Appendix II Varieties of Country Experience

George Mackenzie, and Peter Stella
Published Date:
October 1996
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This appendix describes a variety of QFAs that have been practiced in IMF member countries. Its intent is to give a flavor of the many forms that such practices can take; the countries whose experience is cited here are not the only ones where such practices may be found. The experience of quasi-fiscal practices in IMF member countries is very rich, and an exhaustive treatment would require many pages.

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.

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