between the aver-age export price expressed in local currency at theofficial rate and the price paid to farmers plus pro-cessing, transportation, and marketing margins—which were also subject to strong inflationary pres-sures—budgetary revenue from the coffee export taxwas declining sharply. Certain parastatals, however,including the state-owned breweries and the tobaccocompanies, were allocated foreign exchange at theofficial rate, which artificially reduced their costs,allowing the government to impose excise taxes athigh rates on tobacco and liquor.

Casual observation of the official statisticsshowed a decline in coffee revenue and a quite spec-tacular increase in excise collections. Had thesetransactions been valued at a more appropriateshadow exchange rate, they would have revealed thecontinued crucial role of coffee taxation and theoverstatement by the conventional revenue measureof the role of excise taxation on beer and cigarettes.

Exchange Rate Guarantees andAssumption of Exchange Rate Risk

The experience of Chile in the debt crisis thatbegan in 1982 provides examples of quasi-fiscal op-erations involving the exchange system, includingrecourse to both subsidized exchange rates and ex-change guarantees. Following the devaluation inJune of 1982, the central bank undertook to provideforeign exchange at a subsidized rate to private sec-tor entities with large external debt obligations. IMFstaff estimates suggest that the cost of this operationaveraged about 2 percent of GDP a year during1983-85.

As part of a second policy initiative that began in1983, the central bank offered foreign exchangeguarantees to help obtain scarce foreign exchangereserves. The central bank purchased foreign ex-change and entered into a commitment to resell it atthe same real exchange rate (that is, the initial rateadjusted for domestic inflation minus foreign infla-tion) after one year. An interest premium was also

paid on these "swaps." Its costs were estimated atabout 0.5 percent of GDP a year during 1984-86.

As part of a third operation related to the schemeto restructure private debt, the central bank assumedcertain external liabilities of the private sector.Again, as the result of a substantial real currency de-valuation, the central bank incurred losses averaging1 percent of GDP in 1983-84.

In the former Yugoslavia, the primary factors be-hind the sizable quasi-fiscal deficit of the NationalBank of Yugoslavia (NBY) in the late 1980s werethe exchange rate guarantee extended for foreigncurrency deposits and the policy of maintaining per-sistently negative real interest rates. The exchangerate guarantee worked as a redeposit scheme. Banksredeposited their foreign currency with the NBY. Inreturn, they could obtain a dinar credit from theNBY up to the value of the redeposited foreign cur-rency at the current exchange rate. The valuationlosses accrued to the NBY and were realized uponwithdrawal of the foreign exchange by the banks.The rules of withdrawal, however, were not alwaysclear and were often changed. Although the bankssoon discovered that it was profitable for them towithdraw deposits, and then to redeposit themagain, the central bank sought to prevent this fromoccurring.47

At first, banks were not paid interest on their de-posits, nor did they pay interest on the loans fromthe NBY. Banks profited because they paid interna-tional interest rates on the deposits but were able tolend out the domestic currency counterpart of thesedeposits at much higher nominal rates in the domes-tic market. Because of exchange rate devaluations,however, their liabilities grew more rapidly thantheir credits, and the interest costs of servicing thestock of foreign currency deposits increased corre-spondingly. In response to this, the NBY consentedto pay an interest rate on the foreign currency de-posits that was equivalent to international marketlevels; in turn, it charged the discount rate on thedinar credits. In the meantime, however, these dinarcredits became only a fraction of the amount of for-eign currency deposits. Under these revised arrange-ments, the operations continued to be very profitableto the banks. The arrangements were canceled in Oc-tober 1988, so that net increases in the stock of rede-posits after that date no longer benefited from theguarantee. The consolidated banking system—theNBY and commercial banks taken together—real-ized huge losses as a result of its foreign-exchange-

47By withdrawing and redepositing, the banks were able to in-crease the value of their interest-bearing assets while continuingto benefit from the difference between the interest rates on theirdomestic-currency-denominated assets and the rates on their for-eign-currency-denominated liabilities.

25


APPENDIX II VARIETIES OF COUNTRY EXPERIENCE

denominated liabilities. The counterpart of theselosses was subsidized credits to the state corporatesector.

Subsidized Lending

In Turkey, the agricultural bank used to extendcredits to the agricultural sector at subsidized rates,financing them in part through rediscounts from thecentral bank, as well as deposits from other publicsector entities, on which it paid below-market rates.This practice ended in April 1994. In the former Yu-goslavia, the NBY refinanced commercial bankcredits to agriculture at subsidized rates.

In Argentina before 1990, the central bank bor-rowed from private banks and typically on-lent theseresources to official banks at both the national andprovincial levels at subsidized interest rates. Theseinstitutions in turn financed the budgets of theprovincial governments, as well as the operations ofcertain loss-making public enterprises. The NationalMortgage Bank, relying on central bank financing,granted subsidized credits that became largely non-performing assets. In Uruguay, the Bank of the Re-public of Uruguay has extended a significant amountof subsidized credit, and the mortgage bank hasacted similarly to finance housing and constructionactivity.48

In Bangladesh during the 1980s, state-ownedcommercial banks were directed to grant sizablequantities of credit to preferred sectors, most promi-nently agriculture, often at interest rates below theircost of funds. The directed nature of credit reducedthe banks' autonomy and undermined incentives forproper credit evaluation. Consequently, subsequentloan recovery from priority sectors was poor, andasset quality suffered. Even though the banks be-came insolvent de facto, lax accounting and supervi-sion permitted them to continue to show profits ontheir books and to pay taxes and dividends to thegovernment. In light of the revenue implications, thegovernment tended to turn a blind eye to these prac-tices, which effectively entailed financing transfersto the government out of new deposit growth.

In China and India, countries with a legacy of cen-tral planning, the public banking systems are heavilyinvolved in directed lending. In China, "policyloans" are broadly defined as loans for long-gestation, low-return, high-risk projects consideredessential for national economic development (gener-ally at preferential interest rates and according topriorities determined by the central government).

48The experience of Uruguay is discussed further in Appen-dix III.

Such loans were in the past provided by specializedbanks, but in 1994 this responsibility was transferredto specially created policy banks, paving the way forthe gradual commercialization of the specializedbanks.

The three policy banks that were created—theAgricultural Development Bank, the State Develop-ment Bank, and the Export-Import Bank—have beengranted different mandates. For the Agricultural De-velopment Bank, policy lending will entail loans forbuilding grain reserves, poverty alleviation, agricul-tural development, small-scale farming, animal hus-bandry, water conservation, and technical innova-tion. The State Development Bank is expected tofinance infrastructure and the "pillar" industries. TheExport-Import Bank will provide finance for importsas well as buyers' and suppliers' credits for exportsof capital goods (such as ships, aircraft, communica-tions satellites, and production facilities).

Selective Reserve Requirementsand Credit Ceilings

In Egypt, under the system in effect before theend of 1990, all commercial banks were required tohold 30 percent of specified foreign- and domestic-currency-denominated liabilities in the form of liq-uid assets, the most important of which were govern-ment bonds. This tended to create a captive marketfor government securities, which were sold at nega-tive real interest rates. In Kenya, commercial banksand nonbank financial institutions are required tomaintain a minimum liquid assets ratio; liquid assetsare defined as notes and coins, balances held at thecentral bank, balances with other domestic commer-cial banks and banks outside Kenya, and treasurybills. Until December 1995, at least 50 percent ofliquid assets had to be in treasury bills.49 Instancesof similar practices in other countries could readilybe given. Typically, they lower the costs of publicdebt service at the expense of the financial institu-tions—or their customers—on whom the minimumratios are imposed.

India provides an example of the use of selectivecredit ceilings. The Reserve Bank of India requiresbanks (the major commercial banks are governmentowned) to allocate 40 percent of total credit to prior-

49The Central Bank of Kenya has also designated certain otherinstruments as constituting part of a bank's liquid assets. Theminimum assets ratio for commercial banks and other nonbank fi-nancial institutions is currently fixed at 25 percent, except in thecase of mortgage finance companies, where the ratio is set at 20percent. The requirement regarding treasury bill holdings waseliminated for nonbank financial institutions at the end of 1995,and that for commercial banks in early 1996.

26


Rescue Operations

ity sectors such as agriculture, small-scale farmers,and small borrowers, with subtargets for each. Forexample, credit to small farmers should not fallbelow 9 percent of the total. Interest rates on loans topriority sectors are set by the Reserve Bank and en-tail a subsidy element.

In Greece, although the state-owned banks are runon a commercial basis, at times some of them havebeen pressed to extend credit to nonviable or loss-making firms, a practice that was reflected in a dete-rioration of the banks' loan portfolios as well as theirprofitability.

Rescue Operations

In Chile, in December 1981, the central bank in-tervened in four banks and four finance houses thatwere in liquidation and granted emergency creditamounting to approximately 8/2 percent of GDP tothese institutions. During the following four years,the central bank continued to grant emergency cred-its to commercial banks and also purchased a portionof their nonperforming loans. This latter operationwas in the form of a repurchase agreement whereinthe banks were committed to repurchase the loansout of future profits. The central bank purchased 60percent of the nonperforming loans with securitiesthat paid a real rate of return of 7 percent and ma-tured in four years, while the commercial bankswere given an indefinite period during which theywould repurchase the loans, to which a real interestcost of 5 percent a year was applied. The flows re-lated to these operations amounted to 3.2 percent ofGDP in 1982 and 12.5 percent of GDP in 1983 but,by 1987, had turned negative as repurchases ex-ceeded loans (United Nations, 1991b).

The Central Bank of Chile also financed a debtrescheduling between domestic banks and domesticdebtors. Commercial banks were granted subsidizedcredits to finance an exchange by their debtors ofshort-term liabilities at market interest rates forlong-term debt at subsidized rates. This had the ef-fect of improving the quality of the commercial bankloan portfolio, given the enhanced likelihood that thedebtors would be able to service the subsidized debt.The program was most active in the period 1984-85,with average annual reschedulings of 4 percentagepoints of GDP.

In 1990, state banks in Brazil were experiencingserious financial difficulty because they were unable

to roll over the debts of their state treasuries. In theirefforts to deal with this difficulty, the state banksraised overdrafts on their legal reserves, obtainedlarge rediscount loans from the central bank, andsold certificates of deposit at rates well above thoseoffered by private banks. In early 1991, the centralbank and the governments of the four largest statesreached an agreement for the temporary financing ofthese banks' debt through a swap of central bank se-curities for state securities amounting to approxi-mately 2 percent of GDP.

In Uruguay, the collapse of the system of prean-nounced devaluations in late 1982 prompted a finan-cial crisis, which resulted in the deterioration of asubstantial portion of the banking system's loanportfolio. In response, the central bank institutedseveral programs, of which the most important in-volved the central bank's purchasing the nonper-forming loan portfolios of commercial banks with itsown foreign-currency-denominated bonds andpromissory notes paying market-related interestrates. Because the central bank issued liabilitiesamounting to approximately $965 million and re-ceived in exchange largely nonperforming assets, alarge part of its quasi-fiscal losses are accounted forby this operation. In the Philippines, a rescue opera-tion of troubled financial institutions by the centralbank in the mid-1980s also entailed the acquisitionof nonperforming assets and contributed to substan-tial quasi-fiscal losses.

In Greece, where there exists no deposit insurancescheme and the central bank's statutes do not explic-itly provide for a lender-of-last-resort function, an il-lustrative case of central bank intervention occurred.In 1988 the Bank of Crete, the ninth-largest commer-cial bank, faced a severe crisis owing to mismanage-ment and fraud. The management of the bank wasremoved and replaced by a Bank of Greece commis-sioner. The bank was provided liquidity through over-drafts at the Bank of Greece and by blocking depositsthat public enterprises had maintained at the bank.The overdrafts were subsequently converted into aloan with a concessional rate of interest. The capitalof the bank was extinguished, and Dr 10 billion(about 0.1 percent of GDP) of the public enterprises'deposits were converted into preferred nonvotingshares, while the remaining deposits were convertedinto a five-year loan with an interest-free grace pe-riod. The directed use of public enterprise deposits(quite similar to the directed use of central bank redis-count facilities) is by no means unique to Greece.

27


Appendix III Five Country Case Studies

Uruguay

The history of QFA in the central bank and certainother PFIs since the early 1970s50 can be dividedroughly into three periods: the first, which endedwith the foreign exchange crisis of late 1982; the fol-lowing decade; and the period since 1992.

The most important QFA in the years just preced-ing the foreign exchange crisis was the support thecentral bank was required to extend to the mortgagebank to finance its lending program for low-costhousing. In 1982, the quasi-fiscal losses on this sin-gle operation exceeded 7 percent of GDP. Anothersource of losses was the preferential rates on loansfor nontraditional exports and meat packing chargedby the Bank of the Republic. These loans were redis-counted at preferential rates by the central bank—which thus absorbed the loss—until late 1976.

The collapse of the system of preannounced de-valuations (the tablita) in November 1982 resultedin a substantial unexpected depreciation of the pesoand led to a financial crisis that severely damagedthe quality of the loan portfolios of the commercialbanks. Many of their customers had borrowed heav-ily in U.S. dollars and suffered a substantial loss as aresult of the abandonment of the tablita and the gen-eral worsening of financial conditions.

In response to the crisis, the central bank intro-duced a portfolio purchase scheme to acquire thenonperforming loans of the foreign-owned banks.Medium-term financing for this scheme was pro-vided by the parent banking companies. In 1983,some local banks were included in the scheme; theweakest of them were subsequently taken over byforeign banks under an arrangement worked outwith the central bank. As part of the arrangement,the central bank acquired the weakest part of thesebanks' loan portfolios—on which it would earn nointerest—in exchange for foreign-currency-denomi-nated bonds and promissory notes.

The losses from these quasi-fiscal operations ac-counted for a large part of the losses of the central

50See Perez-Campanero and Leone (1991) for further discussion.

bank until 1992, when the government assumedmost of this debt (Table 4). Local currency expendi-tures on operations, remuneration of reserve require-ments, and open market operations, as well as otherforeign currency outlays—interest on foreign debtand on foreign currency deposits—also contributedto the quasi-fiscal deficit and have become its princi-pal component in recent years.

Until recently, the Bank of the Republic and themortgage bank made losses because of a weak loanportfolio resulting from past operations. Thesebanks' losses were not compensated by the centralbank or the budget. New loans no longer contain asubsidy element, and the subsidy element on out-standing loans is being reduced to the extent possi-ble. The authorities continue to improve the admin-istration and operation of both the Bank of theRepublic and the mortgage bank.

The four local banks that were the object of centralbank intervention were officially taken over by thepublic sector in the mid-1980s. Two were merged,and one of the three remaining was privatized; theirlosses were partially covered by transfers from thebudget. The remaining two commercial banks havenow been recapitalized, and one was privatized inMarch 1994. The last is expected to be privatized in1996. As noted above, in 1992 the government as-sumed most of the debt incurred by the central bankas a result of the portfolio purchase scheme.

The losses of the central bank began a quite steepdecline in the early 1990s as a result of these opera-tions, the decline in the stock of external debt en-tailed by the 1991 Brady operation, the lower levelof international interest rates, and the decline in thestock of central bank bills. In mid-1993, the replace-ment of the central bank's own bills (whose out-standing stock in June 1993 was $110 million) bytreasury bills for the conduct of open market opera-tions caused a further decline.

Jamaica

The Bank of Jamaica experienced large lossessince the mid-1980s, averaging 5.3 percent of GDP

28


Jamaica

Table 4. Uruguay: Operating Losses of the Public Financial Sector1

(In percent of GDP)

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

Operating losses of the financialpublic sector (-) . . . -4.3 -4.5 -2.9 -2.0 -1.0 -0.7 -0.6

Central Bank -3.9 -2.8 -3.1 -3.4 -3.6 -2.3 -1.6 -0.8 -0.6 -0.6Interest on foreign-currency-

denominated debt -2.9 -1.7 -1.7 -1.4 -1.3 -1.6 -0.9 -0.7 -0.6 -0.6Interest on bills for monetary

regulation -0.9 -0.8 -0.9 - I . I -1.4 -0.4 -0.3 -0.1 — —Mortgage bank . . . -0.4 -0.6 -0.5 -0.3 -0.1 -0.1Intervened banks . . . . . . . . . -0.5 -0.3 -0.2 -0.1 — — —

Sources: Central Bank of Uruguay; and IMF staff estimates.1Excludes the Bank of the Republic.

in 1985/86-1992/93 (Table 5). Foreign exchange op-erations were the major source of losses in the mid-1980s, but their relative importance has since de-clined. Subsequently, but before the recent reforms,the interest paid on certificates of deposits (CDs) is-sued by the central bank for the purposes of mone-tary control became the major contributor to the cen-tral bank's losses.

The origin of the central bank's losses on foreignexchange operations lies in the combined effects of aheavily negative NFA position and the role of vari-ous forms of exchange guarantees, which con-tributed to the central bank's large net foreign liabil-ities. The exchange rate guarantees or subsidies havetaken different forms, such as trading losses underthe dual exchange rate regime in the mid-1980s, auc-tion losses, external debt operations on behalf ofpublic enterprises, deposits associated with foreignassistance for development projects, contingencyguarantees under an International Finance Corpora-tion loan, and outright exchange rate guarantees.The central bank's large net foreign exposure meantthat the sharp devaluation that took place in the mid-1980s caused the bank's interest expenditures tosubstantially exceed its interest income, resulting inlarge net losses.

The relative importance of foreign exchange oper-ations has declined since the mid-1980s. Beginningin November 1985, the central bank started issuingits own CDs for the conduct of open market opera-tions, since it had no portfolio of interest-bearinggovernment securities that it could use for this pur-pose. The interest cost of the CDs rose from 1 per-cent of GDP in 1986/87 to 2.6 percent of GDP in1992/93. The incremental effect on the incomestatement of the issue of CDs by the central bankwould have been no different from the effect of a

conventional open market operation, but because thebank's balance sheet was weak to begin with, thelosses began to mount.51 Reflecting these develop-ments, the nonearning assets of the central bank—which include non-interest-bearing government se-curities it has received to cover losses—have risensubstantially.

Since 1992, the Jamaican authorities have taken anumber of actions to put the central bank's financeson a sounder footing. Losses from the issue of CDsby the Bank have now been eliminated, because allCDs have been retired. The central bank has alsostopped providing financing for the external debtservice of the rest of the public sector and makingexchange rate guarantees. These policies have essen-tially eliminated the central bank's losses. The gov-ernment does, however, cover any losses that mayoccur in a given fiscal year by transferring early inthe following year marketable securities in theamount of the losses. In a reflection of these poli-cies, the central bank achieved a small profit in1995/96. The government is also considering recapi-talizing the central bank to offset the non-interest-bearing government securities on its books.

The case of Jamaica is in some respects a good ex-ample of the difficulties involved in separating thequasi-fiscal element of a central bank's operationsfrom the financial and monetary element. A largeshare of the losses entailed by the depreciation of theJamaican dollar are undoubtedly quasi-fiscal in na-

5'The conventional open market operation would have ex-changed an interest-bearing asset for a non-interest-bearing liabil-ity (reserves at the central bank), while the issue of CDs results ina replacement of a non-interest-bearing liability by an interest-bearing one.

29


APPENDIX III FIVE COUNTRY CASE STUDIES

Table 5. Jamaica: Operating Balance of the Bank of Jamaica(In percent of GDP)

Fiscal Years Ended March 31

1985/86 1986/87 1987/88 1988/89 1989/90 1990/91 1991/92 1992/93 1993/94 1994/95 1995/96

Operating balance (loss-) -6.9 -5.7 -5.1 -5.4 -4.9 -4.3 -5.2 -5.2 -2.0 -2.3 0.7Expenditure 9.0 6.7 6.4 6.2 6.6 5.6 6.0 6.5 3.2 5.3 3.0

Foreign interest 5.6 3.8 3.0 2.0 1.6 1.7 2.1 1.8 1.4 0.8 0.6Exchange subsidies 1.0

Certificates of deposit (CDs) . . . 1.0 1.0 1.8 2.2 1.8 1.6 2.6 0.9 1.5Revenue 2.1 1.0 1.0 0.8 1.6 1.3 0.7 1.3 1.2 3.0 3.7

Sources: Bank of Jamaica; and IMF staff estimates.

ture, however, and the use of CDs by the Bank artifi-cially reduced the cost of public debt service.

Ghana

The major source of quasi-fiscal losses of theBank of Ghana dates from the period before the im-plementation of the economic recovery program in1983. Until then, the central bank had assumed theforeign exchange risk on certain foreign loans in-curred by some government-owned developmentbanks and some state enterprises. As the debt-serviceobligations on these loans became due, the centralbank recorded the losses stemming from its guaran-tee in its revaluation account (given the sizable de-preciation of the Ghanaian cedi that had taken placein the meantime, the cost of foreign exchange to theentities who had benefited from the guarantee wasmuch less than the current exchange rate). Despitethe discontinuation in 1983 of the subsidization offoreign exchange risk, the realized losses stemmingfrom this practice have been substantial in recentyears.

Although the central bank has at times engagedin certain other QFAs, these are believed not tohave had a significant effect on its balance sheet.Since 1983, its financing of the operations of thecentral government and the Cocoa Board (a majorstate enterprise) has been provided at market-relatedterms, with the yields on government paper andcocoa bills having been determined since late 1987at weekly auctions. The central bank also engagesin a very modest amount of subsidized lending toits own employees. The government's sizable de-mand deposits with the central bank have tradi-tionally earned no interest.

Only one small government-owned financial insti-tution, the Cooperative Bank, has been given a loan

by the Bank of Ghana on concessional terms (at arate lower than the normal rediscounting rate). Thisloan was needed to ensure that the CooperativeBank, which has been financially troubled, couldmeet the minimum reserve requirements. The Coop-erative Bank has now been restructured.

Since February 1987, all transactions in foreignexchange by the central bank have been conductedat a unified exchange rate, determined at its weeklyauction. MERs were briefly maintained during theperiods April-October 1983 and September 1986-February 1987. Since April 1990, the official auctionmarket and the foreign exchange bureau market (le-galized parallel foreign exchange market) have beenunified in the context of an interbank foreign ex-change market.

The central bank made net profits in its profit andloss account in the mid-to-late 1980s, and a sizableportion of these profits were passed on to the govern-ment (Table 6). However, the derivation of the profitand loss account did not take into account thechanges in the revaluation account of the centralbank that reflected the losses from the exchangeguarantees extended before 1983. In the audited ac-counts of the central bank, however, the accumulatedrevaluation losses were shown as a claim on the gov-ernment, and the government acknowledged this lia-bility to the external auditors of the central bank.

To resolve once and for all the problems createdby the foreign exchange guarantees, the accumu-lated revaluation losses as of end-September 1990((Z311.8 billion or the equivalent of 16.4 percent ofGDP) were replaced in late 1990 with long-termgovernment bonds, offering a yield currently set at4 percent. The takeover of the revaluation accountwas designed to restore solvency to the accounts ofthe central bank and to strengthen its income posi-tion, so as to help ensure that in its liquidity man-agement operations the central bank would not be

30


Poland

Table 6. Ghana: Quasi-Fiscal Operations of the Bank of Ghana(In percent of GDP)

Fiscal YearFiscal Years Ended June June-Dec Ending Dec.

1985 1986 1987 1988 1989 1990 1990 1991 1992

Net profits on the profits and lossaccount of the Bank of Ghana 0.6 0.3 0.4 0.3 0.8 0.1

Transferred to the Government 0.3 0.2 0.1 — — 0.6 — — —Change in the revaluation account1 . . . . . . . . . 3.7 4.8 2.9 0.9 0.7 2.3

Source: Data provided by the Bank of Ghana.'Revaluation losses outstanding as of end-September 1990,amounting to C3\ 1,769.5 million, were taken over by the government in December 1990.

unduly influenced by considerations about its ownprofitability.

Poland

Before the transition to a market economy, therewere no clear lines of demarcation between the bud-get and the financial sector in Poland. This made itdifficult to untangle purely fiscal operations exe-cuted through the budget from quasi-fiscal opera-tions undertaken elsewhere in the financial system.The government sector included a number of extra-budgetary funds (or "special purpose" funds) andsome specialized financial institutions. As an exam-ple, the Foreign Debt Service Fund was establishedin 1986 to disburse subsidies to a specialized bank,which was created to be the government's intermedi-ary in foreign borrowing by state enterprises. Deter-mining the true obligor of such foreign debt was thusquite complicated.

The operations of the National Bank of Poland(NBP)—formally autonomous from the Ministry ofFinance but factually an operating agent for the min-istry—were closely linked to the economic plan. TheNBP operated as a "monobank" in the sense that ithad a monopoly of both central and commercialbanking functions. It was responsible for formulat-ing an annual credit plan and regulating interestrates. In addition, there were a number of specializedstate-owned banks. Financial institutions were re-quired to transfer 80 percent of "profits" to the bud-get (Table 7).

As a part of the structural reform measures thatmarked the transition to a market economy, a newlaw on the NBP and a new banking law came intoforce at the beginning of February 1989. A centralfeature of these two laws was the devolution of mostof the commercial banking functions of the NBP to

nine state-owned commercial banks. At the sametime, the main financial subsidy operations were in-corporated in the budget.

Promulgation of these laws significantly reducedthe scope of QFAs. The NBP has scaled back quasi-fiscal operations in three areas discussed below;quasi-fiscal operations in other PFIs have remainednegligible. However, the recapitalization operationsundertaken in 1990—94, to deal with the nonperform-ing assets in the portfolio of the banking system canbe seen as a form of partial compensation to thebanks for lending to public sector enterprises onpreferential terms.

The exchange system during 1989 was basically adual regime, with both an official rate and an inter-bank auction of zlotys for convertible currencies.These auctions are estimated to have resulted inprofits of around 1 percent of GDP in 1989, whichwere transferred to the state budget. Since the 1990exchange reform, all banking system transactionstake place at the official rate. The elimination of thisprofitable quasi-fiscal operation on the income state-ments of financial institutions was offset by the re-forms discussed above.

The refinance rate of the NBP had a differentiatedstructure until end-1989. This was replaced with aunified refinance rate in 1990; this rate has sincebeen adjusted periodically to keep it positive in realterms. In 1990, interest rate subsidies, mainly forhousing and agriculture, were moved to the budget;the use of preferential interest rates for other lendingoperations was substantially scaled back. Directedand preferential credit programs for housing, certainpublic sector investment projects, and agriculturalprocurement remain in place. The interest rate onmost of these activities is linked to the NBP refi-nance rate; to the extent that the interest rate fallsshort of the refinance rate, these operations entail asubsidy that is covered directly by the budget. The

31



Table 7. Poland: Transfer of Profits by PFIs to the State Budget(In percent of GDP)

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995

Transfer of profits by financialinstitutions to the state budget1 . . . . . . . . . 3.0 3.6 1.8 1.7 1.6 1.6

National Bank of Poland 1.3 1.0 1.2 . . . 1.7 0.8 0.7 0.9 I.I 1.0Enterprise income tax from banks . . . . . . . . . . . . 1.9 1.0 1.0 0.7 0.5

Sources: Data provided by the Polish authorities; and IMF staff estimates.1After 1988, this figure includes payments of enterprise income tax by the banks, as well as transfers from the NBR A breakdown is not available for

1989. The 1989 figure also includes revenues from foreign currency auctions.

stock of outstanding directed credit is estimated tohave declined from about 7 percent of GDP at end-1992 to about 4 percent at end-1994.

No guarantees are provided by the NBP to coverexchange rate or interest rate losses. There is a guar-antee on deposits up to the equivalent of about ECU3,000 in the commercial banking system through adeposit insurance scheme that was mostly financedby transfers from the NBP and the finance ministry.

Efforts to deal with the problem of bad loans ex-perienced by the commercial banks have entailed aseries of recapitalization operations. Two such oper-ations took place in the early stages of reform toclean out nonperforming assets acquired in the pe-riod before reform. In 1990, foreign liabilities ofspecialized financial institutions were explicitly ac-cepted as a government liability. In 1991, the gov-ernment issued treasury bonds to compensate thebanking system for foreign currency losses duringthe pre-reform period; the interest on these bondswas incorporated into the budget.

Notwithstanding these operations, nonperformingassets continued to accumulate, mainly in the formof bank loans to domestic loss-making state enter-prises. Consequently, additional recapitalization op-erations took place in 1993 and 1994. Unlike similaroperations in many other countries, these did not en-tail a swap of government paper for nonperformingloans. Instead, banks received government bonds inan amount determined by an earlier audit of their fi-nancial condition, and the banks were left to collectwhat they could of the money owed them by thestate enterprise sector.52

The interest actually paid on these bonds is incor-porated in the budget, although 10 percentage pointsof the 15 percent interest rate on the bonds is capital-

52This operation came in conjunction with a World Bank enter-prise and financial sector adjustment loan.

ized. Since the operation is included in the budget, itis not quasi-fiscal in nature; nor is it evident that theearlier recapitalization operations were quasi-fiscaloperations. However, recapitalization could be saidto be compensating the commercial banks, whichwere publicly owned, for loans made to keep keypublic enterprises afloat. To the extent that theseloans—as distinct from the recapitalization bonds—had a subsidy element, they entailed a quasi-fiscaloperation by the banks.

An additional QFA was introduced with the pas-sage of the banking law in April 1992. The law stip-ulated that the NBP should remunerate banks for thereserves they are required to hold with the NBP.However, it also stipulated that the income thus gen-erated should be used for agricultural restructuringthrough the establishment of a Fund for Farm Re-structuring and Debt Relief. The fund received anamount equal to 0.1 percent of GDP in 1994.

Romania

The Romanian experience with quasi-fiscal opera-tions illustrates some of the difficulties that reformin this area must confront. Despite some initial suc-cesses in reducing the scope and importance ofQFAs, pressures to perpetuate them remain strong.

Before 1990, the financial system in Romania wassubordinated to the requirements of the system ofcentralized planning, with the flows of fundsthrough the banking system designed to accommo-date the requirement of enterprises implementing thetargets of the physical plan. There were five statebanks, four of which fulfilled specialized functions(in the areas of foreign trade, agriculture, and house-hold lending), but in effect the banking system oper-ated as a monobank system.

Reform of the banking system commenced in De-cember 1990, with the transfer of commercial bank-

32


Romania

ing operations of the National Bank of Romania(NBR) to the newly established Romanian Commer-cial Bank. A legislative framework for a market-based two-tier banking system was put in place inApril 1991, with the passage of a banking law and acentral bank law. Further institutional reforms, cul-minating in the transfer of the management of for-eign exchange reserves and the foreign exchangesystem to the NBR, occurred in November 1991. Anumber of new private and joint venture banks havebeen established since the legal reforms of 1991, butthe five large state banks continue to play a domi-nant role in the banking system.

The reforms instituted in 1991 provided the basisfor the development of a market-based banking sys-tem in which credit is allocated on the basis of com-mercial criteria. However, there have been recurrentpressures on both the NBR and the state-ownedbanks to revert to their traditional role of supplyingcredit to state enterprises that need funds to meettheir production and employment goals. Accommo-dation of these pressures has resulted in a series ofquasi-fiscal operations by both the NBR and thestate-owned banks and has also led the NBR, untillate 1993, to favor an accommodative monetary pol-icy and low administered interest rates. This policystance was reflected in market interest rates thatwere strongly negative in real terms, thereby gener-ating an effective transfer of income from holders offinancial assets to borrowers that provided at leasttemporary support to ailing enterprises.

Quasi-fiscal operations of the NBR have includedthe use of refinancing credits to finance the clear-ance of state enterprises' payments arrears, subsi-dized credit programs, the operation of a de factodual exchange rate system, and the use of NBR prof-its to finance selected extrabudgetary expenditures.The NBR does not extend guarantees on domestic orforeign loans; such guarantees are provided by theMinistry of Finance.

At end-1991, the NBR implemented a comprehen-sive bailout for enterprises with payments arrears,extending to banks low interest credits for onlendingto enterprises, to allow them to clear their arrears toother enterprises. While successful in generating aone-off clearance of arrears, the program resulted ina 62 percent increase in aggregate domestic creditduring the month of December 1991 and validatedstate sector managers' belief that budget constraintscould be violated without penalty. A more modestcredit scheme to allow selected enterprises to clearpayments arrears again was introduced in the firstmonths of 1993. Since 1993, the government hasavoided further arrears-clearance arrangements, al-though there was considerable pressure for such anoperation in late 1994. In late 1995 a debt-concilia-tion process involving multilateral negotiations be-

tween a large group of enterprises, banks, and theMinistry of Finance was initiated. This was intendedto demonstrate that the days of government bailoutswere over and to reinforce the message that creditorswould also suffer from unpaid debts.

Subsidized credits were introduced by the NBR inAugust 1992, following a period in which monetarypolicy had been temporarily tightened. These creditscarried an annual interest rate of 13 percent, com-pared with the NBR reference rate of 80 percent, andwere for onlending primarily to agriculture. By early1993, some 90 percent of NBR credits were ex-tended at subsidized interest rates.53 Nearly all creditlines with interest rates less than the NBR referencerate had been phased out by end-1993. However, alarge part of NBR refinancing is channeled to agri-culture. The ratio reached some 70 percent of allNBR refinancing credits by end-1994, but it de-clined to 64 percent by end-1995. The NBR chargesthe reference rate on the loans, but a subsidy fromthe budget provides for 60 percent of the cost of in-terest payments.

The exchange rate system was formally unified inNovember 1991, but the mechanics of price determi-nation in the fixing session (November 1991-May1992) and the foreign exchange auction that re-placed it failed to clear the market. This led to theemergence of a "gray market" in which foreign ex-change sold at a premium that varied over time from5 percent to 30 percent. The mechanisms used to ra-tion the supply of foreign exchange made availableby the banking system at the official rate were nottransparent, but importers of "strategic" products(oil, foodstuffs) appeared to have received prioritytreatment and hence a de facto subsidy in the alloca-tion process.

The reform of the exchange rate system in April1994 effectively unified the system for a time. How-ever, a significant spread between the official andbureau rates emerged in late 1994 and again in late1995 and early 1996.

The use of central bank profits has been anotherarea in which the NBR has undertaken what are es-sentially budgetary operations. Until 1995, the cen-tral bank law required that the NBR pay profits tax(averaging 45 percent) to the state budget on its re-ported profits, but allowed the NBR board discretionas to how it allocated the after-tax profit. Uses towhich these funds have been put include a variety ofpublic expenditure programs. Through mid-1993,these parafiscal activities were conducted outsidethe budgetary framework; in 1994, some of these op-erations were included as line items in the budget,

53Interest forgone through subsidization of credits was close to1 percent of GDP during the 12 months from August 1992.

33



albeit financed from extrabudgetary revenues (theNBR). The scope for such activity has been substan-tially reduced by the new profit tax law, which wasenacted at the beginning of 1995. It stipulates that 80percent of the NBR profits are to be transferred tothe state budget.

The state-owned banks are mandated to operatealong commercial lines, subject to the formal con-trol of the State Ownership Fund, which in turn ischarged with the task of privatizing all state-ownedcommercial companies by 1998.54 In practice, man-agers of state-owned banks are subject to pressuresto allocate credit on the basis of noncommercialconsiderations. The impact of such pressures oncredit allocation is difficult to quantify, but it isclear that the large credit needs of selected state en-terprises, such as the state agricultural processingand distribution enterprises (Romcereal), have re-ceived priority treatment from the state banks.Large quasi-fiscal deficits in the state enterprise and

54State enterprises not destined for eventual privatization wereconverted into public enterprises (regies autonomes) that reportdirectly to line ministries.

agriculture sectors persist, with the result that a sig-nificant share of the state-owned banks' portfolio isaccounted for by credits to enterprises that are po-tentially unviable.

Banks have appeared reluctant to initiate workoutproceedings with large problem clients because theState Ownership Fund, which owns both the clientsand the banks, has proceeded slowly with the re-structuring of financially troubled state enterprises.Taken together, these factors have contributed to anallocation of credit that is probably quite differentfrom what would prevail in a market-driven bankingsystem.

The government has made a commitment, sup-ported by a World Bank financial and enterprisesector adjustment loan, to accelerate the privati-zation or liquidation of state enterprises, and tostrengthen and privatize the state-owned banks.Measures to strengthen the banks include limitingthe access of problematic state enterprises to bankcredit, strengthening the NBR's bank supervision ca-pabilities, and reducing adverse selection by requir-ing collateral for NBR refinancing. These measuresshould also help to alleviate distortions in creditallocation.

34


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36


Occasional Papers

Recent Occasional Papers of the International Monetary Fund

142. Quasi-Fiscal Operations of Public Financial Institutions, by G.A. Mackenzie and Peter Stella. 1996.

141. Monetary and Exchange System Reforms in China: An Experiment in Gradualism, by Hassanali Mehran,Marc Quintyn, Tom Nordman, and Bernard Laurens. 1996.

140. Government Reform in New Zealand, by Graham C. Scott. 1996.

139. Reinvigorating Growth in Developing Countries: Lessons from Adjustment Policies in Eight Economies,by David Goldsbrough, Sharmini Coorey, Louis Dicks-Mireaux, Balazs Horvath, Kalpana Kochhar,Mauro Mecagni, Erik Offerdal, and Jianping Zhou. 1996.

138. Aftermath of the CFA Franc Devaluation, by Jean A.P. Clement, with Johannes Mueller, Stephane Cosse,and Jean Le Dem. 1996.

137. The Lao People's Democratic Republic: Systemic Transformation and Adjustment, edited by Ichiro Otaniand Chi Do Pham. 1996.

136. Jordan: Strategy for Adjustment and Growth, edited by Edouard Maciejewski and Ahsan Mansur. 1996.

135. Vietnam: Transition to a Market Economy, by John R. Dodsworth, Erich Spitaller, Michael Braulke,Keon Hyok Lee, Kenneth Miranda, Christian Mulder, Hisanobu Shishido, and Krishna Srinivasan.1996.

134. India: Economic Reform and Growth, by Ajai Chopra, Charles Collyns, Richard Hemming, and KarenParker with Woosik Chu and Oliver Fratzscher. 1995.

133. Policy Experiences and Issues in the Baltics, Russia, and Other Countries of the Former Soviet Union,edited by Daniel A. Citrin and Ashok K. Lahiri. 1995.

132. Financial Fragilities in Latin America: The 1980s and 1990s, by Liliana Rojas-Suarez and Steven R.Weisbrod. 1995.

131. Capital Account Convertibility: Review of Experience and Implications for IMF Policies, by staff teamsheaded by Peter J. Quirk and Owen Evans. 1995.

130. Challenges to the Swedish Welfare State, by Desmond Lachman, Adam Bennett, John H. Green, RobertHagemann, and Ramana Ramaswamy. 1995.

129. IMF Conditionality: Experience Under Stand-By and Extended Arrangements. Part II: BackgroundPapers. Susan Schadler, Editor, with Adam Bennett, Maria Carkovic, Louis Dicks-Mireaux, MauroMecagni, James H.J. Morsink, and Miguel A. Savastano. 1995.

128. IMF Conditionality: Experience Under Stand-By and Extended Arrangements. Part I: Key Issues andFindings, by Susan Schadler, Adam Bennett, Maria Carkovic, Louis Dicks-Mireaux, Mauro Mecagni,James H.J. Morsink, and Miguel A. Savastano. 1995.

127. Road Maps of the Transition: The Baltics, the Czech Republic, Hungary, and Russia, by BiswajitBanerjee, Vincent Koen, Thomas Krueger, Mark S. Lutz, Michael Marrese, and Tapio O. Saavalainen.1995.

126. The Adoption of Indirect Instruments of Monetary Policy, by a Staff Team headed by William E.Alexander, Tomas J.T. Balino, and Charles Enoch. 1995.

125. United Germany: The First Five Years—Performance and Policy Issues, by Robert Corker, Robert A.Feldman, Karl Habermeier, Hari Vittas, and Tessa van der Willigen. 1995.

124. Saving Behavior and the Asset Price "Bubble" in Japan: Analytical Studies, edited by UlrichBaumgartner and Guy Meredith. 1995.

123. Comprehensive Tax Reform: The Colombian Experience, edited by Parthasarathi Shome. 1995.

122. Capital Flows in the APEC Region, edited by Mohsin S. Khan and Carmen M. Reinhart. 1995.

121. Uganda: Adjustment with Growth, 1987-94, by Robert L. Sharer, Hema R. De Zoysa, and Calvin A.McDonald. 1995.

120. Economic Dislocation and Recovery in Lebanon, by Sena Eken, Paul Cashin, S. Nuri Erbas, JoseMartelino, and Adnan Mazarei. 1995.

37


OCCASIONAL PAPERS

119. Singapore: A Case Study in Rapid Development, edited by Kenneth Bercuson with a staff team compris-ing Robert G. Carling, Aasim M. Husain, Thomas Rumbaugh, and Rachel van Elkan. 1995.

118. Sub-Saharan Africa: Growth, Savings, and Investment, by Michael T. Hadjimichael, Dhaneshwar Ghura,Martin Muhleisen, Roger Nord, and E. Murat Ucer. 1995.

117. Resilience and Growth Through Sustained Adjustment: The Moroccan Experience, by Saleh M. Nsouli,Sena Eken, Klaus Enders, Van-Can Thai, Jorg Decressin, and Filippo Cartiglia, with Janet Bungay.1995.

116. Improving the International Monetary System: Constraints and Possibilities, by Michael Mussa, MorrisGoldstein, Peter B. Clark, Donald J. Mathieson, and Tamim Bayoumi. 1994.

115. Exchange Rates and Economic Fundamentals: A Framework for Analysis, by Peter B. Clark, LeonardoBartolini, Tamim Bayoumi, and Steven Symansky. 1994.

114. Economic Reform in China: A New Phase, by Wanda Tseng, Hoe Ee Khor, Kalpana Kochhar, DubravkoMihaljek, and David Burton. 1994.

113. Poland: The Path to a Market Economy, by Liam P. Ebrill, Ajai Chopra, Charalambos Christofides, PaulMylonas, Inci Otker, and Gerd Schwartz. 1994.

112. The Behavior of Non-Oil Commodity Prices, by Eduardo Borensztein, Mohsin S. Khan, Carmen M.Reinhart, and Peter Wickham. 1994.

111. The Russian Federation in Transition: External Developments, by Benedicte Vibe Christensen. 1994.

110. Limiting Central Bank Credit to the Government: Theory and Practice, by Carlo Cottarelli. 1993.

109. The Path to Convertibility and Growth: The Tunisian Experience, by Saleh M. Nsouli, Sena Eken, PaulDuran, Gerwin Bell, and Ziihtu Yucelik. 1993.

108. Recent Experiences with Surges in Capital Inflows, by Susan Schadler, Maria Carkovic, Adam Bennett,and Robert Kahn. 1993.

107. China at the Threshold of a Market Economy, by Michael W. Bell, Hoe Ee Khor, and Kalpana Kochharwith Jun Ma, Simon N'guiamba, and Rajiv Lall. 1993.

106. Economic Adjustment in Low-Income Countries: Experience Under the Enhanced StructuralAdjustment Facility, by Susan Schadler, Franek Rozwadowski, Siddharth Tiwari, and David O.Robinson. 1993.

105. The Structure and Operation of the World Gold Market, by Gary O'Callaghan. 1993.

104. Price Liberalization in Russia: Behavior of Prices, Household Incomes, and Consumption During theFirst Year, by Vincent Koen and Steven Phillips. 1993.

103. Liberalization of the Capital Account: Experiences and Issues, by Donald J. Mathieson and Liliana Rojas-Suarez. 1993.

102. Financial Sector Reforms and Exchange Arrangements in Eastern Europe. Part I: Financial Markets andIntermediation, by Guillermo A. Calvo and Manmohan S. Kumar. Part II: Exchange Arrangements ofPreviously Centrally Planned Economies, by Eduardo Borensztein and Paul R. Masson. 1993.

101. Spain: Converging with the European Community, by Michel Galy, Gonzalo Pastor, and Thierry Pujol.1993.

100. The Gambia: Economic Adjustment in a Small Open Economy, by Michael T. Hadjimichael, ThomasRumbaugh, and Eric Verreydt. 1992.

99. Mexico: The Strategy to Achieve Sustained Economic Growth, edited by Claudio Loser and Eliot Kalter. 1992.

98. Albania: From Isolation Toward Reform, by Mario I. Blejer, Mauro Mecagni, Ratna Sahay, RichardHides, Barry Johnston, Piroska Nagy, and Roy Pepper. 1992.

97. Rules and Discretion in International Economic Policy, by Manuel Guitian. 1992.

Note: For information on the title and availability of Occasional Papers not listed, please consult the IMF Publications Catalog or contact IMFPublication Services.

38


Documents

Quasi-Fiscal Operations of Public Financial Institutions · 2020. 4. 1. · Price: US$15.00 (US$12.00 to full-time faculty members and ... these "quasi-fiscal" operations or activities