The financial system of a country comprises all those entities that are permanently engaged in financial transactions, including the incurring of liabilities and acquiring of financial assets, in that country.7 As in the nonfinancial public sector, the coverage of the financial system depends on the institutional framework of a country, as well as on the availability of data. Also, as mentioned below, in analyzing certain financial variables (such as private sector financial assets and quasi-fiscal government deficits), transactions in other economic sectors may need to be taken into account.

Definition of the Sector

The financial system of a country comprises all those entities that are permanently engaged in financial transactions, including the incurring of liabilities and acquiring of financial assets, in that country.7 As in the nonfinancial public sector, the coverage of the financial system depends on the institutional framework of a country, as well as on the availability of data. Also, as mentioned below, in analyzing certain financial variables (such as private sector financial assets and quasi-fiscal government deficits), transactions in other economic sectors may need to be taken into account.

In normal circumstances, most transactions of the financial system are handled through the banking system, which is usually controlled by the monetary authorities. But in certain countries, important financial transactions pass through nonbank financial institutions, which may not be controlled by the monetary authorities. Indeed, if the power of the monetary authorities is strictly limited to the banking system, it may be even more important to adopt a wider coverage of the financial system, because it is likely that many transactions are being conducted outside the control of the monetary authorities. Nevertheless, in many countries, a broader and more meaningful coverage is limited by the lack of information on nonbank transactions.

It is important to know the legal aspects of the financial system, particularly the legal authority of the monetary authorities in terms of modification of interest rates, legal reserve requirements, exchange rates, etc. Certain banks (particularly state-owned banks) may benefit from different legislation or may evade penalties for noncompliance with banking legislation.

Coverage of the System

A financial system includes the banking system, which is composed of the central bank, the deposit money banks, and, in some countries, specialized and development banks. Among the deposit money banks (usually referred to as commercial banks), it is sometimes important to distinguish between state banks, domestically owned banks, and foreign-owned banks.

State commercial banks have often been created to separate the commercial activities of the central bank from its purely central bank activities. In many countries, state commercial banks are very important in terms of their share of total banking system deposits and credit, and in some countries they act as treasury agents for collecting government revenue and have a wide network of branches throughout the country. At the same time, these banks are often vulnerable to political pressure; as a result, their portfolios are plagued by nonperforming loans and large operating losses. For this reason, in several countries, these banks benefit from different, more lenient, banking regulations in terms of access to central bank credit, legal reserve requirements, and penalties for noncompliance with banking legislation. They are capitalized by government transfers and are the only recipients of deposits from the treasury and public sector agencies and enterprises, which often constitute their loanable resources. This favorable treatment is usually justified by the authorities on the grounds that the state banks serve an important social function. Because they lend to small firms that would not qualify for credit from private banks, their extensive network of branches provides banking facilities in small villages where no other bank would operate, and they are expected to play an important role in the implementation of government credit policies.

Foreign-owned banks are often subject to discriminatory banking legislation in terms of capital requirements, deposits that they may receive, access to central bank credit, and legal reserve requirements. This negative discrimination is usually justified by the authorities on the grounds that local banks could not compete with foreign banks in terms of technology and access to foreign markets. Nevertheless, in several instances, foreign-owned banks have acted as intermediaries for lending from their parent companies and can play an important role in attracting external commercial credits.

Specialized banks, which are often government owned, are expected to direct credit exclusively to certain key sectors of the economy, such as the agricultural or the mining sector. Like the state-owned commercial banks, specialized banks benefit from especially lenient legislation and may experience serious financial difficulties, because a large portion of their portfolio is insolvent. Their losses are often covered by periodic transfers from the treasury. Because of the political sensitivity of the operations of these banks, the authorities are usually reluctant or unable to bring these banks under tighter control.

The loanable resources of the development banks are often derived from foreign loans and transfers from the government and/or the central bank (sometimes as a local counterpart to foreign loans). Their credit operations may be in the form of long-term loans. But these banks often lend in local currency, even though most of their resources are from foreign loans. Exchange losses in the event of a devaluation are usually covered by the treasury and sometimes by the central bank. The quality of development banks’ portfolios varies from country to country, but in several instances, they have been a source of financial problems, since they may not have sufficient profits to service their foreign debts.

Apart from the banking system, there are several other financial institutions that can play an important role. In countries where the central bank is trying to enforce strict banking legislation via interest rates and legal reserve requirements, private financial companies are likely to be established. Because these companies are not subject to bank regulations, they are often owned by commercial banks as a way to circumvent central bank regulations. Certain private financial companies specialize in investing abroad private savings, often in violation of exchange regulations. They may also act as intermediaries for foreign lending and as channels for capital flight.

The saving and loan associations also play an important role, receiving deposits from, and lending to, low-income families. They can be a source of serious financial problems, as recent events have demonstrated in several countries. Their accounting systems are often deficient, and controls over their lending operations are not strict. Often their deposits are not subject to legal reserve requirements, so they can afford to pay higher interest rates on their deposits than commercial banks. As a result, they may receive demand deposits that they lend for long-term purposes at fixed interest rates. This creates an unbalanced portfolio of short-term liabilities and long-term assets. The sociopolitical importance of these institutions causes authorities to be reluctant to raise interest rates, because they are aware that several of the savings and loan associations could face serious financial difficulties if rates were increased.

Housing banks have been established for the purpose of lending for residential construction. Their resources may derive from long-term loans, both from the government and from foreign sources (in which case they may be subject to exchange risks, if they have been lending domestically in local currency), and they lend on a long-term basis. Because of the social function of their operations, controls are not necessarily strict.

Insurance companies can represent an important source of credit, but their operations are often difficult to identify. Post offices can also be the recipient of important savings, usually from low-income families.

As mentioned above, the coverage and definition of a country’s financial system should be tailored to the specific problems of that country, as well as to the availability of reliable statistics. In particular, two questions should be asked: (a) whether monetary aggregates can be monitored, and (b) whether the authorities have the legal instruments to control monetary developments. If the answers to these are negative, the coverage of the financial system may have to be modified.

Quality of Data

Monetary accounts are derived from balance sheets, which, by and large, are reliable documents. However, their quality and reliability may be affected by incorrect classification of accounts and by valuation differences. It is advisable, therefore, to have access to a fairly detailed disaggregation of accounts, as well as to the instructions given to banks on the reporting of certain operations.

In general, it is advisable to prepare monetary statistics as much as possible from original sources (such as balance sheets) rather than from derived, aggregate data prepared by the authorities. A balance sheet would provide more information and be a better basis to classify correctly the accounts and to reconcile monetary statistics with fiscal accounts and balance of payments statistics. It is not advisable to ask local officials to fill in tables that were prepared for a recent economic development report. As the local staff are likely to be unfamiliar with the classification of accounts, or with the logic behind it, the outcome might not be satisfactory, and important operations could be misclassified. Preparation by the IMF staff of monetary statistics and their consolidation from original sources involve considerably more work, but the tradeoff is that it enhances quality and reliability of the statistics.

The quality and reliability of financial statistics may also be affected by their periodicity and availability. In general, central bank balance sheets are available with a minimum of delay, unless the bank has a large number of branches, in which case the staff may initially receive preliminary balance sheets that can differ considerably from the final ones. It is not easy to have access to, or to work with, the balance sheets of individual commercial banks, particularly if they are numerous. For this category, the staff has to depend on consolidated data prepared by the local authorities. But staff should attempt to gain access to consolidated information as detailed as possible and to investigate whether available data cover all banks.

If the financial system includes nonbank financial intermediaries, it is likely that their balance sheets are not available with the same periodicity, timeliness, and degree of detail as bank information, in which case a consolidation of the financial system may be delayed considerably.

The quality of monetary statistics may also be affected by valuation of foreign currency denominated operations. In countries with flexible exchange rates, individual banks may be using different exchange rates to convert foreign currency-denominated accounts into local currency. In certain countries, banks may use the exchange rate of each operation in reporting foreign currency operations, without adjusting for devaluations. In this case, an asymmetry will arise between the value in foreign currency and in domestic currency, as shown in the following example:

Assume that a bank purchases $100 at an exchange rate of 1 local currency unit (L/C) per $1, and subsequently sells $50 at an exchange rate of 2 L/C per $1. The entries in the balance sheet would be as follows:

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Quality of data may also be affected by periodic adjustments in the valuation of gold; renegotiation of foreign liabilities, in which case the balance sheet may report a shift from short-term to long-term foreign liabilities; and advances to the central government over and above the level authorized in the central bank charter (these operations may be shown in unclassified assets, pending their legalization). Unclassified assets and liabilities may include a variety of accounts that have not been sectorized properly.

Reconciliation of Data

Financial system statistics may differ from estimates derived from other sources because of either timing or coverage discrepancies. The following summarizes the main sources of discrepancies:

Differences Within the Monetary Accounts

These discrepancies mainly reflect timing differences in interbank transactions. At times, they may also reflect incorrect reporting of central bank emergency rediscounts or credit to banks to cover legal reserve deficiencies, as the central bank may show the transactions on a gross basis, whereas the recipient banks may report them on a net basis. Discrepancies may also reflect incorrect reporting of two-step loans, foreign loans to the central bank for relending to the private sector through the commercial banks, as the latter may report the transaction as a foreign liability rather than a liability to the central bank. If discrepancies are large and persistent, they should be investigated.

Differences from Public Sector Statistics

These differences are listed in Section V. Reconciliation of Data.

Differences from Balance of Payments Statistics

These discrepancies may reflect the incorrect reporting of two-step loans. As the banking system may be responsible for servicing of the debt, these loans may be shown in the bank balance sheets as foreign liabilities rather than liabilities to the central government. As mentioned in the previous section, the use of different exchange rates may create discrepancies between foreign currency-denominated accounts in the monetary statistics, which are in local currency, and their equivalent in foreign currency.

Presentation of Data

Financial statistics are derived from balance sheets and supporting documents of financial institutions; however, accounts in these documents must be rearranged to make their analysis meaningful. Data should be regrouped into five blocks, covering: (a) net foreign assets; (b) net domestic credit; (c) intersectoral transactions; (d) other foreign accounts, which in most developing countries are mainly in the form of liabilities; and (e) the system’s liabilities to the private sector (such as private sector financial assets accruing to the financial system).

There is a certain logic to this presentation, which presents the resources available to the system for lending (liabilities to the private sector and other foreign accounts) and their use (net domestic assets). Intersectoral transactions reflect timing and coverage of discrepancies, which should be equal to zero, if all data were reported correctly and simultaneously—a situation that is impossible to achieve. (In most countries, intersectoral transactions are negligible when compared with other accounts.) The result of the above transactions is reflected in the net foreign assets.

This presentation is also consistent with the flow of funds referred to in other sections, as it separates transactions with other economic sectors of the country (net domestic credit, liabilities to the private sector, and intersectoral transactions), which by definition should add up to zero, from transactions with the external sector (net foreign assets and other foreign accounts).

Following is a brief description of the main components of the blocks:

A. Net foreign assets. These accounts cover short-term foreign assets and liabilities of the financial system. The coverage of the net foreign assets should be the same as that used for the balance of payments. In reviewing the composition and strength of the foreign assets of a country, attention should be paid to certain legal and political aspects.

From a legal point of view, not all short-term foreign assets are at the disposal of the monetary authorities. Thus, net foreign assets of the financial system may be broadly divided into: (a) net international reserves, which include net foreign assets legally owned or controlled by the monetary authorities—mainly the central banks; and (b) other net foreign assets, which include all other net short-term foreign assets and liabilities of the financial system. In certain countries, commercial banks are not authorized to hold claims in foreign currency or to incur liabilities denominated in foreign currency. Since all net foreign assets are owned by the monetary authorities, commercial banks are acting as agents for the monetary authorities. The short-term foreign assets and liabilities shown in the balance sheets of the commercial banks are legally owned by the monetary authorities and form part of the net international reserves of the country. In other countries, commercial banks are legally authorized to maintain foreign assets or incur liabilities denominated in foreign currency; these net foreign assets are not under the control of the monetary authorities and, therefore, do not form part of the net international reserves of the country.

Short-term foreign assets include claims on nonresidents that are fairly liquid. Short-term foreign liabilities include all liabilities with an original maturity of up to 12 months. In addition, all transactions with the IMF (except transactions related to the Trust Fund Account) are considered part of net international reserves, even though their maturity exceeds 12 months.

The composition of foreign assets varies from country to country. Assets usually include holdings of foreign currency; claims on other central banks and foreign banks; foreign treasury bills and bonds, including International Bank for Reconstruction and Development (IBRD) bonds; claims under clearing and payments arrangements; and holdings of gold and SDRs. (However, the allocation of SDRs is not a short-term liability.) In reviewing the foreign asset position of a country, staff should also be aware of any political constraints that may limit the authorities’ use of certain assets, regardless of their liquidity. For example, in some countries, the monetary authorities would not dare to sell, or give as collateral, their gold holdings because of possible political repercussions. Also, certain claims on other central banks (particularly balances under clearing and payments arrangements) may be liquid on paper, but in practice they cannot be redeemed at the agreed settlement periods because the debtor bank has no resources to pay for them. For instance, in the past, balances under the Central American Clearing House accumulated in favor of or against some member countries, in spite of provisions calling for their periodic settlement in hard currency. Banks may be reluctant to drop these assets from their international reserves, partly because it would be an admission that these assets are indeed not liquid.

In some countries, central bank regulations may prescribe that currency in circulation should be backed by foreign currency or gold. Foreign assets of a central bank may also include foreign-currency deposits of domestic commercial banks to discharge legal reserve requirements on foreign currency-denominated liabilities. The central bank liability to the commercial banks would not be shown as a foreign liability because it represents a transaction among residents of the country. Nevertheless, in assessing the adequacy of the foreign assets of a central bank, staff should be aware of the potential liability in foreign currency that could arise if the commercial banks were to draw down their legal reserve deposits with the central bank in the case of a drop in their own foreign currency-denominated deposits.

Sometimes the level and changes in net international reserves reflect certain exceptional transactions, which may inflate or reduce the gross short-term foreign assets and liabilities. For instance, a central bank may borrow foreign currency at a maturity of more than one year, in which case the gross foreign assets would show an increase, while the offsetting liability may be included in other, longer-term liabilities. Similarly, gross foreign assets of a central bank would remain unchanged if the country is accumulating external arrears (this issue is reviewed below). The reversal of these two operations (that is, repayment of a loan or settlement of arrears) could also result in an abnormal change in gross foreign assets and liabilities. As a result of the renegotiation of external debt, the maturity of short-term foreign liabilities may have been extended, in which case short-term foreign liabilities would show a drop offset by an increase in other, longer-term foreign liabilities.

B. Net domestic credit. The three main components of net domestic assets are: (i) net credit to the nonfinancial public sector, (ii) credit to the private sector, and (iii) other accounts.

  • (i) Net credit to the nonfinancial public sector. These accounts cover net financial system credit and liabilities to the nonfinancial public sector. The coverage of the nonfinancial public sector should be the same as that used in the previous section and in the balance of payments; otherwise, reconciliation of data would be impossible. But regardless of the coverage, the central government and the state enterprises should always be shown separately, because of the policy implications of their transactions with the financial system. Moreover, the central government usually deals only with the central bank, whereas state enterprises may also deal with commercial banks. There is a certain logic in presenting these accounts on a net basis, as the user of credit and holder of deposit is the same institution.8

Bank credit may be granted to the nonfinancial public sector in the form of direct credit for specific purposes such as financing of the government budget or a state enterprise, advances against future credit authorizations, and purchases of treasury bills and bonds. Bank credit may also be extended to finance certain extrabudgetary operations, as described in the previous section, including capitalization of interest due, and not paid, by the public sector to the financial system, and credit extended to service a debt carrying a guarantee of the financial system. Public sector deposits with the banking system also include sinking funds for servicing of debts and temporary deposits of government revenues prior to their being credited to the treasury accounts.

In classifying monetary accounts, staff should be aware that, in several countries, certain extrabudgetary operations will not be shown under government credit, because they are considered to be operations that are either transitory in nature or pending legalization. These operations are usually included under unclassified assets and liabilities.

Bank credit to the central government may be related to the capitalization (or recapitalization) of state-owned financial institutions. Such capitalization is usually in the form of a special issue of long-term government bonds, which would be reported in the balance sheet of the recipient bank as a credit to the central government on the asset side and as an increase in capital on the liability side. These bond issues are often carried outside the regular central government budget, although the payment of interest would be included in the budget.

In several countries, the central government has taken over the external debt of the rest of the public sector and/or of banks as a result of a comprehensive renegotiation of the country’s external obligations. In certain instances, the government has also taken over the domestic debts of the private sector, in which case, the monetary accounts would show an increase in credit to the government, offset by a decline in credit to the private sector. In this event, analysis may be complicated; first, because the expansion of credit to the private sector could be underestimated, and second, because a discrepancy may arise with the fiscal statistics, since these operations are usually carried out outside the regular budget of the central government, although they may be reflected in the balance sheets of the affected banks.

  • (ii) Credit to the private sector. These accounts include gross credit from the financial system to the private sector, broadly defined; that is, all credit to individuals, enterprises, nonfinancial public sector entities, and financial institutions that were not included in other sectors. As in the case of credit to the nonfinancial public sector, some of the credit to the private sector may be recorded in banks’ balance sheets under different accounts.

Usually, the staff would also have access to certain other classifications of credit, which vary from country to country. A common classification is by recipient sector or purpose (for example, industry, agriculture, commerce, etc.) or by maturity. However, such classification is at times misleading because credit may have been erroneously recorded under a certain category to take advantage of preferential (subsidized) interest rates or to comply with banking regulations that may require a minimum percentage of bank credit to be directed to a certain sector. Another important piece of information is how much of the portfolio is nonperforming, as it indicates the strength or weakness of the financial system, particularly if the ratio of overdue loans to total outstanding credit is rising. This could be particularly important in the case of state-owned banks, because they may require capitalization from the central government or credit from the central bank. In reviewing these figures, the staff should be alert to sharp decreases in the outstanding nonperforming portfolio. Such decreases may indicate a rescheduling of these loans for the sole purpose of showing an improvement in the financial situation of a bank, but it is not certain whether the debtor will repay the rescheduled loans.

Another important classification is between credit denominated in local currency and in foreign currency, because of the implications of a devaluation from a policy point of view. In this case, the staff should ascertain also whether the foreign currency-denominated credit carries an exchange rate guarantee.

  • (iii) Other accounts. This broad heading covers all other monetary accounts that have not been classified under other categories or that, because of their nature, cannot be properly classified. Generally speaking, other accounts include:

    • (a) Official capital and reserves. These cover capital and reserves of state-owned banks, including government participation in private banks. (Privately owned capital and reserves are recorded with private sector financial assets.) It should be mentioned that the capitalization (or recapitalization) of state-owned financial institutions is usually provided for by the issue of long-term government bonds, which would be recorded as a bank claim on the central government. Often, this operation is not reported in the central government budget, thus occasioning an extrabudgetary operation; and

    • (b) Profit and losses of state-owned banks. The staff should analyze these accounts with great care, as they indicate whether a state-owned financial institution is experiencing serious difficulties that may require a (re)capitalization from the central government. Also of particular importance are the profit and losses of the central bank, as they may be the result of quasi-fiscal losses, that is, operations that should be carried out by the central government, including exchange rate losses incurred by the central bank in connection with the servicing of the government external debt.9

As already mentioned, in certain countries, due to fiscal difficulties, the central government does not pay interest on its outstanding central bank debt, even though it is legally expected to do so. In such circumstances, the central bank usually will extend a credit to the central government for the unpaid (capitalized) interest and record the offsetting entry as a profit. There is the risk that in order to present a lower fiscal imbalance, the minister of finance may request that central bank profits be transferred to the treasury, even though these profits originated from nonpayment by the treasury and have not—and in all likelihood never will—materialize, since they are strictly the result of an accounting procedure.

State banks’ losses usually reflect loans to customers that, in normal circumstances, would not be creditworthy, as well as loans made under political pressure. As a result, these credits are difficult to recover. Under these circumstances, the resources available for lending to the private sector are reduced. Also, given the circumstances of such lending, the central government and/or the central bank are under pressure to cover these losses. This provides an incentive for inefficiency or, at best, for postponing a reorganization of the troubled financial institutions. It also sends the wrong signal to other weak financial institutions, whether they are state or privately owned.

  • (c) Fixed assets. In the flow of funds these would be recorded as investment. In some countries, changes in fixed assets of the financial system have been ignored in preparing national accounts, whereas in others changes in fixed assets of state-owned financial institutions may have been included in government investment. In the latter case, the staff should be careful to avoid duplications when reviewing or adjusting the national accounts.

  • (d) Valuation adjustments. These are mostly in the form of adjustments resulting from changes in the exchange rate. Two kinds of valuation adjustments may occur. The first is attributable to adjustments made by the authorities, while the second may result from adjustments made by the staff to record foreign currency-denominated accounts at a certain exchange rate. It would be advisable to separate the two valuation adjustments, because the authorities are aware of their own adjustments, and a consolidation of the two adjustments may be a source of confusion and misunderstandings.

  • (e) Unclassified assets and liabilities. These cover all those miscellaneous accounts that cannot be properly attributed to a sector, including transitory and pending accounts. Because of their nature, these accounts are likely to show only minor fluctuations from year to year on a net basis; therefore, any major fluctuation should be investigated because it could be the result of incorrect classification of other operations. One of the most important misclassified operations is bank credit to the central government over and above the level that banks are allowed to extend. It is advisable to calculate unclassified assets and liabilities directly and not derive them as a residual balancing item; otherwise, errors made elsewhere in the monetary accounts will not be detected.

C. Other foreign accounts. These accounts include medium- and long-term claims on and liabilities to nonresidents. The most important accounts are:

  • (i) Subscriptions to, and deposits of, international nonmonetary institutions, including the World Bank, Inter-American Development Bank (IDB), African Development Bank (AfDB), and Asian Development Bank (AsDB). These subscriptions represent long-term claims; deposits may be used by those institutions to cover domestic costs of projects and/or their local offices;

  • (ii) Foreign medium- and long-term liabilities (as well as long-term claims on nonresidents), including the assumption of public and/or private sector external debt as a result of debt renegotiations;

  • (iii) Counterpart deposits generated by foreign assistance, in particular, proceeds from the sale of commodities received as foreign aid, such as the U.S. Public Law 480. Uncoordinated use of these counterpart funds may complicate the preparation and implementation of monetary programs, particularly when these counterpart deposits are large and there is pressure in the donating country to use them in lieu of additional assistance; and

  • (iv) Allocations of SDRs (holdings of SDRs are recorded as foreign assets).

D. Interbank transactions. These accounts cover all claims and liabilities among those financial institutions that are included in the definition of the financial sector. They include primarily cash holdings of the rest of the financial system, deposits lodged with the central bank to discharge legal reserve requirements, holdings of central bank bills, credits and rediscounts from the central bank (including emergency credit to cover legal reserve deficiencies), and interbank deposits. In certain countries, state-owned banks do not report in their balance sheets emergency rediscount to cover their legal reserve deficiencies, in which case gross claims and liabilities would not agree, although the net balance would not be affected.

In theory, interbank transactions should add up to zero, as claims on and liabilities to financial institutions should offset each other. In practice, however, claims and liabilities do not match each other,10 mostly because of timing discrepancies, and interbank transactions show a net balance that may shift from positive (net claims) to negative (net liabilities) in a rather erratic fashion. The lack of a net interbank float usually means that the monetary accounts have been adjusted and that an entry has been made elsewhere to compensate for the bank interfloat (in which case another account—usually, unclassified assets and liabilities—has been altered). Also, the presence of a large and persistent interbank float (particularly if it is always either a net claim or a net liability) may be an indication of incorrect sectorization of accounts.

The fact that interbank balances may shift from positive to negative complicates the preparation of monetary projections. In this context, it is preferable to assume that the net interbank float remains unchanged, thus allowing for a clearer projection of all other accounts, including unclassified assets and liabilities.

E. Liabilities to the private sector. These accounts include all private sector claims on the financial system and may differ from total private sector financial assets (see section on Private Sector Financial Assets below). These claims include cash holdings, demand deposits, time and savings deposits (including certificates of deposit), foreign currency deposits, bank bills and bonds, and advance import deposits, as well as bank capital and reserves owned by the private sector. (As mentioned above, the private sector is herewith defined as all those individuals and enterprises that have not been attributed to a specific sector, such as nonfinancial public sector, financial system, or external sector.)

In the past, the distinction between demand deposits and time and savings deposits was emphasized; however, this distinction has lost its importance, because in many countries, banks allow their clients to shift deposits liberally and with very short or no notice. Foreign currency-denominated deposits may be a source of difficulties, because in many cases there is insufficient information to separate deposits of residents from deposits of nonresidents. Advance import deposits at times have been used to obtain resources needed to finance public sector deficits. But these deposits can accumulate rapidly, so their dismantlement may have serious monetary implications.

In certain circumstances, private sector claims on the banking system may be inflated by bank action to circumvent banking legislation. Thus, in countries with rigid ceilings on bank lending interest rates, banks may insist that borrowers request a loan for a greater amount than needed, with the difference being deposited in a blocked account in the bank. In this case, both credit to the private sector and private sector deposits with the financial system would be inflated. Similarly, the emergence of arrears may result in an artificially inflated level of private claims on the financial system. This problem is reviewed in more detail below.

Analysis and Interpretation of Data

Private Sector Financial Assets

Apart from investing in the financial system, the private sector may invest its financial assets in other forms; for instance, government bonds. However, since the overall size of financial assets that the private sector is willing to hold in the country is somewhat inelastic, investment in government bonds reduces the savings that accrue to the financial system. In these circumstances, to better analyze and project private sector claims on the financial system, the staff should attempt to estimate total private sector financial assets, including all financial claims on other sectors of the economy. In addition to claims on the financial system, these private sector financial assets may include claims on the public sector in the form of bills and bonds, which can be denominated in local and/or foreign currency; claims on financial institutions not included in the consolidated financial system; and investment in stocks and bonds. This approach may be important in countries where the central government is actively competing for private resources through the sale of bills and bonds. These instruments would usually carry a competitive interest rate and/or other fiscal incentives (such as tax-free interest, inflation-adjustment clauses, bearer notes, and sight redemption). If the government has issued bearer instruments denominated in foreign currency, staff may be faced with the difficulty of separating holdings by nonresidents from holdings of residents.

Measuring Changes in Monetary Accounts

In analyzing monetary developments in a country, questions may arise as to how to measure flows of financial transactions.11 There are two ways to do this, and each is important, depending on the purpose of the measurement. In the IMF, changes are measured against a common base, which is the stock of the financial system’s liabilities to the private sector at the beginning of the period. This base has been selected because it represents the resources available to the financial system for lending. In other words, any lending that exceeds or is below the accrued resources would be reflected in the net foreign assets. At the same time, percentage changes of individual items are important in reviewing the adequacy of those financial transactions. For instance, the staff may wish to calculate the percentage change of private sector credit against itself to ensure that the expected credit expansion is consistent with the projected rate of economic growth.

Changes in Exchange Rate

Modification of the exchange rate may create valuation problems when the staff is measuring changes in foreign currency-denominated accounts. If there was only one modification of the exchange rate during the year, the problem is relatively simple; however, it can be rather complex if several modifications took place during the year, or in the event of a crawling peg or freely fluctuating exchange rate.

Table 5 presents a numerical example. Assume that (a) the banking system can extend credit denominated in foreign currency, but this methodology may be applied to any foreign currency-denominated account, including net foreign assets; (b) this credit is expanded by $10 million each quarter; and (c) the exchange rate is depreciated at the end of each quarter. The monetary accounts, which are in local currency (L/C), would show an increase, in terms of stocks, to L/C 252 million ($140 million) at the end of the year from L/C 100 million ($100 million at the beginning of the period).

Table 5.

Changes in Exchange Rate

(In millions)

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L/C per U.S. dollar.

Over the stock at the beginning of the year.

There are three ways that the changes in these accounts may be measured:

A. In terms of changes of the stocks in L/C, in which case credit would have expanded by L/C 152 million (or by 152 percent) in the year (accounting changes);

B. By converting into local currency the changes in U.S. dollars in each quarter at the rate prevailing during each respective quarter. In this case, the credit expansion would be $40 million, and the equivalent in local currency would be L/C 51 million (or a 51 percent increase) in the year (effective changes); or

C By converting the foreign currency credit expansion into local currency, using an average exchange rate for the year (L/C 1.4 per U.S. dollar). In this example, the credit expansion would be $40 million, equivalent to L/C 56 million (or 56 percent increase) in the year (average exchange rate changes).

All three calculations can be useful, depending on the circumstances and on the purpose of the analysis. If the effective credit expansion is being measured, for instance, in preparing a flow of funds or to reconcile monetary data with fiscal operations, the effective changes method (B) is the correct one. However, in the event of a crawling peg or of a fluctuating exchange rate, staff may not have sufficient information to carry out the calculation. In this case, the use of the average annual or quarterly exchange rate (C) is acceptable. If the implications of the credit expansion in terms of future burden to repay private (or public) sector bank debt are being analyzed, the accounting changes method (A) would be preferable, because it would show the outstanding debt, including the impact of valuation adjustments.

The three alternatives have considerable implications in terms of seasonal variations, however. In this example, credit expanded by $20 million in each semester. Under the accounting changes method, about one-third of the credit expansion occurred during the first semester and two-thirds during the second semester. According to the effective changes method, 43 percent of the new credit was extended during the first semester and 57 percent during the second semester, while according to average changes method, credit expansion was equally divided during the two semesters. These differences could be of great importance in deciding on the seasonality of a monetary program.

Contingent Operations

As mentioned before, monetary statistics are derived from balance sheets of the financial institution. However, it is sometimes also important to review certain accounts that are reported outside the balance sheets. This may be particularly true in countries with tight requirements on legal reserves and on interest rates. In certain cases, a bank may accept private sector financial savings on trust rather than in the form of deposits. Depending on the local legislation, these trust deposits would be reported as contingent liabilities of the bank, outside the balance sheet, and as such they would not be subject to legal reserve requirements. The bank can use these trust deposits to extend credit over and above what it would be allowed to do if these deposits were subject to legal reserve requirements. In these circumstances, the bank may also pay a rate of remuneration on the trust funds that is higher than it would pay on a regular deposit and charge an interest rate on the use of the trust funds that is lower than it would charge on its regular loans. In this case, a proportion, which could be substantial, depending on the circumstances, of private financial assets accruing to the financial system and of financial system credit to the private sector would not be accounted for if monetary statistics were based exclusively on accounts included in the balance sheets.

Treatment of Arrears

In certain countries, external arrears may arise because the central bank does not have sufficient foreign exchange. In such cases there are two alternatives.

First, the debtor may be requested to lodge a deposit with the central bank for the equivalent of the needed foreign exchange, even though no payment will be made abroad by the central bank. The debtor may argue that the central bank has taken over the foreign obligation, even though, legally, the original party is still the debtor. Presumably, to lodge this deposit, the debtor would borrow from the banking system or would draw down its deposits with the banking system. The central bank balance sheet would show private deposits for pending payments abroad, but it is unlikely that it would report the outstanding arrears as a central bank external liability. It would be correct, however, to adjust the net foreign assets of the central bank for these foreign liabilities (otherwise, these foreign assets would be inflated by the unpaid bills) with a balancing counterpart entry on the asset side. If staff does not wish to modify the monetary accounts as reported by the central bank, outstanding arrears could be recorded as a memorandum item to the monetary accounts. It should be borne in mind that by making a deposit, the private sector is, in effect, obtaining an exchange rate guarantee, unless central bank instructions specify that the debtor is responsible for any adjustments according to the exchange rate prevailing when the payment is made abroad.

The second alternative—where debtors are not requested to lodge deposits with the central bank for the unpaid foreign bills—is somewhat more complicated. Private sector financial assets may be inflated by the unused resources, thus distorting growth trends in these accounts. It may appear that more loanable resources are accruing to the banking system, thus resulting in a credit expansion well above what the economy could support, and aggravating the inflationary and balance of payments difficulties of the country. As in the previous case, two offsetting entries could be made in foreign short-term liabilities and compensatory credit entries, respectively, or a memorandum item could be recorded.

Treatment of Two-Step Loans

In certain countries, the central bank may receive foreign loans to be used for extending credit to the private sector through the local commercial banks (two-step loans). The local relending may have different terms and a different maturity than the foreign loans. The central bank would show in its balance sheet a long-term foreign liability and claims on the local banking system (which would be reported under interbank transactions) for the portion of the loan allocated to the local banks. Commercial banks’ balance sheets would show liabilities to the central bank and claims on the private sector. In certain countries, the entire loan could be transferred to a single commercial bank (usually a state-owned or development bank), which would be responsible for extending credit to the private sector and for servicing the external debt.

Problems may arise whenever banks that are responsible for relending to the private sector report their liabilities as due to the external lender, rather than to the central bank, on the grounds that they are responsible for servicing the original foreign debt. A reconciliation with the central bank accounts, the external debt tables, and the balance of payments statements may be complicated, and may result in duplication of external debts.

In certain countries, the original loan is granted to the central government, with the understanding that its proceeds are to be re-lent, through the central bank, by the local commercial banks to the private sector (a three-step loan). Since the central bank is fully responsible for the use and servicing of the debt, which may carry a central bank guarantee, it is likely that the loan would be reported as a foreign liability in the central bank’s balance sheet.

Renegotiation of Private Debt

In some countries, as part of a comprehensive external debt renegotiation, the central government or the central bank has taken over the foreign debt of state enterprises and of the private sector. This operation should be reported in the central bank balance sheet as a foreign loan, offset by credit to the original debtor. In many cases, the original debtor is expected to service the debt according to the original terms, even though the central bank may have obtained more favorable terms in regard to maturity and interest rate. Discrepancies may arise with external debt records, as original debtors may continue to show as foreign liabilities those debts taken over by the central bank, on the grounds that the original debtors are responsible for servicing these debts. The staff should remind the authorities that payments received from the original debtors should be sterilized in an escrow account until the renegotiated due date is reached. The end result of the operation is that the central bank has taken over a liability and has acquired an asset. However, often the latter is a nonperforming asset, because it is not certain whether the original debtor will be able to service its debt. The external debt of state enterprises and/or the private sector can become an expensive proposition for the central bank, if the original debtor is authorized to repay the loan at the exchange rate prevailing at the time of the renegotiation, because the central bank could incur a loss for any exchange rate modification.

Monetary Policy Instruments

The monetary policy instruments at the disposal of the authorities include central bank credit and rediscounts, legal reserve requirements, use of interest rates, capital/asset ratios, open market operations, and direct credit controls.12 In suggesting the use of these instruments, the staff should take into account the circumstances of the country. For example, weak supervision of banks would preclude an audit of commercial bank operations. Strong political pressures may make the use of interest rates and/or credit controls ineffective. Troubled state-owned banks may require extensive central bank credit and rediscount, or the effectiveness of the legal reserve requirements may be limited. In countries where the monetary authorities are empowered to regulate only the operations of the banking system, an aggressive use of certain instruments, such as legal reserve requirements and interest rates, to control or limit the operations of the banks would stimulate the establishment of financial institutions that are outside the control of the monetary authorities, thus weakening the effectiveness of the instruments used by the authorities. Monetary policy instruments are used as follows:

  1. Central bank credit and rediscount. By expanding or restricting access to central bank credit and rediscounts, the monetary authorities can influence credit expansion. This instrument has also been used to channel credit (occasionally at preferential interest rates) to certain economic activities that would otherwise be avoided by commercial banks. As with the use of preferential instruments, there is always the danger that the central bank will come under pressure to extend credit to banks with legal reserve deficiencies or to finance projects that are only politically motivated.

  2. Legal reserve requirements. These were initially introduced to ensure that a bank would have sufficient liquid resources to satisfy any reasonable, or expected, withdrawal of deposits, without recalling its portfolio. Over time, this instrument has been used to satisfy other objectives, such as to limit bank credit expansion to the private sector, to capture resources from the banking system in order to minimize the impact of financing public sector deficits,13 to direct credit to certain economic activities, and to redistribute credit among areas and/or banks.

    There is a difference between required reserves and actual reserves. In a country with weak supervision of banks and/or weak monetary authorities or with lenient penalties for legal reserve deficiencies (for instance, fines levied at rates below interest rates charged on bank loans), banks are likely to run legal reserve deficiencies. Increases in reserve requirements would be ineffective because they could not be enforced. (At the beginning of this chapter, references were made to the problems of enforcing legal reserve requirements in the case of state-owned banks.) It is, therefore, important that staff review the pertinent legislation and obtain data on both required and actual reserves, together with sufficient information to be able to evaluate how these requirements are enforced.

    In certain countries, reserve requirements may vary, depending on bank liability. Higher requirements may be levied on demand deposits and lower ones on time and savings deposits. Initially, these differences were justified on the grounds that the risk of withdrawal was higher on demand deposits than on longer-term deposits. But many modern banks now authorize their depositors to make use of their time and savings deposits with little or no advance notice. In those cases, differential legal reserve requirements may encourage banks to shift their deposits into forms that are subject to lower requirements, thus defeating the purpose of decisions to increase legal requirements in order to restrict credit expansion.

    Occasionally, central banks have levied legal reserve requirements equal to 100 percent of deposits held by the banking system. In those cases, the entire credit expansion was financed by central bank credit, as individual banks could not use their deposits. These extreme measures were justified to ensure a more equitable distribution of credit, either among banks (particularly when locally owned commercial banks could not compete with foreign-owned banks in capturing private deposits) or among different regions of the country (banks located in rural areas claimed that they did not have sufficient resources to finance agricultural credit demand). Although well intentioned, these measures usually did not yield the expected results, as more efficient banks had no incentive to attract deposits that they could not use, while inefficient banks made fast use of the resources received from the central bank. The end result was that private financial assets accruing to the banking system usually fell short of the projected amount and were not sufficient to finance the authorized credit expansion.

  3. Interest rates. As in the case of legal reserve requirements, interest rates are expected to discharge several functions as a monetary policy tool, including controlling and/or directing credit and providing incentives for the accrual of private savings to the financial system. Banks may try to circumvent certain decisions of the monetary authorities. Thus, any increases in interest rates are likely to be implemented by the banks first on credit, and only later on deposits to preserve the banks’ profitability as much as possible. The level of interest rates would depend also on the legal reserve structure, as any increase in these requirements would have to be compensated by adjustments in interest rates to protect the financial situation of the banks (Appendix Table IV-1). Finally, in determining the interest rate structure, a country should take into account international interest rates.

  4. Capital-asset ratio. A minimum capital-asset ratio is often used by monetary authorities to force branches of foreign-owned banks to increase their capital.

  5. Open market operations. Open market operations have been used often by central banks to sterilize excess resources and to obtain resources needed to finance central government deficits. In the latter case, the same result could be achieved by the sale of government bonds, except that this would have an impact on the government budget and thus could be politically controversial. The interest paid by the central bank represents a government transaction (quasi-fiscal losses), as the sale of bonds is strictly for fiscal purposes. The authorities may argue against broadening the definition of the government deficit by stressing that central bank open market operations fall within the area of monetary policy broadly defined, whereas financing the government deficit is and should be considered a separate, specific operation. Interest rates paid on central bank papers must be competitive. There is a risk that banks may pressure the monetary authorities into allowing them to discharge their legal reserve obligations by using central bank or central government papers, in which case the legal reserve instrument would be weakened, and banks would tend to invest their unused resources in these papers. During uncertain economic or political periods, banks may prefer to invest their loanable resources in central bank papers that have no risk, rather than to lend them to the private sector.

  6. Credit controls. The monetary authorities may introduce credit controls to control credit expansion or to direct bank credit to certain activities. For instance, they may demand that a certain share of bank credit be directed to specific activities. Unless controls over the financial system are very effective, there is a danger that these limitations or guidelines will not be enforced, or that banks will incorrectly report credit operations in order to exceed the allowed limits.

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  • El Salvador, Ministry of Finance, Informe Complementario Constitutional sobre la Hacienda Publica, Ejercicio 1983 (El Salvador: 1983).

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