IV Implications for Policy

George Mackenzie, and Peter Stella
Published Date:
October 1996
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When quasi-fiscal activity is prevalent, the conventional measures of fiscal activity, such as the NFPS borrowing requirement or the deficit of the central government, are misleading indicators of the stance of fiscal policy and of the demands the government makes on credit availability.

Traditional Approaches

For example, if the central bank is used as a conduit for subsidies to PFIs or NFPEs, both the true budget deficit and credit to the government are understated by the budgetary accounts. In these cases, it is preferable to rely on an enlarged measure of the financial operations of the NFPS, one that is extended to incorporate the net income of the central bank and other PFIs that engage in QFA.30 Central bank losses are often included in the definition of the public sector used in IMF-supported programs (see Bennett, Carkovic, and Dicks-Mireaux, 1995). Since the operations of the NFPS will be measured generally on a modified cash basis, while central banks normally would use an accruals-based measure, the amalgamation of the results for the central bank and the NFPS normally requires that adjustments be made to the central bank’s income statement.31

This approach makes no attempt to distinguish between the fiscal and the financial operations of the central bank or PFIs. Instead, it assumes that QFAs will be fully reflected in the profit and loss accounts of the PFIs that engage in them. Given the difficulty of disentangling the fiscal from the monetary and financial operations of the public financial sector, this treatment of QFAs has the considerable merit of being relatively simple.

More Sophisticated Approaches

When QFAs are recognized as a problem, the calculation of an enlarged measure of the NFPS balance that incorporates the net income (or losses) of the central bank and other PFIs will provide a better measure of the true fiscal stance than the conventional measure. That said, more ambitious approaches should be considered in cases where QFAs are deemed to have a significant macroeconomic impact and are readily quantifiable.

A range of analytic options may be considered, all of which would supplement reliance on the enlarged measure of the financial balance of the public sector. Least ambitious, and most appropriate where quantification is difficult or subject to significant imprecision, would be to make a qualitative analysis of those QFAs that give rise to significant distortions in resource allocation or whose macroeconomic impact would appear significant (and for which only a rough order of magnitude can be estimated). For some of the QFAs cited above, the number of assumptions required to quantify them may simply make quantification unfeasible. Among others, unfunded or contingent liabilities may require a qualitative rather than a quantitative approach.

In other cases, the implicit taxes or subsidies entailed by QFAs may be more readily quantifiable. To make these estimates, those QFAs that can be measured relatively easily would effectively be extracted from the accounts of the central bank or other PFIs (see Box 1). The estimates could be included in an analysis of the fiscal stance—albeit shown separately—and used to calculate alternative measures of the fiscal contribution to monetary expansion.32 This analysis would highlight the impact of QFAs and the dangers they pose to macroeconomic policy. The quantification of QFA in common currency areas poses other problems (see Box 2).

Box 1.Calculating the Value of Quasi-Fiscal Activities: Two Examples

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

The quasi-fiscal tax on exports is calculated as:

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

The quasi-fiscal subsidy to imports is calculated as:

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

The centra bank was thus a net gainer from this particular QFA in 1995, to the extent of LCU 400 million. Under the procedure proposed in the text for financial programming and analytical purposes, export taxes of the central government would be increased by LCU 600 million, and commodity subsidies by LCU 200 million. Central bank credit to the government could be adjusted downward by the amount of the net tax (LCU 400). The net income of the central bank after adjustment for the QFA would be reduced by LCU 400 million, so that the combined public sector deficit would not change.

2. A central bank extends a loan at an interest rate of 10 percent a year to the agricultural development bank; the current annual rate of inflation is 15 percent; loans of comparable maturities have rates of interest ranging from 20 to 25 percent. If the outstanding balance of the loan is LCU 200 million, a reasonable estimate of the range of the annual subsidy extended to the agricultural development bank would be:

Lower bound:

(20 - 10)/100 × (LCU 200 million) = LCU 20 million.

Upper bound:

(25 - 10)/100 × (LCU 200 million) = LCU 30 million.

The degree of uncertainty surrounding the size of the subsidy may make it inappropriate to enter an estimate in the accounts of the central government even for programming or analytical purposes. Nonetheless, this information could enter the standard presentation of the public finances as a memorandum item. When the estimate has a lower variance, however, it could be entered as a subsidy in the accounts of the central government and financed by additional credit from the central bank. The central bank’s net income would be correspondingly adjusted.

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

The issue arises whether the proposed treatment of QFA might pose problems for a common currency area such as the CFA franc zone of West and Central Africa, or the East Caribbean Currency Union (ECCU). In the CFA franc zone, monetary policy is largely conducted on a regional basis, with the national central banks in the two regions acting essentially as agents for the two regional central banks. In such a setting, it is not obvious how to allocate the cost of any QFA across governments.

However, a rule for the division of the losses from QFA has to be worked out if the procedures advocated in this paper for incorporation of QFA in the budget can be applied. If QFA can be quantified and has not already been reflected in reduced transfers from the central bank, one criterion consistent with that used in the paper would be to divide its cost among the member countries according to their stipulated share in the profits (that is, their share of the capital) of the regional bank. Consequently, any transfer made by the central bank to a member country would, for analytical purposes, be reduced by the amount of the prorated loss incurred from QFA.

Where feasible, the most desirable option would be to classify such QFAs as any other conventional NFPS operation. This treatment would then allow them to be incorporated on a gross basis—that is, quasi-fiscal taxes with budgetary revenue and quasi-fiscal subsidies with expenditure—in the conventional presentation of public sector operations; a corresponding adjustment of the estimated net income of the affected PFIs would be made.

The adoption of these alternative approaches would simply mean that QFAs, instead of being buried in the accounts of the central bank and other PFIs, would, to the maximum extent possible, be brought out into the open and included as part of the analysis of fiscal policy. This procedure would not require a change in established procedures for statistical compilation, since the proposed estimates of quasi-fiscal taxes and subsidies would be used only for analytical and financial programming purposes.

Proposals to consolidate central bank budgets with the government’s budget have been opposed by some on the grounds that consolidation would pre-commit monetary policy to an unacceptable degree; that it would circumscribe the central bank’s flexibility to act as provider of liquidity and lender of last resort. Even if this view is accepted, there is little reason not to isolate those central bank activities that are obviously fiscal in character. Thus, the central bank could produce a budget that would differentiate between items for which a specific expenditure allocation is made, and those for which the outcome is neither predetermined nor publicly predicted.33

Structural Reform

Beyond the exercise of accurately measuring and illuminating the scope and magnitude of QFAs, the issue then remains whether such activities should be more formally recognized as fiscal activities (thus reducing their impact on the net income and balance sheets of PFls), One possibility would be for governments to include QFAs explicitly in the budget, to execute them through the normal budgetary channels, and to subject them to the same scrutiny as other budgetary operations. A second and less radical alternative would be to require the budget to make explicit compensation to PFIs for the losses entailed by any QFAs they are obliged to perform. The latter approach has been used by Ghana and Bolivia in recent IMF-supported programs, but for particular QFAs.

The first of these alternatives, if it could be implemented, would make QFAs more transparent and would subject them to greater scrutiny than would the second. Both alternatives, however, have drawbacks. First, some types of QFAs would normally have to remain within the accounts of the central bank, simply because they would defy efforts to estimate them. As a consequence, it will not generally be possible to apply either of the two approaches— at least not in a thoroughgoing way.

Second, and more fundamental, neither approach deals with the problem of QFAs with distortive effects on the allocation of resources. For example, converting an MER system into a set of explicit taxes on trade, or converting a complex scheme of differentiated reserve requirements into budgetary taxes, only makes the practices more transparent. Their distortive effects on production and consumption decisions remain, although their presence in the budget may make it more likely that the political will to eliminate them can be mustered.34

The ultimate solution to the truly harmful quasi-fiscal practices will often lie in measures outside the budgetary realm. With reference to the two examples just given, the solution to the distortive effects of an MER system that on balance is a net tax on the economy may be the adoption of a unified exchange rate system and a broadening of the base of a relatively neutral levy such as the value-added tax. A permanent solution to distortive QFAs in PFIs will require basic reform of the banking system, rather than the inclusion in the budget of any subsidies or taxes to compensate for those losses or gains resulting from such quasi-fiscal instruments as selective credit controls and reserve requirements.

The importance of structural reform may be especially great for economies in transition, where the financial system has long been expected, as a matter of course, to bail out loss-making establishments. In such conditions, it is particularly difficult to draw a line between the functions of the NFPS and PFIs. Here, reform has to extend beyond even the financial system, so that the systemic pressure on banks to facilitate the violation of the hard budget constraint is eliminated at its source. Indeed, QFAs in the setting of a formerly centrally planned economy are, in a sense, only a symptom of a far greater problem: the lack of incentives in the public enterprise sector for financial discipline.

The measures taken by Uruguay in mid-1992 in its IMF-supported adjustment program illustrate how these various approaches can be combined to address the problem of QFAs. To deal with the short-run macroeconomic and financial consequences of QFAs, the central bank’s net losses, the losses of banks that had received assistance from it, and the losses of the state-owned mortgage bank were included in the measure of the overall public sector deficit. At the same time, the authorities made a commitment to privatize the commercial banks that remained in the public sector and to transfer part of the central bank’s external debt to the treasury. Clearly, the solution to the problems posed by quasi-fiscal measures requires both a modification of traditional definitions of public sector activity and structural reforms.

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