Definitional Issues

A good starting point for the discussion is a modified version of the narrow definition of QFA set out in Section II: an operation or measure carried out by a central bank or other PFI with an effect that can, in principle, be duplicated by budgetary measures in the form of an explicit tax, subsidy, or direct expenditure and that has or may have an impact on the financial operations of the central bank or other PFIs.

This definition merits a number of observations:

• It excludes certain activities that in some countries have entailed large losses for the central bank. One topical and important example is the losses that have been incurred by policies to sterilize capital inflows; another is the impact on a central bank’s income statement generated by a restrictive open market operation.³⁵ There is a sense in which these losses—or any central bank loss—are fiscal, inasmuch as they ultimately have to be covered by the government. Although they do not have to entail a tax or subsidy element, they are commonly referred to as QFAs.

• Consistent application of the definition may require that certain activities normally considered monetary in character be recognized as having a fiscal element. For example, most central banks impose a reserve requirement, and many of these do not pay a market-related rate of interest on their reserves. If a reserve requirement results in banks holding a greater share of their assets in reserves than they would in the absence of that requirement, it imposes a tax, as discussed in Section II.³⁶ Yet this practice may be seen by some as an integral part of monetary policy.

• The definition would also exclude some government regulations and other acts of public policy that have little or nothing to do with either the budget or monetary policy but that can have effects akin to those of taxes and subsidies. For example, a regulation restricting the use of property can inflict a capital loss on the owner, and in this respect it is similar to a tax on wealth. The definition excludes these practices from the ambit of QFA, because they do not directly affect the financial operations of PFIs.³⁷

• It would not include tax expenditures, which are already covered by the budget and in principle are subject to budgetary scrutiny. This exclusion does not mean that a government should not be concerned about the fiscal cost of special deductions from taxable income and the like. These are clearly important, but they are rather different from the quasi-fiscal activity pursued by PFIs. Similarly, the definition excludes the estimated cost of loan guarantee programs created by the government and other programs entailing contingent liabilities. As the paper stresses, these operations are potentially very costly, whether conducted by the government or by a PFI. See Towe (1993) for further discussion.

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

  • —The inflation tax is not really an “operation” or a measure, but the end result of a particular combination of monetary and fiscal policies. The term “tax” is, consequently, somewhat misleading.

  • —The replacement of an explicit tax on money balances by the inflation tax entails a wholesale change in the macroeconomic environment (that is, an increase in the rate of inflation). Replacing an export tax by an MER practice has, by contrast, no such effect.

  • —The rate of the inflation tax will not typically equal any given rate of an explicit tax on money balances.

Another implication of the definition is that its strict application would exclude certain types of operations that entail the creation of taxes and subsidies through the financial system when these have no direct impact on the net income of the central bank or other PFIs. As discussed in Section II, the central bank may establish regulations setting maximum lending rates and deposit rates for commercial banks, both privately and publicly owned. Artificially low deposit rates are like a tax on savers, and low interest rates are a subsidy to borrowers. Yet the net income of PFIs may be entirely unaffected by the regulations (that is, if there are no publicly owned commercial banks). These kinds of regulations bear a certain resemblance to employer-mandated benefit plans. Nonetheless, these operations do affect the financial operations of the government, as previously discussed, because they artificially lower the cost of borrowing.

Since the spirit of these regulations is the same as preferential interest rates and other QFAs, and since they impose a tax that ultimately benefits the government, the definition could be expanded to include them. The modified definition would be as follows: an operation or measure carried out by a central bank or other PFI with an effect that can, in principle, be duplicated by budgetary measures in the form of an explicit tax, subsidy, or direct expenditure and that has or may have an impact on the financial operations of the central bank, other PFIs, or government.

In practice, QFA is defined even more broadly, since it can refer to any operation that has a significant impact on the net income of a PFI. That said, there is some merit to distinguishing between such practices as MERs or subsidized interest rates, which clearly entail taxes and subsidies, and practices such as open market operations, which have fiscal implications but cannot be so obviously duplicated by explicitly budgetary operations. The paper has relied on a definition of QFAs broad enough to encompass these kinds of operations, while paying special attention to those operations of a more obviously fiscal character.

Problems Resulting from the Use of Cash Versus Accrual Accounting

Most Fund member countries measure the financial operations of the NFPS or central government on what might be called a modified cash basis—taxes and other revenues are recorded as collected, and expenditures when they are paid, with interest recorded when due, and sometimes with an adjustment for changes in arrears. Financial institutions, and central banks in particular, will typically use accruals-based accounting. To take a few examples: interest on loans is recorded when it is due, not when it is paid; provisions for doubtful loans, loss write-offs, or loss reserves will be made that have no counterpart in a cash transaction; depreciation of physical assets is recorded as an expense; expenditure on capital assets is recorded in the capital account and does not affect the net income position. For all these reasons, it cannot be assumed that the cash transfer made by the central bank to the budget in a given period will equal its cash income for that period, measured in the same way as the operations of the NFPS, even if it transfers 100 percent of its accrued income to the central government.

To derive the enlarged public sector balance described earlier—to amalgamate central bank or other PFI income (losses) with the balance of the NFPS in a consistent way—requires that some fairly major adjustments be made. However, since the operations of the NFPS or the central government are not measured entirely on a cash basis, neither should the operations of the PFIs. For example, if interest paid to the central bank by the central government is measured on an accrual basis the bank’s receipts should be measured in the same way to avoid inconsistency. There is also a potential problem with a cash-based measure of central bank income: it has happened that borrowers in arrears on their interest obligations to public sector banks have obtained fresh loans to pay off their arrears. This kind of operation can be used to reduce artificially the overall public sector deficit. To avoid this kind of manipulation, appropriate bank supervisory regulations prohibiting such recapitalization of interest should be put in place.

The accounting treatment of net lending by the central bank for policy purposes deserves particular attention. Such operations, if conducted through the budget, are recorded as above-the-line transactions in the framework of the IMF’s government finance statistics (International Monetary Fund, 1986). Hence, they increase the deficit. Typically, they would not be treated this way in the accounts of the central bank.

Particular Problems Resulting from Foreign Exchange Transactions and MER Systems

This section begins with a brief discussion of accounting procedures for spot foreign exchange transactions without the added complication of the quasi-fiscal taxes and subsidies entailed by MERs.³⁸ It then takes up the special problems posed by MERs.

In its role as custodian of a country’s foreign exchange reserves, a central bank is constantly accruing or realizing losses or gains in its foreign exchange transactions. Considering first losses or gains that are not realized—those that result from a change in the value of the stock of foreign exchange—the standard treatment, whatever the precise rule used to value foreign exchange, is to make a counterpart entry in the revaluation account. If central banks make a daily valuation of their reserves based on the average daily rate, then the revaluation account is also changed on a daily basis. These accrued gains or losses, however, are not reflected in the central bank’s income and loss statement.³⁹ This treatment of accrued losses or gains is consistent with the standard presentation of the financial operations of the NFPS. The same conclusion holds true when valuations are less frequent, provided that a counterpart entry is made in the revaluation account.

This use of the revaluation account makes no distinction between nominal and real gains and losses. Thus, for example, the central bank’s foreign exchange reserves can actually increase or decrease in real terms without there being any effect on the income and loss statement. Such accrued losses or gains, however, do affect the strength of a country’s reserve position and cannot be entirely ignored.

In general, recommended accounting practice calls for only realized gains on foreign exchange transactions to be brought to the profit and loss account. A number of central banks (perhaps most prominently the U.S. Federal Reserve System), however, include both realized and unrealized gains and losses in the profit and loss statement; that is, they include the valuation change on the stock of net foreign assets (NFA). In such cases it is clear that, in order to ensure consistency with government accounts, the central bank operating result would need to be adjusted before amalgamating it with NFPS operations.

Given the way realized gains are frequently measured, their inclusion could be problematic. To take a concrete example, suppose a central bank had acquired its target level of foreign exchange reserves at an average rate of LCU 1 per U.S. dollar, and that the exchange rate had subsequently been devalued to LCU 2 per dollar. At the time of the devaluation, a revaluation gain of LCU 1 million for each $1 million of reserves would have been recorded. Without any sales of foreign exchange, this gain would not have 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 by LCU 2 million. If it subsequently repurchases the foreign exchange with monetary base at the same rate—LCU 2 per dollar—the earlier transaction is reversed. In determining profits and losses for the year, however, the bank’s accountant would debit the revaluation account by the amount of profit deemed to be realized from the sale of foreign exchange. If the foreign exchange sold was valued at LCU 1 per dollar, the sale is recorded as generating a profit of LCU 1 million, which is added to the profit and loss account and subtracted from the revaluation account.

The economic justification for distinguishing this as realized “profit” is rather dubious, however. In the example given, the balance sheet would have been identical had the central bank undertaken no intervention (presuming the final exchange rate was unaffected by the intervention). The only difference would be that in the latter case the accountant would not have debited the revaluation account and added the amount to the profit and loss statement, since no transactions had taken place.

An analogy could be made with the use of first in, first out (FIFO) accounting by any enterprise with inventories in an inflationary period. Historic cost pricing means that accounting profits are artificially overstated; the cost to the enterprise of replacing its inventories has risen, and once it has replaced them it is in the same position as before with the exception that the value of its inventory has risen. The profit is “locked up” in the inventory, however, and the enterprise does not realize this gain unless it reduces its stock of inventory. The same is true of the central bank. If it maintains an unchanged target for NFA, it will not effectively realize a gain on its foreign exchange holdings despite gross sales and purchases in the market.

We now consider the valuation and classification problems posed by MERs. Two cases should be distinguished: when the central bank’s NFA do not change, and when they do. As a simple example, take a three-rate MER system in which the officially designated central rate is LCU 2 per dollar, with a special appreciated rate of LCU 1 per dollar applying to certain exports, and a depreciated rate of LCU 3 per dollar applying to certain imports.

In the first case, where net sales at the central rate are zero, the sale of $1,000 million to importers at the special rate and the purchase of $1,000 million from exporters at their special rate entail no change in NFA, a reduction in the monetary base (or negative monetary impact) of LCU 2,000 million, and an increase in OIN (other items net) of LCU 2,000 million, reflecting the central bank’s profits from the operation (Table 2). These calculations are not affected by the choice of the central rate, even if that choice is to some extent arbitrary, because there is no change in NFA.

^{Table 2.}

Impact of an MER System on the Central Bank’s Balance Sheet: With No Change in Reserves

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

^{Table 2.}

Impact of an MER System on the Central Bank’s Balance Sheet: With No Change in Reserves

A. Foreign Exchange Transactions and Their Monetary Impact
		Exchange Rates (LCUs per dollar)
					At
		1	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		–2,000
Change in NFA		—
Change OIN
	(central bank profits)	2,000

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

View Table

^{Table 2.}

Impact of an MER System on the Central Bank’s Balance Sheet: With No Change in Reserves

A. Foreign Exchange Transactions and Their Monetary Impact
		Exchange Rates (LCUs per dollar)
					At
		1	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		–2,000
Change in NFA		—
Change OIN
	(central bank profits)	2,000

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

What would be affected by the choice of the central rate, however, is the classification of the quasi-taxes or subsidies entailed by the MER system. If, in the example just presented, the officially designated central exchange rate applies to most transactions, then this may not be an issue. However, the structure of a multiple rate system might be such that there were at least two plausible candidates for the central rate. In this case, any measure of the tax or subsidy equivalent of special exchange rates will inevitably be arbitrary.

When the level of international reserves changes, the choice of the central exchange rate does matter for the calculation of central bank income. To return to the earlier example, now augmented by a fourth exchange rate of LCU 2.5 to the dollar, let us suppose that net sales of foreign exchange at the rates of LCU 2 and LCU 2.5 are zero, but that sales of foreign exchange to importers at the rate of LCU 3 to the dollar are now $500 million, not $1,000 million.

The monetary base is reduced by LCU 500 million, but the measured impact on OIN clearly varies depending on which exchange rate is used to value the change in reserves (Table 3). This result is a simple illustration of the inventory valuation problem, but it does illustrate how different accounting conventions will affect the measure of central bank income.

^{Table 3.}

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

Note: OIN, other items net.

^{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
		1	2	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 of LCU 2 = $l	With Exchange Rate of LCU 2.5 = $l
Monetary impact	–500	–500
Change in NFA	1,000	1,250
Change in OIN (central bank profits)	1,500	1,750

Note: OIN, other items net.

View Table

^{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
		1	2	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 of LCU 2 = $l	With Exchange Rate of LCU 2.5 = $l
Monetary impact	–500	–500
Change in NFA	1,000	1,250
Change in OIN (central bank profits)	1,500	1,750

Note: OIN, other items net.

The conventional approach to the valuation of reserve gains and losses—the use of the rate at which most official transactions take place—becomes even more problematic when none of the official exchange rates is close to the free-market rate. In such a case, the use of any official exchange rate for valuation purposes can be quite misleading. To take an extreme example, suppose that the free-market rate in the example above is LCU 10 to the dollar. If this rate, rather than an official rate, is used to value the reserve gain, the calculated impact on central bank income is substantially different. Even when there is no change in NFA, the use of official exchange rates in such a situation to measure the relative size of the implicit taxes and subsidies created by the exchange system will be seriously misleading.

Reserve Requirements

Section III discussed the role of reserve requirements as quasi-fiscal taxes. When banks are obliged to hold reserves and are paid a lower rate of interest than they would earn on an alternative and equally attractive investment, they are in effect being subject to a tax. If banks’ reserves are lent to the government, and if this lending is a substitute for sales of government securities to the private sector, then the government is in effect given an interest subsidy that equals the difference between the rate of interest on government bonds (ib) and the rate of interest paid to banks on their reserves (ir) times the stock of reserves (R). The amount of the subsidy (S) is thus given 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 of the government in one or a combination of two ways. If the central bank does not charge interest on its loans to the government, its net income is reduced by the imposition of—or increase in—a reserve requirement, since it may pay interest on the bank reserves. This means that transfers of central bank profits to the government will be lower than otherwise.⁴⁰ However, this negative impact on the government’s accounts will be more than offset by lower explicit interest payments by the government, since ib exceeds ir. Although government borrowing is subsidized, the explicit rate of interest on government securities is not reduced; instead, the amount of borrowing by this means is reduced.

If the central bank does charge a market rate of interest on its loans to the government, the government’s interest expenditures will not be affected. The central bank’s net income will be affected, however, and the increase in its transfer to the government will reduce the budget deficit. Despite the fact that interest expenditure is not affected, the imposition of a reserve requirement where reserves are compensated at a rate below the market effectively lowers the government’s cost of borrowing.

The reserves tax does not have to be used to subsidize lending to the government; it can be used to finance any expenditure. Nonetheless, the use of artificially high reserve requirements to channel credit to the government is certainly not uncommon.

The quasi-fiscal tax on reserves can be made transparent by including it—for analytical purposes at least—in government tax revenue, which will then increase by the value S. If the central bank has not been charging the government interest on the loans that are financed by the increase in reserves, this should be offset by an increase in interest payments of the same amount. When the central bank has been charging interest, the increase in tax revenue should be offset by a decline in central bank income —if a marginal rate of transfer of central bank profits of 100 percent is assumed, then the government’s property income is reduced by the amount of the tax.

This discussion has focused on how the tax entailed by reserve requirements is determined, and on the way it shows up in the public sector’s financial accounts. The incidence of the tax is another matter. To the extent that reserve requirements lower deposit rates, for example, then depositors bear part of the cost; higher lending rates mean that borrowers pay part of it as well. These issues have been discussed at some length in Molho (1992).

Contingent Liabilities

The problems posed for the contingent liabilities entailed by a central bank’s quasi-fiscal operations are essentially the same as those posed by similar operations of the central government. Both central banks and central governments can guarantee loans, for example. In both cases the size of the operations can be very large, but it will have no impact on a cash-based measure of the financial operations of the government until money is actually paid out for a loss. The inadequacies of a cash measure of the public sector’s operations, when contingent liabilities are important, have been the subject of some commentary (see Towe, 1993, for example). At a minimum, cash-based measures of the deficit should be supplemented with a measure of the outstanding value of contingent liabilities.

Substantial valuation problems may arise with contingent liabilities; these problems are not unique to the operations of central banks and other financial public institutions. To take the case of loan guarantees, should one seek data on the total stock of loans that are guaranteed or just that part of the stock that is deemed to be at risk of non performing? Often the information that would permit the calculation of the expected value of realized losses entailed by a contingent liability program may not be available.⁴¹

Towe (1993) has described one method for calculating the capitalized subsidy element created by a loan guarantee. This is the present value of the reduction in interest payments that results from the guarantee and is given by the following formula, where L is the loan principal, i^w is the interest rate that would have been obtained without the guarantee, and i^g is the guaranteed rate:

Inflation Adjustment

The adjustment of the conventional measure of the financial balance of the NFPS to take account of the impact of inflation on the real value of net public debt is a controversial issue.⁴² Nevertheless, inflation-adjusted deficits can play a useful complementary analytical role to traditional indicators of the fiscal stance. The basic rationale for the adjustment is that the inflationary component of the government’s interest expenditure is really a form of amortization. It compensates the holders of public sector debt for the decline in the real value of their assets; therefore it should not be classified as a current expense of the government or as income in the hands of the recipient.⁴³

The income statements of central banks are also affected by inflation, and the issue arises whether the conventional results need to be adjusted for inflation. This section briefly discusses some of the consequences of using the standard inflation adjustment, with the aid of this highly simplified central bank balance sheet:

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

View Table

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 no operating costs and no physical assets. Also for simplicity, net worth includes the valuation adjustment for changes in the nominal value of foreign exchange: hence, it reflects not only nominal increases in the bank’s net credit position, other things being equal, but also increases in the nominal (local currency) value of foreign exchange.⁴⁴

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

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

where r is the real rate of interest, d is the rate of depreciation of the local currency, and pw and pd are the international and domestic inflation rates.⁴⁵ This can be reexpressed as

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

Adjusted for inflation in the usual way, central bank 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 inflation tax, pdMB, in the real income of the central bank. Thus, if the “real” component of the central bank’s income were transferred to the government, revenue from the inflation tax would be counted above the line. This suggests that the standard approach to adjusting deficits for inflation is not appropriate in the case of the central bank. Eliminating the inflation tax term from the preceding equation would simply leave:

r(NFA + DCP + DCG).

If, for the sake of argument, it is assumed that the central bank were paying the market rate of interest on the entire monetary base, then the conventional adjustment would result in the following statement of real income:

r(NFA + DCP + DCG- MB).

In this case, however, the central bank would be compensating holders of the MB by paying a market-related rate of interest on its liabilities. The central bank is—by assumption—not exploiting its monopoly over money creation, and it is earning simply the market-related return on its net worth (the expression in parentheses equals NW). In this case, the conventional adjustment would be appropriate.

MER Practices

An example of the subsidy entailed by a preferential exchange rate can be drawn from the experience of Costa Rica, where the central bank, during the period 1979-82, sold foreign exchange at lower rates in domestic currency than those at which the foreign exchange had been purchased. These subsidies were mainly for imports of certain medicines, medical equipment, and petroleum products, and for public external debt service. In 1981, the subsidies amounted to 4 1/2 percent of GDP (United Nations, 1991a).

A second subsidy arrangement in Costa Rica involved a broader set of beneficiaries. In 1981, during a foreign exchange crisis, a large backlog of requests for foreign exchange accumulated at the central bank. Unable to satisfy the demand, the central bank compensated importers who purchased foreign exchange in the parallel market by issuing foreign-exchange-denominated bonds paying the six-month London interbank offered rate (LIBOR) and equivalent to the difference between the official exchange rate and the rate importers had to pay in the parallel market.⁴⁶ The face value of these bonds issued amounted to 12.7 percent of GDP and accrued an annual interest cost of 2 percent of GDP (United Nations, 1991a).

A good example of a simultaneous implicit tax and subsidy scheme operated through the foreign exchange market is provided by Egypt, where, before the exchange system reforms of 1991, a separate foreign exchange pool was established for certain transactions. Implicit taxes were imposed on exports of petroleum and cotton and Suez Canal dues. Foreign exchange was provided at a subsidized rate for certain foodstuffs and external public sector debt-service payments. Net foreign exchange purchases by the central bank at the more appreciated rate—and, consequently, net profits or losses obtained from the operation of the system—varied over time, reflecting, among other influences, movements in international oil prices and the impact of arrears, rescheduling, and forgiveness on actual payments of external public debt service.

In Venezuela, in the period from 1983 up to the adoption of a unified freely floating exchange rate system in March 1989, the most important quasi-fiscal operation of the central bank related to the operation of an MER system. In December 1986, the central bank rate applying to most imports was Bs 14.5 per U.S. dollar, compared with a free market rate of about Bs 22 per dollar. imports of foodstuffs and certain other items were permitted a rate of Bs 7.5 per dollar, and certain debt-service payments were transacted at Bs 4.3 per dollar. Petroleum export receipts, which accounted for approximately 90 percent of Venezuela’s foreign currency earnings, were converted at Bs 7.5 dollar until mid-1987, when the rate was changed to Bs 14.5 per dollar.

The net outcome of the system was to generate profits for the central bank until the devaluation of the rate applied to oil exports, whereupon the balance shifted to a deficit. The resulting decline in profitability of the central bank was exactly offset by the increased profitability of the state oil company, so that the combined balance of the central bank and the NFPS was not affected by the change to the exchange rate. The recourse to the overvalued rate for petroleum transactions did, however, obscure the important role played by the state oil company in the generation of public sector revenues.

A further example of the way in which the lack of transparency that results from the implicit taxes and subsidies of an MER regime can extend beyond the impact on the central bank’s accounts is furnished by the experience of Uganda in 1987-88. The official rate of U Sh 60 per U.S. dollar was in sharp contrast to the parallel market rate of U Sh 200-400 per dollar. The Coffee Marketing Board was surrendering its foreign exchange earnings at the official rate to the Bank of Uganda, which was selling, in part, to parastatal enterprises at approximately the same rate.

Because the revenue from the coffee export tax was determined by the difference between the average export price expressed in local currency at the official rate and the price paid to farmers plus processing, transportation, and marketing margins— which were also subject to strong inflationary pressures—budgetary revenue from the coffee export tax was declining sharply. Certain parastatals, however, including the state-owned breweries and the tobacco companies, were allocated foreign exchange at the official rate, which artificially reduced their costs, allowing the government to impose excise taxes at high rates on tobacco and liquor.

Casual observation of the official statistics showed a decline in coffee revenue and a quite spectacular increase in excise collections. Had these transactions been valued at a more appropriate shadow exchange rate, they would have revealed the continued crucial role of coffee taxation and the overstatement by the conventional revenue measure of the role of excise taxation on beer and cigarettes.

Exchange Rate Guarantees and Assumption of Exchange Rate Risk

The experience of Chile in the debt crisis that began in 1982 provides examples of quasi-fiscal operations involving the exchange system, including recourse to both subsidized exchange rates and exchange guarantees. Following the devaluation in June of 1982, the central bank undertook to provide foreign exchange at a subsidized rate to private sector entities with large external debt obligations. IMF staff estimates suggest that the cost of this operation averaged about 2 percent of GDP a year during 1983-85.

As part of a second policy initiative that began in 1983, the central bank offered foreign exchange guarantees to help obtain scarce foreign exchange reserves. The central bank purchased foreign exchange and entered into a commitment to resell it at the same real exchange rate (that is, the initial rate adjusted for domestic inflation minus foreign inflation) after one year. An interest premium was also paid on these “swaps.” Its costs were estimated at about 0.5 percent of GDP a year during 1984—86.

As part of a third operation related to the scheme to restructure private debt, the central bank assumed certain external liabilities of the private sector. Again, as the result of a substantial real currency devaluation, the central bank incurred losses averaging 1 percent of GDP in 1983-84.

In the former Yugoslavia, the primary factors behind the sizable quasi-fiscal deficit of the National Bank of Yugoslavia (NBY) in the late 1980s were the exchange rate guarantee extended for foreign currency deposits and the policy of maintaining persistently negative real interest rates. The exchange rate guarantee worked as a redeposit scheme. Banks redeposited their foreign currency with the NBY. In return, they could obtain a dinar credit from the NBY up to the value of the redeposited foreign currency at the current exchange rate. The valuation losses accrued to the NBY and were realized upon withdrawal of the foreign exchange by the banks. The rules of withdrawal, however, were not always clear and were often changed. Although the banks soon discovered that it was profitable for them to withdraw deposits, and then to redeposit them again, the central bank sought to prevent this from occurring.⁴⁷

At first, banks were not paid interest on their deposits, nor did they pay interest on the loans from the NBY. Banks profited because they paid international interest rates on the deposits but were able to lend out the domestic currency counterpart of these deposits at much higher nominal rates in the domestic market. Because of exchange rate devaluations, however, their liabilities grew more rapidly than their credits, and the interest costs of servicing the stock of foreign currency deposits increased correspondingly. In response to this, the NBY consented to pay an interest rate on the foreign currency deposits that was equivalent to international market levels: in turn, it charged the discount rate on the dinar credits. In the meantime, however, these dinar credits became only a fraction of the amount of foreign currency deposits. Under these revised arrangements, the operations continued to be very profitable to the banks. The arrangements were canceled in October 1988, so that net increases in the stock of redeposits after that date no longer benefited from the guarantee. The consolidated banking system—-the NBY and commercial banks taken together—realized huge losses as a result of its foreign-exchange denominated liabilities. The counterpart of these losses was subsidized credits to the state corporate sector.

Subsidized Lending

In Turkey, the agricultural bank used to extend credits to the agricultural sector at subsidized rates, financing them in part through rediscounts from the central bank, as well as deposits from other public sector entities, on which it paid below-market rates. This practice ended in April 1994. In the former Yugoslavia, the NBY refinanced commercial bank credits to agriculture at subsidized rates.

In Argentina before 1990, the central bank borrowed from private banks and typically on-lent these resources to official banks at both the national and provincial levels at subsidized interest rates. These institutions in turn financed the budgets of the provincial governments, as well as the operations of certain loss-making public enterprises. The National Mortgage Bank, relying on central bank financing, granted subsidized credits that became largely non-performing assets. In Uruguay, the Bank of the Republic of Uruguay has extended a significant amount of subsidized credit, and the mortgage bank has acted similarly to finance housing and construction activity.⁴⁸

In Bangladesh during the 1980s, state-owned commercial banks were directed to grant sizable quantities of credit to preferred sectors, most prominently agriculture, often at interest rates below their cost of funds. The directed nature of credit reduced the banks’ autonomy and undermined incentives for proper credit evaluation. Consequently, subsequent loan recovery from priority sectors was poor, and asset quality suffered. Even though the banks became insolvent de facto, lax accounting and supervision permitted them to continue to show profits on their books and to pay taxes and dividends to the government. In light of the revenue implications, the government tended to turn a blind eye to these practices, which effectively entailed financing transfers to the government out of new deposit growth.

In China and India, countries with a legacy of central planning, the public banking systems are heavily involved in directed lending. In China, “policy loans” are broadly defined as loans for long-gestation, low-return, high-risk projects considered essential for national economic development (generally at preferential interest rates and according to priorities determined by the central government). Such loans were in the past provided by specialized banks, but in 1994 this responsibility was transferred to specially created policy banks, paving the way for the gradual commercialization of the specialized banks.

The three policy banks that were created—the Agricultural Development Bank, the State Development Bank, and the Export-Import Bank—have been granted different mandates. For the Agricultural Development Bank, policy lending will entail loans for building grain reserves, poverty alleviation, agricultural development, small-scale farming, animal husbandry, water conservation, and technical innovation. The State Development Bank is expected to finance infrastructure and the “pillar” industries. The Export-Import Bank will provide finance for imports as well as buyers’ and suppliers’ credits for exports of capital goods (such as ships, aircraft, communications satellites, and production facilities).

Selective Reserve Requirements and Credit Ceilings

In Egypt, under the system in effect before the end of 1990, all commercial banks were required to hold 30 percent of specified foreign- and domesticcurrency-denominated liabilities in the form of liquid assets, the most important of which were government bonds. This tended to create a captive market for government securities, which were sold at negative real interest rates. In Kenya, commercial banks and nonbank financial institutions are required to maintain a minimum liquid assets ratio; liquid assets are defined as notes and coins, balances held at the central bank, balances with other domestic commercial banks and banks outside Kenya, and treasury bills. Until December 1995, at least 50 percent of liquid assets had to be in treasury bills.⁴⁹ Instances of similar practices in other countries could readily be given. Typically, they lower the costs of public-debt service at the expense of the financial institutions—or their customers—on whom the minimum ratios are imposed.

India provides an example of the use of selective credit ceilings. The Reserve Bank of India requires banks (the major commercial banks are government owned) to allocate 40 percent of total credit to priority sectors such as agriculture, small-scale farmers, and small borrowers, with subtargets for each. For example, credit to small farmers should not fall below 9 percent of the total. Interest rates on loans to priority sectors are set by the Reserve Bank and entail a subsidy element.

In Greece, although the state-owned banks are run on a commercial basis, at times some of them have been pressed to extend credit to nonviable or loss-making firms, a practice that was reflected in a deterioration of the banks’ loan portfolios as well as their profitability.

Rescue Operations

In Chile, in December 1981, the central bank intervened in four banks and four finance houses that were in liquidation and granted emergency credit amounting to approximately 81/2 percent of GDP to these institutions. During the following four years, the central bank continued to grant emergency credits to commercial banks and also purchased a portion of their nonperforming loans. This latter operation was in the form of a repurchase agreement wherein the banks were committed to repurchase the loans out of future profits. The central bank purchased 60 percent of the nonperforming loans with securities that paid a real rate of return of 7 percent and matured in four years, while the commercial banks were given an indefinite period during which they would repurchase the loans, to which a real interest cost of 5 percent a year was applied. The flows related to these operations amounted to 3.2 percent of GDP in 1982 and 12.5 percent of GDP in 1983 but, by 1987, had turned negative as repurchases exceeded loans (United Nations, 1991b).

The Central Bank of Chile also financed a debt rescheduling between domestic banks and domestic debtors. Commercial banks were granted subsidized credits to finance an exchange by their debtors of short-term liabilities at market interest rates for long-term debt at subsidized rates. This had the effect of improving the quality of the commercial bank loan portfolio, given the enhanced likelihood that the debtors would be able to service the subsidized debt. The program was most active in the period 1984—85, with average annual reschedulings of 4 percentage points of GDP.

In 1990, state banks in Brazil were experiencing serious financial difficulty because they were unable to roll over the debts of their state treasuries. In their efforts to deal with this difficulty, the state banks raised overdrafts on their legal reserves, obtained large rediscount loans from the central bank, and sold certificates of deposit at rates well above those offered by private banks. In early 1991, the central bank and the governments of the four largest states reached an agreement for the temporary financing of these banks’ debt through a swap of central bank securities for state securities amounting to approximately 2 percent of GDP.

In Uruguay, the collapse of the system of preannounced devaluations in late 1982 prompted a financial crisis, which resulted in the deterioration of a substantial portion of the banking system’s loan portfolio. In response, the central bank instituted several programs, of which the most important involved the central bank’s purchasing the nonperforming loan portfolios of commercial banks with its own foreign-currency-denominated bonds and promissory notes paying market-related interest rates. Because the central bank issued liabilities amounting to approximately $965 million and received in exchange largely nonperforming assets, a large part of its quasi-fiscal losses are accounted for by this operation. In the Philippines, a rescue operation of troubled financial institutions by the central bank in the mid-1980s also entailed the acquisition of nonperforming assets and contributed to substantial quasi-fiscal losses.

In Greece, where there exists no deposit insurance scheme and the central bank’s statutes do not explicitly provide for a lender-of-last-resort function, an illustrative case of central bank intervention occurred. In 1988 the Bank of Crete, the ninth-largest commercial bank, faced a severe crisis owing to mismanagement and fraud. The management of the bank was removed and replaced by a Bank of Greece commissioner. The bank was provided liquidity through overdrafts at the Bank of Greece and by blocking deposits that public enterprises had maintained at the bank. The overdrafts were subsequently converted into a loan with a concessional rate of interest. The capital of the bank was extinguished, and Dr 10 billion (about 0.1 percent of GDP) of the public enterprises’ deposits were converted into preferred nonvoting shares, while the remaining deposits were converted into a five-year loan with an interest-free grace period. The directed use of public enterprise deposits (quite similar to the directed use of central bank rediscount facilities) is by no means unique to Greece.

Uruguay

The history of QFA in the central bank and certain other PFIs since the early 1970s⁵⁰ can be divided roughly into three periods: the first, which ended with the foreign exchange crisis of late 1982; the following decade; and the period since 1992.

The most important QFA in the years just preceding the foreign exchange crisis was the support the central bank was required to extend to the mortgage bank to finance its lending program for low-cost housing. In 1982, the quasi-fiscal losses on this single operation exceeded 7 percent of GDP. Another source of losses was the preferential rates on loans for nontraditional exports and meat packing charged by 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 devaluations (the tablita) in November 1982 resulted in a substantial unexpected depreciation of the peso and led to a financial crisis that severely damaged the quality of the loan portfolios of the commercial banks. Many of their customers had borrowed heavily in U.S. dollars and suffered a substantial loss as a result of the abandonment of the tablita and the general worsening of financial conditions.

In response to the crisis, the central bank introduced a portfolio purchase scheme to acquire the nonperforming loans of the foreign-owned banks. Medium-term financing for this scheme was provided by the parent banking companies. In 1983, some local banks were included in the scheme: the weakest of them were subsequently taken over by foreign banks under an arrangement worked out with the central bank. As part of the arrangement, the central bank acquired the weakest part of these banks’ loan portfolios—on which it would earn no interest—in exchange for foreign-currency-denominated bonds and promissory notes.

The losses from these quasi-fiscal operations accounted for a large part of the losses of the central bank until 1992, when the government assumed most of this debt (Table 4). Local currency expenditures on operations, remuneration of reserve requirements, and open market operations, as well as other foreign currency outlays—interest on foreign debt and on foreign currency deposits—also contributed to the quasi-fiscal deficit and have become its principal component in recent years.

^{Table 4.}

Uruguay: Operating Losses of the Public Financial Sector¹

(In percent of GDP)

Sources: Central Bank of Uruguay; and IMF staff estimates.

¹Excludes the Bank of the Republic.

^{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 financial
		public 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	–0.6
		Interest on foreign-currency-
			denominated debt	–2.9	–1.7	–1.7	–1.4	–1.3	–1.6	–0.9	–0.7	–0.6	–0.6
		Interest on bills for monetary
			regulation	–0.9	–0.8	–0.9	–1.1	–1.4	–0.4	–0.3	–0.1	—	—
	Mortgage bank			…	…	…	–0.4	–0.6	–0.5	–0.3	–0.1	–0.1	—
	Intervened banks			…	…	…	–0.5	–0.3	–0.2	–0.1	—	—	—

Sources: Central Bank of Uruguay; and IMF staff estimates.

¹Excludes the Bank of the Republic.

View Table

^{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 financial
		public 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	–0.6
		Interest on foreign-currency-
			denominated debt	–2.9	–1.7	–1.7	–1.4	–1.3	–1.6	–0.9	–0.7	–0.6	–0.6
		Interest on bills for monetary
			regulation	–0.9	–0.8	–0.9	–1.1	–1.4	–0.4	–0.3	–0.1	—	—
	Mortgage bank			…	…	…	–0.4	–0.6	–0.5	–0.3	–0.1	–0.1	—
	Intervened banks			…	…	…	–0.5	–0.3	–0.2	–0.1	—	—	—

Sources: Central Bank of Uruguay; and IMF staff estimates.

¹Excludes the Bank of the Republic.

Until recently, the Bank of the Republic and the mortgage bank made losses because of a weak loan portfolio resulting from past operations. These banks’ losses were not compensated by the central bank or the budget. New loans no longer contain a subsidy element, and the subsidy element on outstanding loans is being reduced to the extent possible. The authorities continue to improve the administration and operation of both the Bank of the Republic and the mortgage bank.

The four local banks that were the object of central bank intervention were officially taken over by the public sector in the mid-1980s. Two were merged, and one of the three remaining was privatized; their losses were partially covered by transfers from the budget. The remaining two commercial banks have now been recapitalized, and one was privatized in March 1994. The last is expected to be privatized in 1996. As noted above, in 1992 the government assumed most of the debt incurred by the central bank as a result of the portfolio purchase scheme.

The losses of the central bank began a quite steep decline in the early 1990s as a result of these operations, the decline in the stock of external debt entailed by the 1991 Brady operation, the lower level of international interest rates, and the decline in the stock of central bank bills. In mid-1993, the replacement of the central bank’s own bills (whose outstanding stock in June 1993 was $110 million) by treasury bills for the conduct of open market operations caused a further decline.

Jamaica

The Bank of Jamaica experienced large losses since the mid-1980s, averaging 5.3 percent of GDP in 1985/86-1992/93 (Table 5). Foreign exchange operations were the major source of losses in the mid-1980s, but their relative importance has since declined. Subsequently, but before the recent reforms, the interest paid on certificates of deposits (CDs) issued by the central bank for the purposes of monetary control became the major contributor to the central bank’s losses.

^{Table 5.}

Jamaica: Operating Balance of the Bank of Jamaica

(In percent of GDP)

Sources: Bank of Jamaica: and IMF staff estimates.

^{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	0.7
Expenditure		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	0.6
	Exchange subsidies	1.0	…	…	…	…	…	…	…	…	…	…
Certificates of deposit (CDs)		…	1.0	1.0	1.8	2.2	1.8	1.6	2.6	0.9	1.5	—
Revenue		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.

View Table

^{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	0.7
Expenditure		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	0.6
	Exchange subsidies	1.0	…	…	…	…	…	…	…	…	…	…
Certificates of deposit (CDs)		…	1.0	1.0	1.8	2.2	1.8	1.6	2.6	0.9	1.5	—
Revenue		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.

The origin of the central bank’s losses on foreign exchange operations lies in the combined effects of a heavily negative NFA position and the role of various forms of exchange guarantees, which contributed to the central bank’s large net foreign liabilities. The exchange rate guarantees or subsidies have taken different forms, such as trading losses under the dual exchange rate regime in the mid-1980s, auction losses, external debt operations on behalf of public enterprises, deposits associated with foreign assistance for development projects, contingency guarantees under an International Finance Corporation loan, and outright exchange rate guarantees. The central bank’s large net foreign exposure meant that the sharp devaluation that took place in the mid-1980s caused the bank’s interest expenditures to substantially exceed its interest income, resulting in large net losses.

The relative importance of foreign exchange operations has declined since the mid-1980s. Beginning in November 1985, the central bank started issuing its own CDs for the conduct of open market operations, since it had no portfolio of interest-bearing government securities that it could use for this purpose. The interest cost of the CDs rose from 1 percent of GDP in 1986/87 to 2.6 percent of GDP in 1992/93. The incremental effect on the income statement of the issue of CDs by the central bank would have been no different from the effect of a conventional open market operation, but because the bank’s balance sheet was weak to begin with, the losses began to mount.⁵¹ Reflecting these developments, the nonearning assets of the central bank-which include non-interest-bearing government securities it has received to cover losses—have risen substantially.

Since 1992, the Jamaican authorities have taken a number of actions to put the central bank’s finances on a sounder footing. Losses from the issue of CDs by the Bank have now been eliminated, because all CDs have been retired. The central bank has also stopped providing financing for the external debt service of the rest of the public sector and making exchange rate guarantees. These policies have essentially eliminated the central bank’s losses. The government does, however, cover any losses that may occur in a given fiscal year by transferring early in the following year marketable securities in the amount of the losses. In a reflection of these policies, the central bank achieved a small profit in 1995/96. The government is also considering recapitalizing the central bank to offset the non-interest-bearing government securities on its books.

The case of Jamaica is in some respects a good example of the difficulties involved in separating the quasi-fiscal element of a central bank’s operations from the financial and monetary element. A large share of the losses entailed by the depreciation of the Jamaican dollar are undoubtedly quasi-fiscal in nature, however, and the use of CDs by the Bank artificially reduced the cost of public debt service.

Ghana

The major source of quasi-fiscal losses of the Bank of Ghana dates from the period before the implementation of the economic recovery program in 1983. Until then, the central bank had assumed the foreign exchange risk on certain foreign loans incurred by some government-owned development banks and some state enterprises. As the debt-service obligations on these loans became due. the central bank recorded the losses stemming from its guarantee in its revaluation account (given the sizable depreciation of the Ghanaian cedi that had taken place in the meantime, the cost of foreign exchange to the entities who had benefited from the guarantee was much less than the current exchange rate). Despite the discontinuation in 1983 of the subsidization of foreign exchange risk, the realized losses stemming from this practice have been substantial in recent years.

Although the central bank has at times engaged in certain other QFAs, these are believed not to have had a significant effect on its balance sheet. Since 1983, its financing of the operations of the central government and the Cocoa Board (a major state enterprise) has been provided at market-related terms, with the yields on government paper and cocoa bills having been determined since late 1987 at weekly auctions. The central bank also engages in a very modest amount of subsidized lending to its own employees. The government’s sizable demand deposits with the central bank have traditionally earned no interest.

Only one small government-owned financial institution, the Cooperative Bank, has been given a loan by the Bank of Ghana on concessional terms (at a rate lower than the normal rediscounting rate). This loan was needed to ensure that the Cooperative Bank, which has been financially troubled, could meet the minimum reserve requirements. The Cooperative Bank has now been restructured.

Since February 1987, all transactions in foreign exchange by the central bank have been conducted at a unified exchange rate, determined at its weekly auction. MERs were briefly maintained during the periods April-October 1983 and September 1986— February 1987. Since April 1990, the official auction market and the foreign exchange bureau market (legalized parallel foreign exchange market) have been unified in the context of an interbank foreign exchange market.

The central bank made net profits in its profit and loss account in the mid-to-late 1980s, and a sizable portion of these profits were passed on to the government (Table 6). However, the derivation of the profit and loss account did not take into account the changes in the revaluation account of the central bank that reflected the losses from the exchange guarantees extended before 1983. In the audited accounts of the central bank, however, the accumulated revaluation losses were shown as a claim on the government, and the government acknowledged this liability to the external auditors of the central bank.

^{Table 6.}

Ghana: Quasi-Fiscal Operations of the Bank of Ghana

(In percent of GDP)

Source: Data provided by the Bank of Ghana.

¹Revaluation losses outstanding as of end-September 1990, amounting to ¢311.769.5 million, were taken over by the government in December 1990.

^{Table 6.}

Ghana: Quasi-Fiscal Operations of the Bank of Ghana

(In percent of GDP)

			Fiscal Years Ended June						June-Dec	Fiscal Year Ending Dec.
			1985	1986	1987	1988	1989	1990	1990	1991	1992
Net profits on the profits and loss
		account 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.

¹Revaluation losses outstanding as of end-September 1990, amounting to ¢311.769.5 million, were taken over by the government in December 1990.

View Table

^{Table 6.}

Ghana: Quasi-Fiscal Operations of the Bank of Ghana

(In percent of GDP)

			Fiscal Years Ended June						June-Dec	Fiscal Year Ending Dec.
			1985	1986	1987	1988	1989	1990	1990	1991	1992
Net profits on the profits and loss
		account 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.

¹Revaluation losses outstanding as of end-September 1990, amounting to ¢311.769.5 million, were taken over by the government in December 1990.

To resolve once and for all the problems created by the foreign exchange guarantees, the accumulated revaluation losses as of end-September 1990 (¢311.8 billion or the equivalent of 16.4 percent of GDP) were replaced in late 1990 with long-term government bonds, offering a yield currently set at 4 percent. The takeover of the revaluation account was designed to restore solvency to the accounts of the central bank and to strengthen its income position, so as to help ensure that in its liquidity management operations the central bank would not be unduly influenced by considerations about its own profitability.

Poland

Before the transition to a market economy, there were no clear lines of demarcation between the budgel and the financial sector in Poland. This made it difficult to untangle purely fiscal operations executed through the budget from quasi-fiscal operations undertaken elsewhere in the financial system. The government sector included a number of extra-budgetary funds (or “special purpose” funds) and some specialized financial institutions. As an example, the Foreign Debt Service Fund was established in 1986 to disburse subsidies to a specialized bank, which was created to be the government’s intermediary in foreign borrowing by state enterprises. Determining the true obligor of such foreign debt was thus quite complicated.

The operations of the National Bank of Poland (NBP)—formally autonomous from the Ministry of Finance but factually an operating agent for the ministry—were closely linked to the economic plan. The NBP operated as a “monobank” in the sense that it had a monopoly of both central and commercial banking functions. It was responsible for formulating an annual credit plan and regulating interest rates. In addition, there were a number of specialized state-owned banks. Financial institutions were required to transfer 80 percent of “profits” to the budget (Table 7).

^{Table 7.}

Poland: Transfer of Profits by PFIs to the State Budget

(In percent of GDP)

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.

^{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 financial
		institutions 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	1.1	1.0
	Enterprise 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.

View Table

^{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 financial
		institutions 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	1.1	1.0
	Enterprise 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.

As a part of the structural reform measures that marked the transition to a market economy, a new law on the NBP and a new banking law came into force at the beginning of February 1989. A central feature of these two laws was the devolution of most of the commercial banking functions of the NBP to nine state-owned commercial banks. At the same time, the main financial subsidy operations were incorporated in the budget.

Promulgation of these laws significantly reduced the scope of QFAs. The NBP has scaled back quasifiscal operations in three areas discussed below; quasi-fiscal operations in other PFIs have remained negligible. However, the recapitalization operations undertaken in 1990-94, to deal with the nonperforming assets in the portfolio of the banking system can be seen as a form of partial compensation to the banks for lending to public sector enterprises on preferential terms.

The exchange system during 1989 was basically a dual regime, with both an official rate and an interbank auction of zlotys for convertible currencies. These auctions are estimated to have resulted in profits of around 1 percent of GDP in 1989, which were transferred to the state budget. Since the 1990 exchange reform, all banking system transactions take place at the official rate. The elimination of this profitable quasi-fiscal operation on the income statements of financial institutions was offset by the reforms discussed above.

The refinance rate of the NBP had a differentiated structure until end-1989. This was replaced with a unified refinance rate in 1990; this rate has since been adjusted periodically to keep it positive in real terms, In 1990, interest rate subsidies, mainly for housing and agriculture, were moved to the budget; the use of preferential interest rates for other lending operations was substantially scaled back. Directed and preferential credit programs for housing, certain public sector investment projects, and agricultural procurement remain in place. The interest rate on most of these activities is linked to the NBP refinance rate; to the extent that the interest rate falls short of the refinance rate, these operations entail a subsidy that is covered directly by the budget. The stock of outstanding directed credit is estimated to have 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 cover exchange rate or interest rate losses. There is a guarantee on deposits up to the equivalent of about ECU 3,000 in the commercial banking system through a deposit insurance scheme that was mostly financed by transfers from the NBP and the finance ministry.

Efforts to deal with the problem of bad loans experienced by the commercial banks have entailed a series of recapitalization operations. Two such operations took place in the early stages of reform to clean out nonperforming assets acquired in the period before reform. In 1990, foreign liabilities of specialized financial institutions were explicitly accepted as a government liability. In 1991, the government issued treasury bonds to compensate the banking system for foreign currency losses during the pre-reform period; the interest on these bonds was incorporated into the budget.

Notwithstanding these operations, nonperforming assets continued to accumulate, mainly in the form of bank loans to domestic loss-making state enterprises. Consequently, additional recapitalization operations took place in 1993 and 1994. Unlike similar operations in many other countries, these did not entail a swap of government paper for nonperforming loans. Instead, banks received government bonds in an amount determined by an earlier audit of their financial condition, and the banks were left to collect what they could of the money owed them by the state enterprise sector.⁵²

The interest actually paid on these bonds is incorporated in the budget, although 10 percentage points of the 15 percent interest rate on the bonds is capitalized. Since the operation is included in the budget, it is not quasi-fiscal in nature; nor is it evident that the earlier recapitalization operations were quasi-fiscal operations. However, recapitalization could be said to be compensating the commercial banks, which were publicly owned, for loans made to keep key public enterprises afloat. To the extent that these loans—as distinct from the recapitalization bonds— had a subsidy element, they entailed a quasi-fiscal operation by the banks.

An additional QFA was introduced with the passage of the banking law in April 1992. The law stipulated that the NBP should remunerate banks for the reserves they are required to hold with the NBP. However, it also stipulated that the income thus generated should be used for agricultural restructuring through the establishment of a Fund for Farm Restructuring and Debt Relief. The fund received an amount equal to 0.1 percent of GDP in 1994.

Romania

The Romanian experience with quasi-fiscal operations illustrates some of the difficulties that reform in this area must confront. Despite some initial successes in reducing the scope and importance of QFAs, pressures to perpetuate them remain strong.

Before 1990, the financial system in Romania was subordinated to the requirements of the system of centralized planning, with the flows of funds through the banking system designed to accommodate the requirement of enterprises implementing the targets of the physical plan. There were five state banks, four of which fulfilled specialized functions (in the areas of foreign trade, agriculture, and household lending), but in effect the banking system operated as a monobank system.

Reform of the banking system commenced in December 1990, with the transfer of commercial banking operations of the National Bank of Romania (NBR) to the newly established Romanian Commercial Bank. A legislative framework for a market-based two-tier banking system was put in place in April 1991, with the passage of a banking law and a central bank law. Further institutional reforms, culminating in the transfer of the management of foreign exchange reserves and the foreign exchange system to the NBR, occurred in November 1991. A number of new private and joint venture banks have been established since the legal reforms of 1991, but the five large state banks continue to play a dominant role in the banking system.

The reforms instituted in 1991 provided the basis for the development of a market-based banking system in which credit is allocated on the basis of commercial criteria. However, there have been recurrent pressures on both the NBR and the state-owned banks to revert to their traditional role of supplying credit to state enterprises that need funds to meet their production and employment goals. Accommodation of these pressures has resulted in a series of quasi-fiscal operations by both the NBR and the state-owned banks and has also led the NBR, until late 1993, to favor an accommodative monetary policy and low administered interest rates. This policy stance was reflected in market interest rates that were strongly negative in real terms, thereby generating an effective transfer of income from holders of financial assets to borrowers that provided at least temporary support to ailing enterprises.

Quasi-fiscal operations of the NBR have included the use of refinancing credits to finance the clearance of state enterprises’ payments arrears, subsidized credit programs, the operation of a de facto dual exchange rate system, and the use of NBR profits to finance selected extrabudgetary expenditures. The NBR does not extend guarantees on domestic or foreign loans; such guarantees are provided by the Ministry of Finance.

At end-1991, the NBR implemented a comprehensive bailout for enterprises with payments arrears, extending to banks low interest credits for onlending to enterprises, to allow them to clear their arrears to other enterprises. While successful in generating a one-off clearance of arrears, the program resulted in a 62 percent increase in aggregate domestic credit during the month of December 1991 and validated state sector managers’ belief that budget constraints could be violated without penalty. A more modest credit scheme to allow selected enterprises to clear payments arrears again was introduced in the first months of 1993. Since 1993, the government has avoided further arrears-clearance arrangements, although there was considerable pressure for such an operation in late 1994, In late 1995 a debt-conciliation process involving multilateral negotiations between a large group of enterprises, banks, and the Ministry of Finance was initiated. This was intended to demonstrate that the days of government bailouts were over and to reinforce the message that creditors would also suffer from unpaid debts.

Subsidized credits were introduced by the NBR in August 1992, following a period in which monetary policy had been temporarily tightened. These credits carried an annual interest rate of 13 percent, compared with the NBR reference rate of 80 percent, and were for onlending primarily to agriculture. By early 1993, some 90 percent of NBR credits were extended at subsidized interest rates.⁵³ Nearly all credit lines with interest rates less than the NBR reference rate had been phased out by end-1993. However, a large part of NBR refinancing is channeled to agriculture. The ratio reached some 70 percent of all NBR refinancing credits by end-1994, but it declined to 64 percent by end-1995. The NBR charges the reference rate on the loans, but a subsidy from the budget provides for 60 percent of the cost of interest payments.

The exchange rate system was formally unified in November 1991, but the mechanics of price determination in the fixing session (November 1991-May 1992) and the foreign exchange auction that replaced it failed to clear the market. This led to the emergence of a “gray market” in which foreign exchange sold at a premium that varied over time from 5 percent to 30 percent. The mechanisms used to ration the supply of foreign exchange made available by the banking system at the official rate were not transparent, but importers of “strategic” products (oil. foodstuffs) appeared to have received priority treatment and hence a de facto subsidy in the allocation process.

The reform of the exchange rate system in April 1994 effectively unified the system for a time. However, a significant spread between the official and bureau rates emerged in late 1994 and again in late 1995 and early 1996.

The use of central bank profits has been another area in which the NBR has undertaken what are essentially budgetary operations. Until 1995, the central bank law required that the NBR pay profits tax (averaging 45 percent) to the state budget on its reported profits, but allowed the NBR board discretion as to how it allocated the after-tax profit. Uses to which these funds have been put include a variety of public expenditure programs. Through mid-1993, these parafiscal activities were conducted outside the budgetary framework: in 1994, some of these operations were included as line items in the budget, albeit financed from extrabudgetary revenues (the NBR). The scope for such activity has been substantially reduced by the new profit tax law. which was enacted at the beginning of 1995. It stipulates that 80 percent of the NBR profits are to be transferred to the state budget.

The state-owned banks are mandated to operate along commercial lines, subject to the formal control of the State Ownership Fund, which in turn is charged with the task of privatizing all state-owned commercial companies by 1998.⁵⁴ In practice, managers of state-owned banks are subject to pressures to allocate credit on the basis of noncommercial considerations. The impact of such pressures on credit allocation is difficult to quantify, but it is clear that the large credit needs of selected state enterprises, such as the state agricultural processing and distribution enterprises (Romcereal), have received priority treatment from the state banks. Large quasi-fiscal deficits in the state enterprise and agriculture sectors persist, with the result that a significant share of the state-owned banks’ portfolio is accounted for by credits to enterprises that are potentially unviable.

Banks have appeared reluctant to initiate workout proceedings with large problem clients because the State Ownership Fund, which owns both the clients and the banks, has proceeded slowly with the restructuring of financially troubled state enterprises. Taken together, these factors have contributed to an allocation of credit that is probably quite different from what would prevail in a market-driven banking system.

The government has made a commitment, supported by a World Bank financial and enterprise sector adjustment loan, to accelerate the privatization or liquidation of state enterprises, and to strengthen and privatize the state-owned banks. Measures to strengthen the banks include limiting the access of problematic state enterprises to bank credit, strengthening the NBR’s bank supervision capabilities, and reducing adverse selection by requiring collateral for NBR refinancing. These measures should also help to alleviate distortions in credit allocation.