This paper examines the fiscal activities that governments in a sample of 26 developing countries have obliged their central banks to undertake. On the revenue side, the banks’ fiscal activities include collecting seigniorage by issuing currency and imposing reserve requirements, demonetizing currency notes of particular denominations, forcing unfavorable conversions of old for new currency after a currency reform, setting interest rate ceilings on financial assets that compete with government bonds, and requiring import pre-deposits. They may also be charged with administering multiple exchange rate systems--in which exporters are obliged to sell their foreign exchange earnings to the central bank at prices lower than those some importers pay for foreign exchange from the central bank--and with collecting miscellaneous fees.
On the expenditure side, central banks allocate subsidized credit to agriculture and export sectors and to development finance institutions through selective credit policies, provide explicit or implicit deposit insurance and bail out insolvent financial (or even nonfinancial) institutions when necessary, and provide exchange rate subsidies or guarantees, particularly for debt service and essential imports. Interest rate ceilings imposed and enforced by central banks constitute both taxes and fiscal expenditures in the form of subsidies. The taxes are imposed on depositors/lenders, who subsidize “preferred” borrowers.
By making central banks responsible for a range of fiscal expenditures, developing countries undermine not only the banks’ independence but also monetary policy objectives. Fiscal activities involve expenditures that reduce central bank profits and may even produce losses. If central bank losses are not met from government budget appropriations, they must eventually lead to an expansion in central bank money and the abandonment of any monetary policy goal of price stability. As this paper shows, central banks do not possess any miraculous widow’s cruse. Governments can tap central bank profits either directly through transfers or indirectly by obliging the central banks to engage in the fiscal activities described here. They cannot, however, have their cake and eat it.