metadata: authors: 0: author: de Rezende Rocha, Roberto
1: author: Saldanha, Fernando
count: Europe and Central Asia
docna: 0: docna: Fiscal and quasi - fiscal deficits, nominal
            and real : measurement and policy issues
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Economic Adjustment and Lending,Public Sector Economics,Banks & Banking Reform,International Trade and Trade Rules,Inflation,Public Finance Decentralization and
            Poverty Reduction,Financial Structures
teratopic: Finance and Financial Sector Development
abstracts: cdata!: The paper reviews alternative
            definitions of the non-financial public sector deficit.
            Important points giving rise to different definitions are
            the problem of foreign exchange losses, the appropriateness
            of including net government lending to the private sector
            and the distinction between nominal and real deficits. The
            paper also introduces alternative definitions of
            quasi-fiscal deficit, and discusses the same issues in the
            context of these definitions. Foreign exchange losses and
            the distinction between nominal and real deficits are
            discussed in greater detail, since these issues are even
            more relevant in the case of the central bank. The authors
            also merge the accounts of the non-financial and financial
            public sector into a consolidated budget constraint. Then
            the analysis of fiscal and quasi-fiscal deficits are
            illustrated through a detailed examination of some stylized
            cases. Finally, the authors provide a summary of major
            issues and some conclusions are derived from them.
repnme: repnme: Fiscal and quasi - fiscal deficits, nominal
            and real : measurement and policy issues
display_title: Fiscal and quasi - fiscal deficits,
            nominal and real : measurement and policy issues
listing_relative_url: /research/1992/06/699666/fiscal-quasi-fiscal-deficits-nominal-real-measurement-policy-issues
topicv3: Commercial Banking m1326069 1236,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Fiscal Policy m1327144 445,Central Banks m1327453 1235
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Finance and Financial Sector Development
origu: ECA/MNA Regions Technical Department
no_of_pages: 63
model_extractions: <!-- Start of picture text --> Trade and Flnance<br><!-- End of picture text -->

# WPS 919

- This paper a product of the Trade and Finance Division, Europe, Middle East, and North Africa - Technical Department is part of a larger effort in the Bank to investigate the issues of inflation and stabilization in EMENA countries. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Lanha Ly, room H9-07 1, extension 37352 (June 1992, 59 pages).

In many developing countries, the central bank assumes an active role in mobilizing domestic and foreign exchange and allocating it to the public and private sectors. In these countries, central bank operations may create imbalances between costs and revenues, usually called quasi-fiscal deficits. Sometimes these can be as large as, or larger than, deficits of the nonfinancial public sector. Failure to consider these operations may give rise to the puzzling simultaneous occurrence of low fiscal deficits and high inflation.

There have been few attempts to formally integrate the accounts of the central bank and the nonfinancial public sector. Rocha and Saldanha examine the interactions between (nominal and real) govemment and central bank accounts, analyze the problem of systematic foreign exchange losses in the central bank, and identify policy issues associated with quasi-fiscal deficits.

Despite their limits, real measures of the deficit are less distorted than nominal measures, especially for the central bank's quasi-fiscal deficit. Central banks rarely spell out losses in their income statements, which often show sizable nominal surpluses - even where there is a real deficit in operations of the private domestic and foreign sectors.

The accumulation of foreign exchange losses imposes a burden on the consolidated public sector's finances. This burden - especially the central bank's foreign exchange losses - is transferred in part to future periods, so policymakers often overlook its consequences. It is not uncommon for these losses to be allowed to accumulate in large amounts, while domestic interest rates are kept low and the central bank keeps transferring its declining cash profits to the nonfinancial public sector. The mounting burden of net interest expenditures may then contribute significantly to monetary expansion - a situation that worsens when the central bank must repay its net foreign liabilities.

Rocha and Saldanha argue that foreign exchange losses must be considered in evaluating fiscal policy, even where losses seem to be largely unrealized - as over time all losses are "realized" through interest flows. When foreign exchange losses systematically accumulate, the interest rates on domestic credits need to be adjusted and the central bank's cash profits should stop being transferred to the government. Otherwise, a large quasi-fiscal deficit can lead to monetary expansion and spiraling inflation, as happened in Yugoslavia in the 1980s. In certain circumstances, subsidies implicit in public sector credits should also be part of deficit calculations.

Real quasi-fiscal deficits usually reflect losses in other sectors of the economy and the need for a resource transfer. So correcting these deficits may require more than simply eliminating credit subsidies by increasing real interest rates to positive levels. Eliminating losses at their source often requires a fiscal adjustment, the need for which may not be apparent.

The Policy Research Working Paper Series dissemninates the findings of work under way in the Bank. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

Produced by the Policy Research Dissemination Center
# Fiscal and Quasi-Fiscal Deficits, Nominal and Real: Measurement and Policy Issues

<!-- Start of picture text --> by<br>Roberto de Rezende Rocha<br>and<br>Femando Saldanha<br><!-- End of picture text -->

# Table of Contents

|I.|Introduction|2|
|---|---|---|
|II.|The Deficit of the Non-Financial Public Sector|4|
|111.|The Quasi-Fiscal Deficit of the Central Bank|1 2|
|IV.|The Consolidated Public Sector Deficit|2 3|
|V.|Some Stylized Examples|2 5|
||Case 1: Primary deficits financed by Interest rate subsidies<br>Case 2: Private sector activities financed by interest rate subsidies<br>Case 3: Forebgn<br>exchange losses at the central bank|2 5<br>2 7<br>3 0|
|VI.|Conclusions and Further Thoughts|4 0|
|Appe|ndix|4 3|
||A.1 Above and below the line deficit estimates<br>A.2 Money finance|4 3<br>4 6|
||<br>A.3 Domestic debt finance|5 4|
||A.4 Extemal debt finance|5 4|
|Refe|rences|5 8|
# **1. Introduction.**

In many developing countries the central bank assumes a very active role in the mobilization of domestic and foreign exchange resources and their allocation to the public and private sectors. In these countries, the central bank operadons may result in significant imbalances between revenues and costs, usually referred to as quasi-fiscal deficits. In some cases, the imbalances include the accumulation and realization of foreign exchange losses and systematic default on central bank credits to the private sector. As a consequence, the deficits generated by central bank operations may become as large or even larger than the deficits of the non-financial public sector. Failure to take these operations explicitly into account may give rise to apparent puzzles such as the simultaneous occurrence of low fiscal deficits and very high inflation rates.

Although the importance of quasi-fiscal deficits has been widely recognized (see Anand and Van Wijnbergen (1988), The World Bank (1988), Robinson and Stella (1988), Teijeiro (1989) and Blejer and Cheasty (1991)), there have been few attempts to integrate formally the accounts of the non-financial public sector and the central bank . The impact of inflation on central bank operations and accounts has not been thoroughly examined in the literature. This is surprising, since the distincdon between nominal and real deficits is especially relevant to the central bank, given the financial nature of its operations. Other critical issues, such as the accumulation of foreign exchange losses by the central bank are not fully analyzed in the existing literature either. Instead, the analysis of this issue is usually restricted to drawing a distinction between unrealized and realized losses, or between accrued and cash losses. The dynamic implications of systematic foreign exchange losses are not duly explored. Finally, although it is widely recognized that the quasi-fiscal functions of the central bank should be ideally transferred 2
to the budget, the causes of chronic quasi-fiscal deficits, and the policies that are required to correct them, have not been thoroughly examined.

We seek to contribute to the literature on fiscal and quasi-fiscal deficits in several ways. First, we examine in detail the interactions between the government and central bank accounts, in nominal and real terms. Second, we analyze the problem of foreign exchange losses in the central bank, including the reasons for their accumulation and the conditions under which these losses may be monetized. The analysis is illustrated with referrence to the Yugoslav and Hungarian cases. Third, we identify some important policy issues related to the problem of quasi-fiscal deficits. Finally, we discuss the practical problems that are encountered in the measurement of central bank and consolidated public sector deficits, and explore alternative methods to measure these deficits from below the line.

The outline of the paper is as follows. Section II reviews alternative definitions of the non-financial public sector deficit. Important points giving rise to different definitions are the problem of foreign exchange losses, the appropriateness of including net government lending to the private sector and the distinction between nominal and real deficits. Section III introduces alternative definitions of quasi-fiscal deficit, and discusses the same issues in the context of these definitions. Foreign exchange losses and the distinction between nominal and real deficits are discussed in greater detail, since these issues are even more relevant in the case of the central bank. Section IV merges the accounts of the non-financial and financial public sector into a consolidated budget constraint. Section V illustrates the analysis of fiscal and quasi-fiscal deficits through a detailed examination of some stylized cases. Finally, the last section summarizes the major issues and derives some conclusions. The Appendix provides an analysis of different methods to estimate the public sector deficit from below the line.

3
# 11. **The Deficit of the Non-Financial Public Sector.**

The non-financial public sector (government for short) is broadly defined so as to include the central and local governments, state enterprises and other non-financial public institutions. The central bank and state-owned commercial banks are excluded. In the discussion of alternative definitions of the government's deficit, it is useful to start with the following definition: (1) _Dg=D+i 8 C8 +ibB+(i" +E)_ **_BE-i-L=Ci +(B-L)+(B'E)_** Here D = nominal primary deficit (total non-interest expenditures minus revenues, including the dividends from the central bank and from the state-owned commercial banks), _ig_ = nominal interest rate on central bank's credits to the government, _CS_ = nominal stock of central bank's credits to the government (including direct credits to the government as well as any form of government debt held by the central bank), _ib_ = nominal interest rate on the government's domestic debt held outside the central bank, B = nominal stock of the government's domestic debt held outside the central bank', i' = nominal foreign interest rate on the government's external debt, B' = nominal foreign currency value of the stock of the government's external debt, E = nominal exchange rate, i = nominal interest rate on government loans to the private sector, and _L_ = stock of government loans to the private sector. The dots over the variables indicate time derivatives, and the hats percentage changes<sup>2</sup> .

'Net of government deposits in the commercial banks. The interest rate _ib_ is defined accordingly.

> **_2 X_** _=_ **_dX/dt_** and **_X=X/X._**

_4_
The government deficit, as defined in (1), consists of the primary deficit, the interest expenditures on domestic debt held inside and outside the central bank, the depreciation-adjusted interest expenditures on external debt, minus the interest revenues on credits to the private sector. The last term in (1) indicates the three possible sources of financing for the non-financial public sector deficit. These are the changes in central bank credits to the government, **_Cg,_** the changes in net domestic debt outside the central _-_ bank, **_(B_** _L)_ , and the changes in external debt, _(B E) ._ It should be noted that, although the central bank's credits to the government are included, the central bank's operations with the private domestic and foreign sectors are excluded from the definition.

There are three noteworthy points related to this definition of the non-financial public sector deficit. First, the nominal capital losses on the stock of external debt arising from nominal exchange rate devaluations are included. Second, the increases in government lending to the private sector are not included. Instead, government lending is treated as a financing item, and subtracted from the changes in gross domestic debt with the private sector. Third, investment expenditures are taken into account in the calculation of the primary deficit. We now discuss these two points in more detail.

As mentioned above, the nominal deficit as defined in (1) includes all capital losses on the stock of external debt due to exchange rate devaluations, _EB'E =_ **_EB*,_** independently of whether these foreign exchange losses are all realized in the current period<sup>3</sup> . Foreign exchange losses are realized through interest payments and through net repayments of the stock. The amount immediately realized depends on the schedule of interest and net debt repayments, and is usually a small fraction of the total loss. From

> 3Note that (i + _E)BE= iB*E+_ **_EB,_** where the first term is a cash cost and the second the capital loss.

**_5_**
another point of view, one can see these losses as being automatically financed by foreign lenders, who "agree" to increase the domestic currency value of their loans (since they are primarily concerned with the foreign currency value of these loans). Therefore, the inclusion of foreign exchange losses provides important information about the potential burden imposed by exchange rate devaluations on the public finances. However, these losses do not generate any significant immediate pressure on the economy, and a deficit definition that excludes them is also useful<sup>4</sup> : (2) _D1 = D+i,C, +i4B+i*BE-i 1 L = CJ +(B- L)+B'E._ The second question is whether government lending to the private sector should be included in the deficit definidon. The answer to this question involves conceptual and practical considerations. There are, in fact, solid arguments for not including the net changes in government loans to the private sector in the non-financial public sector's deficit. By borrowing from and lending to the private sector, the government is simply acting as a financial intermediary, just like any other private financial iiistitution. If these financial operations are carried out at market rates and the loans are effectively recovered, they may not produce any significant impact on aggregate demand, inflation or the current account, relative to a situation where the lending is conducted by the private sector.

The macroeconomic impact of the government's loans to the private sector is greater in the cases where these loans are not effectively recovered, or where they are made at rates below market rates. Government loans that are not repaid are actually grants or transfers, and should obviously be included in the definiton of the deficit. The problem of adjusting the deficit definition for these factors is not so much conceptual as 4Any possible link between urealized capilal losses on public debt and private savings along Ricardian lines (see Barro (1974 and 1979)) is ruled out here.

6
practical. It may be very difficult to screen the government's loan portfolio and separate loans from transfers. The concession of government loans at below market rates also involves a transfer of resources to the private sector that should arguably be included in the deficit. The problem here lies in the measurement of the implicit subsidy. The concept of real deficit to be introduced below provides one solution to this problem. The subsidy and deficit definitions could be extended to include all foregone revenues<sup>5</sup> .

The inclusion of changes in government loans to the private sector in the government's deficit is still frequently advocated, independently of whether these loans are collected and correctly priced. The argument is based on the observation that these loans effectively increase the government's financing requirements. The argument is sometimes stretched by the observation that an increase in the govemment's financing requirements might ultimately result in an increase in government's borrowing from the central bank and in monetary expansion. Thus, according to this argument, the relevant deficit definition for fiscal policy evaluation is: (3) _Ds =D+i8C 8_ **_+ibB+_** _iB*E+(L-i,L)=C. +B+B E ._ Equation (3) defines the public sector borrowing requirements (PSBR), a measure of the government's deficit which is commonly employed for the assessment of the fiscal policy stance. The term _(L-ilL)_ indicates the financing requirements implied by the expansion of government loans to the private sector.

5The problem of measuring a credit subsidy lies in the choice of a benchmark interest rate. One option is to compare nominal rates with the rate of inflation (the criterion implicit in the concept of real deficit used in this paper). If the subsidy and deficit definitons are defined so as to include all foregone revenues, the benchmark is the market interest rate.

7
The argument that government lending to the private sector should be included in the deficit because it increases financing requirements is frequently presented without further elaboration. As mentioned above, although financing requirements are obviously increased, the macroeconomic impact of government borrowing and lending activities is by no means obvious. If the government finances its loans to the private sector through issues of market-priced securities, that does not result necessarily in a crowding out of private sector activities by the public sector. The immediate result is rather a reallocation of scarce financial resources among different private sector activities. The final result depends on whether the government's intervention involves a gain or a loss in efficiency.

Although the record of the government's intervention in resource allocation has generally been poor, especially in the case of developing countries, such intervention may be in principle justified in cases of severe credit rationing due to imperfect information and perceptions of excessively high credit risk. For instance, government loans to education as well as loans to small enterprises may correct market inefficiencies and generate high returns to the economy as a whole. Government housing loans may also alleviate housing bottlenecks, although in the latter case resources may be indeed diverted from other sectors of industry, with adverse consequences for growth.

The conclusion seems to be that the inclusion of government loans to the private sector in the deficit definition without proper consideration of the nature and conditions of such lending activities may provide a misleading indication of the stance of fiscal policy. It is only after such examination is made that one can ascertain whether the fiscal deficit thus defined is crowding out productive investment, or pressing the current account, or still pressing domestic markets to the point where monetary accommodation becomes inevitable.

8
The government's real deficit can be analyzed along similar lines. Dividing<sup>all</sup> terms in equation (1) by the price level, P, multiplying and dividing the terms denominated in foreign currency by the foreign price level P', and splitting<sup>the nominal</sup> interest rates between the relevant real rate and the inflation premium, i =<sup>_r_+</sup><sup>_P_, one</sup> obtains: _-_ (4) _d, = d +r*c, +rbb+(r +e)b'e-r,l c +(b-i)+b e ._ Here _rg, rb_ and _r 1_ are, respectively, the real interest rates on government debt held inside and outside the central bank, and on goveriment loans<sup>to the private sector, r'</sup> is the real foreign interest rate, e _= EP'/P_ is the real exchange rtte.<sup>All other lower</sup> case variables are defined in real terms, x = _X / P_ . Note also the extensive use of the identity x -X/P - **_PA_** in arriving at equation (4).

As equation (4) indicates, the real deficit is not just the nominal<sup>deficit divided by</sup> the price level. The critical difference is the exclusion of the inflation component from the government's interest payments and revenues. The argument<sup>for the utilization of a</sup> real definition of the deficit has been extensively discussed in the literature. When inflation increases and the real rate of interest remains constant, nominal<sup>interest</sup> payments also increase. However, these larger payments are just a compensation<sup>given to</sup> asset-holders for their nominal capital losses due to inflation. On the assumption that asset-holders do not channel these revenues into consumption,<sup>such increase in nominal</sup> expenditures does not exert any additional pressure on aggregate demand. Instead, the asset-holders will be willing to reinvest these revenues in newly<sup>issued government</sup> securities, allowing the govemment to roll-over the existing stock of<sup>debt under the same</sup> conditions of price and maturity<sup>6</sup> .

'See Eisner and Pieper (1984), and Eisner(1986, 1989a, and 1989b) for discussions of inflation-induced distortions in the measurement of the deficit<sup>and other macroeconomic</sup> 9
Although the discussion in the literature has centered on the effect of inflation on interest payments on domestic debt, the same line of reasoning can be applied to the interest revenues on government loans to the private sector, and to the interest expenditures on the government's external debt. Finally, the same argument can also be applied to the problem of capital losses on the stock of external debt. While nominal exchange rate devaluations generate capital losses by increasing the domestic currency value of the stock of debt, domestic price inflation generates a capital gain on the stock. Thus, only real capital losses should be included in an inflation-adjusted definition of the deficit, as in equation (4).

It should be noticed that the deficit, as given by (4), equals (minus) the variation in the government's real net worth. This means, of course, that all capital gains and losses due to inflation and exchange rate devaluations are properly taken into account. However, ilie question of whether unrealized real capital gains or losses on the stock of external debt should be included in the definition still remains. Likewise, the question of whether government lending to the private sector should be included in the definition also remains, whether the deficit is defined in nominal or real terms. Thus, defining equations (2) and (3) in real terms yields:

- _(5) d8 =d+r8c+ +rbb+r b e-rl=i', +(b-i)+be_

- _(6) dg =d +r8cS +rbb+rb*e+(i-r,l) +b+b'e._

variables, with focus in the US case. Cukierman and Mortensen (1983) provide a similar analysis for the OECD countries. Blejer, Tanzi and Teijeiro (1987) discuss the conditions under which the inflation-corrected deficit provides a better indication of the fiscal policy stance.

10
At this point one may become confused by the proliferation of alternative definitions of the deficit. However, a careful evaluation of fiscal policy may indeed require the use of more than one indicator. As mentioned above, measures of the<sup>deficit</sup> that include and exclude exchange rate-induced losses are both useful indicators of<sup>fiscal</sup> policy. In particular, the latter may provide very timely and useful information on<sup>future</sup> budgetary pressures arising from the realization of such losses and the need for fiscal adjustments.

Ultimately, none of the definitions presented above may fully capture the actual underlying behavior of economic agents. For instance, while it can<sup>be argued that the real</sup> deficit provides a more acurate indication of the fiscal policy stance than<sup>the nominal</sup> deficit under most possible circunstances, it is not itself free<sup>of problems. If there is some</sup> degree of money illusion, domestic asset-holders will tend to consume part of<sup>the</sup> inflation-related interest revenues and will be unwilling to refinance the roll<sup>over of the</sup> stock of government debt under the same conditions. In this case<sup>the real deficit will</sup> underestimate the extent of fiscal pressures on the economy<sup>7</sup> . Similarly,<sup>foreign holders</sup> of government debt may be unwilling to reinvest the foreign inflation component<sup>of</sup> interests. The reason for ti,is may be money illusion or the availability<sup>of information</sup> that lenders loans to the country an unattractive proposition.

Clearly, there is no easy solution to these and other problems. Instead, what<sup>the</sup> above discussion suggests is the need for good judgement in<sup>the selection and</sup> interpretation of the most relevant indicators. Knowledge about the specific<sup>country</sup> conditions and institutions must dictate the choice of the indicators<sup>and even the</sup> construction of taylor-made indicators.

7See Blejer, Tanzi and Teijeiro (1987).

11
**111. The Quasi-Fiscal Deficit of the Central Bank.**

### Consider the simplified balance sheet of a representative central bank in

Figure 18.

# Figure 1

## Balance Sheet of the Central Bank

<!-- Start of picture text --> FA H=C +S<br>u<br>C FL<br>C NW<br>? cb<br><!-- End of picture text --> The central bank is assumed to hold foreign assets _FA,_ and extend credits to the government Cg , and to the private sector _Cp ._ Its liabilities are the money base H, (equal to the sum of currency Cu , and bank reserves S), and foreign exchange liabilities, _FL._ Its net worth, NW, is the difference between its assets and liabilities, and its credits to the government are net from any government deposits. It is assumed that the private sector does not hold sight deposits at the central bank<sup>9</sup> .

The central bank's balance sheet may be written in terms of changes as: (7) _NFA + Ct + Cp = H + NWcb_ 8The central bank's non-financial assets are ignored.

90therwise, any such deposits should also be included in the definition of base money.

12
where _NFA = FA - FL_ denotes the net foreign assets of the central bank expressed in domestic currency. These may become large and negative if, for instance, the central bank borrows actively abroad, or manages schemes to attract the remittances of nationals working abroad, or still incurs in foreign exchange liabilities as a result of the implementation of foreign exchange insurance schemes. The reason net foreign assets turn out to be negative in these cases is that the central bank does not hold an equivalent stock of foreign assets. That, in turn, results from sales of previously acquired foreign exchange to the government or the private sector, and the channelling of the revenues from the sales towards credits denominated in domestic currency.

The variations in the central bank's net worth are identically equal to the difference between the central bank's revenues and expenditures, including the capital gains and losses due to exchange rate devaluations. Thus, these variations are obtained through a combination of its income statement and revaluation accounts:

- (8) _NWtb = (i + E)NFA E+isCs ipCp -iRS-A_

The first term on the right hand side of (8) is a depreciation-adjusted interest revenue or cost, depending on the sign of net foreign assets. Here we make the simplifying assumption that the central bank earns on its foreign assets the same international interest rate that it pays on its foreign liabilities. The second and third terms are the interest revenues collected on credits to the government and to the private sector, respectively. Next comes the interest expenses on bank reserves, and finally the dividend payments to the government, **4IO.** Equation (8) does not cover all possible operations that might affect the central bank's profits. For instance, the central bank can run a profit 'Olt is assumed that the government is the central bank's sole shareholder.

13
(loss) if it sells foreign exchange at a rate higher (lower) than the buying rate. These and other operations are not included for the sake of simplicity.

Note that the central bank may experience a decline in its net worth while also generating cash profits. This situation may be caused by the provision of domestic credits at interest rates below the depreciation-adjusted cost of net foreign assets (assumed to be negative), or by the transfer of cash profits to the government. If the central bank transfers all its cash profits to the government, then it experiences a decline in its net worth equal to the foreign exchange losses in the period.

If the central bank's nominal deficit is defined as the inverse of the variations in its net worth, then it is given by equation (8) (with a negative sign). In the special case where the government has no non-financial assets and does not invest this definition is analogous to the definition of the government's deficit in (1):

- (9) _De, = -NW,= -[(i C+E)NFAKE+igC1 +ipCp -i,S-D] =_ **_H_** _-NFA -C8_ **_-Cp_** _._

As in the discussion of the government's deficit, it could be argued that the central bank's deficit should exclude the capital gains/losses on net foreign assets (as long as they remain unwrealized) and, under certain conditions, include the changes in credits to the private sector. In these two cases, the nominal deficit of the central bank would be respectively defined by equations (10) and (11) (the counterpart of equations (2) and (3)):

- (10) _Deb =-[iNFAE+isC +ipCp -_ **_iS_** _- D] =_ **_H-NFA_** _E-C_ **_-Cp_**

- (11) _D; =-[iCNFAE+i,C, +iipCp - iS-D]+_ **_C_** _= F-NFWAE-C -_

Of course, any of the equations (9)-( 11) could be solved for the changes in base money, yielding the same result: 14
_H = -[i*NFA`E+i 5 C, +ipC, -iSA]+NFKAE+C, +Cp ._ (12) Even though these are just manipulations of accounting identities, they do provide valuable insights on the sources of monetary expansion in any given country. Equation (12) states that base money expands whenever net foreign assets and domestic credits are expanded, or when the central bank runs an excess of interest costs plus dividends paid over interest revenues. This last term is usually disregarded in monetary policy analysis, but is at the core of the problem of monetary disequilibrium in some developing countries.

Notice that the inclusion of foreign exchange losses in the definition of the deficit does not make a difference, as far as the immediate impact on base money is concerned. This is actually the argument that is frequently used for its exclusion from the definition. An exchange rate depreciation generates an immediate increase in the domestic currency value of net foreign assets (assumed to be negative) and a matching increase in the stock of foreign exchange losses (a decrease in the central bank's net worth), with no immediate impact on base money creation". However, the capital losses may be eventually monetized through two channels. First, through net repayments of foreign liabilities and, second, through larger interest payments on the stock of (negative) net foreign assets. These two effects are captured in equation (12).

It follows that the accumulation of foreign exchange losses does provide very important information for fiscal policy evaluation, even when these losses do not constitute a current source of monetary expansion. When foreign exchange losses are allowed to accumulate over time, the stock of central bank's earning assets shrinks "Notice that that the capital loss terms, _ENFA' ,_ on both sides of equation (10) cancel out _15_
relative to the stock of interest paying liabilities. This eventually generates cash losses that may have to be financed through monetary expansion, even if the principal of foreign liabilities is not being repaid. Of course, net repayments of foreign liabilities tend to worsen the financial condition of the central bank and may trigger further monetary expansion.

The existence of central bank credits to the orivate sector creates another difficult conceptual issue. As in the case of government loans to the private sector, a judgment must be made on whether the changes in these loans should also be included in the definition of the deficit. The answer to this question requires a very careful examination of the central bank's portfolio, since the quality of central bank loans may vary widely across countries and over time. For instance, if the central bank borrows abroad and extends domestic credits to unprofitable enterprises, there is clearly a deficit associated with the operation, since the central bank is acquiring liabilities, but no meaningful assets as counterparts. Over time a serious situation may develop, as the central starts servicing its liabilities, but is unable to collect the interest and principal from its assets. In more general terms, if the central bank extends credits that cannot be recovered, that creates a serious problem of monetary managemen **t** hat usually results in excessive monetary expansion. In these cases excessive monetary creation may happen by omission, i.e., the new credits extended by the central bank are not offset by the repayment of outstanding credits.

On the other extreme, one finds ordinary liquidity rediscounts, which are extended exclusively for the purposes of monetary management and that are fully repaid by the borrowing banks. These rediscounts may be extended under conditions of monetary equilibrium at low rates of inflation. In this kind of situation it is clear that there is not a deficit associated with central bank lending to the private sector.

16
In most developed countries the central bank's financial operations are not a source of macroeconomic imbalances. The central bank exercises its traditional functions and earns profits, which are partially or fully transferred to the government's budget as a non-tax revenue. In contrast, in many developing countries the central bank intervenes extensively in the process of financial intermediation. Such intervention usually involves the allocation of large amounts of credits to favored sectors at subsidized terms, and may result in significant imbalances between revenues and costs, especially when the credits are backed by foreign liabilities.

For instance, the central banks of several developing countries borrow directly abroad, or run schemes to attract the savings of nationals working abroad, while extending credits in domestic currency at an interest rate that does not reflect the cost of foreign liabilities<sup>1 2</sup> . The introduction of foreign exchange insurance schemes by central banks in developing countries may create a similar problem, since the insurance premium is usually severely underpriced in these countries. Another common source of problems in developing countries is the concession of credits to banks or enterprises in fragile fmancial conditions. These credits may be extended in situations of emergency - the central bank may be induced to increase its lending in order to avert a financial crisis - or simply result from ordinary institutional practices. For instance, in some Eastem European countries all foreign borrowings were conducted by the central bank, which also extended credits to enterprises that were clearly unable to repay them.

The lack of transparency involving central bank accounts in several developing countries may allow a deteriorating financial situation to remain undetected for a long liThis is actually the final result of three different operations. The first operation involves an equivalent increase in the central banks' foreign assets and liabilities. The second operation involves sales of foreign exchange by the central bank to importers. Finally, domestic credits are granted with the proceeds from the sales.

17
period of time. In some cases this is caused by the deliberate window-dressing of central bank income statements. For instance, a large share of interest revenues may be accrued but not effectively collected, while interest expenses are effectively paid. Another example of creative accounting involves the inclusion of foreign exchange gains on foreign assets in the flow of interest revenues, together with the exclusion of foreign exchange losses on the foreign liabilities altogether from the income statement'<sup>3</sup> . Of course, it is impossible to exclude the accumulation of foreign exchange losses from the balance sheet. However, these can be disguised under one of the several entries that comprise the net worth of the central bank.

In other cases the central bank's accounts may be just poorly interpreted, even when there is no attempt to conceal losses of any kind. Such misinterpretation may simply result from the failure to distinguish nominal from real interest flows in the central bank operations. For instance, consider the situation of a central bank that borrows abroad and provides subsidized loans in domestic currency. Suppose that this situation has resulted in a large accumulation of foreign exchange losses and has driven the stock of interesting-earning credits well below the stock of interest-paying foreign liabilities. It is clear that a central bank in this situation would be unable to balance its accounts under low rates of inflation and nominal interest rates. However, if inflation is high, the domestic nominal interest rates will be much higher than the foreign interest rates. Such difference in nominal rates may partly or fully offset the difference between Adomestic credits and foreign liabilities, giving the impression of an equilibrium when the central bank is in fact running a real deficit. Moreover, such a deficit may be an important source of monetary expansion.

OCapital gains and losses should either be explicity shown in the income statement or put in a separate revaluation account.

18
This example suggests that the quasi-fiscal character of some of the central bank operations becomes more transparent when inflation is properly taken into account. Indeed, the distinction between nominal and real deficits is particularly relevant in the case of the central bank, since central bank operations are exclusively financial. To start the analysis of real quasi-fiscal deficits, consider first a definition identical to the variation of the central bank's real net worth. Such definition may be obtained by dividing equation (9) by the price level, splitting the nominal interest rates between the real rate and inflation premium and considering the identities _NW*I P = n w+ Pnw_ and **_H I_** _P_ = **_h_** _+_ **_Ph_** , where **_H I_** P are the total seignorage revenues, equal to the variations in real base money, _h,_ plus the inflation tax, **_Ph:_** (13) _- nwcb = -[(r + )nfa + rcp +rc -_ **_6-is+ Ph] =h-nfa_** _-_ **_c_** _-_ **_cp_** = Here the small case variables are defined as the real variables, as before _(6 AlP),_ and the _r's_ are the relevant real interest rates. Note that such a definition of the real quasi fiscal deficit includes the inflation tax, net of the interest paid on reserves, _Ph - i.s_ .That is, the real net worth of the central bank is increased by the inflation tax and decreased by the payment of interests on reserves. Note also that if no interest is paid on reserves (i = 0) the central bank's real net worth is increased by the full value of the inflation tax. If some interest is paid on reserves, the inflation tax is only fully collected on currency, while the amount which is effectively collected on reserves depends on the real interest rate. The net inflation tax revenues are then _PC. -_ **_rs_** _= Ph -is_ Why would it make sense to define the central bank's deficit as (the negative of) its net worth variation, when (in the general case) the analogous definition for the government deficit was inappropriate? The central bank's non-financial assets are usually insignificant, when compared to its financial assets. They can therefore be valued with a 19
reasonable degree of accuracy. It follows that the principal objection against using a net worth-based deficit definition does not apply in this case. However, the definition (13) of real central bank deficit, which equates the deficit to the (negatis A of) central bank's real net worth variation, leads to some counterintuitive results. One can envisage a steady state with a high rate of inflation where all variables in the central bank's balance sheet (including net worth) are constant in real terms. For instance, assume a central bank that has a large stock of foreign liabilities and that provides subsidized financing to the public and private sectors. In this case _r_ > 0 and all r's < 0, i.e., the central bank runs a deficit in its real interest flows. However, the inclusion of the inflation tax as an ordinary source of revenue makes the real deficit, as defined in (13), equal to zero.

It follows that a definition that treats the inflation tax (net of interest on reserves) as a financing item, instead of an ordinary source of revenue, may convey more information about the effective financial situation of the central bank. Equation (14) defines the central bank's real deficit as (minus) its net worth variation net of any inflation tax revenues: (14) _db =_ **_-[nfWcb-(Ph -i,S)]_** _= -[(r' +e)nfa +rpcp +r5c8 -83=_

> Here _H/P - is_ is the net seignorage collected by the central bank, equal to gross seignorage less the interests paid on commercial bank reserves. As above, alternative definitions may exclude the capital losses/gains on net foreign assets and include the changes in credits to the private sector:

_H - (15) d,,, == -(r nfa e+rpcp+rc,a -)= D-i,s-nfa e-c -c_ 20
_s - nfiae - c_ _dCb-==-(r'nfa'e+recprc,-a)+ cp_ (16) These definitions of the central bank's real deficit<sup>reveal clearly the transfers of</sup> real resources that may take place in an inflationary<sup>economy. They also indicate what</sup> type of corrections may be needed in order to<sup>stabilize an economy where the monetary</sup> imbalances are rooted in the central bank. If the<sup>seignorage collected by the central bank</sup> is being channelled towards the servicing of foreign<sup>liabilities and the concession of</sup> credit subsidies to the public and private sectors,<sup>monetary control may require a variety</sup> of measures, such as the increase in interest rates<sup>on central bank credits, the interruption</sup> of central bank's explici **t** ransfers to the government's budget, and possibly the absorption of central bank foreign liabilities by the government.<sup>This last measure is</sup> required if the real stock of central bank credits has fallen<sup>to such low levels that an</sup> increase in real interest rates to reasonable levels<sup>does not generate enough real resources</sup> to cover the servicing of foreign liabilities.

For instance, the Yugoslav stabilization program of<sup>1990 included the transfer to</sup> the federal budget of central bank credit subsidies<sup>to agriculture and exports, as well as</sup> the absorption of most of the central bank's foreign liabilities<sup>by the federation. Such</sup> absorption took place through the replacement of the large<sup>stock of foreign exchange</sup> losses in the central bank by an equivalent stock of federal<sup>government bonds indexed to</sup> the exchange rate and yielding an interest rate equal to LIBOR.<sup>Of course, all these</sup> 4 . measures required ultimately a fiscal adjustment by<sup>the federal government'</sup> 1<sup>4</sup> See Coricelli and Rocha (1991) for an analysis of the<sup>Yugoslav and Polish stabilization</sup> programs of 1990 and Bole and Gaspari (1990), Mates<sup>(1991), Rocha (1991), and The</sup> World Bank (1989) for detailed studies of Yugoslavia's quasi-fiscal deficits and inflation.

21
The Yugoslav case suggests that proper examination of the central bank's foreign exchange losses may prevent the emergence of serious macroeconomic imbalances. If the inclusion of foreign exchange losses results in consistently large real deficits, that indicates that domestic credits are not correctly priced, and/or that the transfer of the central bank's cash profits to the government is excessive. The prevention of a serious financial situation requires not only a correction of interest rates but also the interruption of the transfer of central bank cash profits to the government. Failure to implement these corrective measures in time inevitably generates the need for an even larger fiscal adjustment in the future.

These corrective measures may not be easily implemented in many countries, since policy makers may interpret the existence of cash profits as an indication that the central bank enjoys a comfortable financial situation, and that it would be a "waste" for the institution to retain these profits, as opposed to transferring them to the government. However, it is precisely the retention of cash profits that may prevent a drastic decline in the central bank's net worth and the emergence of a situation where the central bank starts running cash losses. Moreover, when inflation increases, the assessment of the situation may become even more complicated, because domestic nominal interest rates are likely to increase along with the rate of inflation, even when real interest rates remain negative.

Hungary and Turkey provide additional examples of real quasi-fiscal deficits caused by the combination of massive borrowings abroad by the central bank and the concession of low interest rate credits to the public and private sectors. In the late 1980s the governments of both countries acknowledged the difficult financial situations faced by their respective central banks, and absorbed the stocks of foreign exchange losses. In the case of Hungary, the foreign exchange losses were replaced by a stock of credits to 22
the government, while in Turkey the government replaced the central bank losses by a stock of long-term securities. However, in neither country the real quasi-fiscal deficit has been effectively eliminated. This is because the correction in the stocks has not been accompanied by a correction in the flows. In Hungary, the amount of interests effectively paid by the government on the converted stock seems to be negligible, while in Turkey the amount of interests paid is not only small, but is also financed by new central bank credits to the government.

The final outcome has been at best mixed in the Hungarian and Turkish cases. Although some of the institutional measures required to eliminate the real quasi-flscal deficit were indeed implemented, the essential ingredient of the solution - a fiscal transfer from the government to the central bank - was not implemented. The high rates of inflation of both countries (30 and 70 percent in Hungary and Turkey, respectively) may be still masking the financial problems of their central banks. Another explanation for the lack of an effective adjustment lies simply in the difficulty to generate a sufficient fiscal adjustment at the government level. In any case, the real quasi-fiscal deficit remains and seems to be affecting adversely the conduct of monetary policy in both countries.

# **IV. The Consolidated Public Sector Deficit.**

The deficits of the non-financial public .sector and of the central bank can be easily consolidated, whether they are defined in nominal or real terms. Consider, for instance the nominal deficits in (1) and (9). Adding these two equations, one obtains (17) _J= Da +ibB + (i + E)(B E-NFAKE)-i,L-ioCp - i,S =_

## _-_ **_H-Co_** _+_ **_(B_** _- L)+(B'E-_ **_NFA*E)._**

23
Here D. is the government's primary deficit, adjusted so as to exclude all dividends received from the central bank. This definition of the consolidated nominal deficit, A excludes government and central bank lending to the private sector, and includes the capital losses on the net external debt of the consolidated public sector - the government's external debt minus the net foreign assets of the central bank. The last term in (17) indicates the three possible sources of public sector financing. These are: (i) the changes in base money, (ii) the changes in net domestic debt, and (iii) the changes in net external debt. It is tedious to write other definitions, where the capital losses are excluded, and public sector lending to the private sector is included.

The real consolidated public sector deficit c can also be easily obtained, by addition of (4) and (14): (18) _1 = d,, +rbb+(r' + e)(be - nfa e)-r,l -rrpc-_ _=X - I;S-C ~+(b-i)+(be C-tnfa'e) ._ This deficit may be estimated either by excluding the inflation component from the nominal interest revenues and expenditures of the public sector, or by calculating the real changes in the net domestic and external debts and the net seignorage revenues on base money. Once again, the equations may be defined so as to exclude the real capital losses on the net external debt, or to include public sector lending to the private sector.

The consolidation of the government and the central bank cancels out all explicit and implicit transfers between the two entities. Of course, the consolidated deficit arises as a result of the government and central bank operations with the private domestic and foreign sectors. Thus, equations (17) and (18) are unaffected by the transfer of fiscal 24
funcdons to the central bank and also indicate clearly the sources of public sector

### financing, irrespective of where the financing,needs are located.

# V. Some Stylized Examples.

In order to clarify the analysis of real fiscal and quasi-fiscal deficits we provide three stylized examples in this section. The first of these is the case of government deficits financed exclusively from zero-interest central bank credits. In the other two examples we assume that the government's accounts are fully balanced and the pressures towards monetization are coming from different sources. Any one of these latter two cases would thus present a puzzle to the less informed observer. The imbalances are either in the private sector (enterprise or bank losses, subsidization of selected consumer goods) or in the central bank, which incurs valuation losses.

## Case 1: Primary deficits financed by Interest rate subsidies

Consider the case of a central bank that does not have foreign assets or liabilides, does not extend credits to the private sector, does not pay interest on reserves, does not charge interest on its credits to the government, and does not pay dividends. To simplify, assume also that the government's net foreign and private domestic debts are both zero. In this case the real revenues collected from the holders of base money are fully transferred to the government. Part of this transfer is effected in the form of an interest rate subsidy, while the remainder, which equals the real fiscal deficit, takes the form of real credit expansion. Under these conditions, the nominal and real financing flows are as depicted in equations (19)-(24):

- (19) **_D, =D=C,_**

- (20) _d, -d +rtc, =c,_

**_25_**
<!-- Start of picture text --> (21) (21 C=& P 8 i=E=+Ph PC8 p<br><!-- End of picture text --> (22) <!-- Start of picture text --> db 8cg =p-c8<br><!-- End of picture text --> (23) <!-- Start of picture text --> H<br>l = dg + dCb=p<br><!-- End of picture text --> Equation (19) gives the government's nominal deficit, which is equal<sup>to its</sup> primary deficit (since **_i8_** = 0). The government's real deficit is given by (20).<sup>Since</sup> _ig =_ 0, **_r8c8_** = _-Pc,_ . Equation (21) is a balance sheet identity for the<sup>central bank.</sup> Equation (22) gives the central bank's real deficit, which is equal<sup>to the subsidy given to</sup> the government. Finally, equation (23), which is the sum of (20)<sup>and (22), shows that the</sup> consolidated public sector deficit is the sum of the government and central<sup>bank deficits,</sup> and is entirely financed from seignorage revenues.

One can easily envisage a steady state with a constant rate of inflation,<sup>where the</sup> real stocks of base money and central bank credits are equal and constant,<sup>and the real net</sup> worth of the central bank is zero'<sup>5</sup> . In this special case, the seignorage<sup>equals the inflation</sup> tax, and is fully used to extend an interest rate subsidy that matches the government's<sup>real</sup> primary deficit. Thus, the government's real deficit is zero. The central bank's<sup>real deficit,</sup> the consolidated public sector deficit, the government's real primary deficit,<sup>the</sup> seignorage, the inflation tax, and the interest rate subsidy from the central bank<sup>to the</sup> . government are all equal'<sup>6</sup>

# Th'is steady state is consistent with a zero output growth rate.

1<sup>6</sup> Notice that this is a case in which counting the inflation tax as a revenue<sup>of the central</sup> bank would yield zero deficits (both for the central bank and for the consolidated<sup>public</sup> sector). As noted above, this would be awkward, given that the inflation<sup>rate is positive</sup> and constant.

26
_nw=cp SO_

**_c 5 h_** m constant

<!-- Start of picture text --> d = d = dCb = -r8c = Pc8 =--=-p=Ph.<br>P P<br><!-- End of picture text --> This example may give the impression that the methodology is just a convoluted way to arrive at obvious conclusions. Ultimately, the government's real primary deficit was financed by seignorage revenues, as it should be in a model where neither the government nor the central bank borrow from or lend to the foreign or domestic private sectors. However, the methodology does introduce a discipline in the assessment of central bank's accounts that proves very fruitful when th central bank operates extensively with the private and foreign sectors.

# **Case 2. Private Sector Activities Financed by Interest Rate Subsidies**

Suppose that the government's real deficit is zero, and the only activity of the central bank is the provision of zero interest rate credits to favored private sector activities. Assuming a steady state with constant real stocks for simplicity, the situation would be essentially as follows: _c,_ **_fnWcb So_** _cp a h_ = constant <!-- Start of picture text --> =dCb =-~rpcp = Ph=- .<br><!-- End of picture text -->

**27**
In this case, the real quasi-fiscal deficit is again equal to the consolidated public sector deficit. But now the central bank is transferring resources from the holders of base money to the private sector (to the recipients of credits at zero nominal interest rates). T his situation is similar to the one where the government's deficit is due to the provision of ordinary subsidies and transfers to segments of the private sector (e.g., food subsidies and payments to the elderly), and the deficit is financed from central bank credits. In both cases there is a deficit in the public sector, which originates from redistributional objectives, and which may result in excessive monetary creation and inflation.

In this example the rate of inflation is constant and positive, and the government does not borrow from the central bank or even from the private sector. Although this may appear as a puzzle, the solution consists in accounting for the real quasi-fiscal deficit, _-rpcp =_ **_Ph_** . Indeed, the transfer of real resources associated to a credit subsidy is entirely equivalent to that produced by any other type of subsidy, ordinarily included in fiscal budgets.

Now consider a steady state where the nominal interest rate charged by the central bank on its loans to the private sector is positive, but still below the rate of inflation. In this case, the central bank has a positive nominal surplus equal to _ipCp,_ but a real deficit equal to _-rpCp ._ Note also that in this case the real net worth of the central bank is positive"<sup>7</sup> : _cp_ a constant _h_ constant _nw_ = c - _h_ - constant '<sup>7</sup> It is easy to show that _nw = Pp-'>_ 0.

28
a _= d= t= -rpcp_ **_= Ph_** _=_ This example shows clearly that nominal surpluses are no guarantee of real surpluses, and that real, and not nominal deficits provide the correct measure of the pressures towards monetization. In this example the real deficit is associated with a credit subsidy. This type of subsidy is common in developing countries and difficult to eliminate in many cases.

Credit subsidies may be the instrument utilized by policy-makers to keep afloat loss-making enterprises and banks. Large enterprise losses can arise as a result of the removal of protection, large exchange rate devaluations, price controls, excessive personnel, or sheer inefficiency. Fear of the social costs of adjustment may induce policy-makers to delay adjustment, and keep afloat a large number of enterprises<sup>through</sup> credit subsidies from the central bank. In many cases enterprise losses spill over<sup>into</sup> commercial banks, through massive defaults on bank loans. In these cases,<sup>central bank</sup> credits may be directed towards the commercial banks.

When the central bank's deficit is directly or indirectly associated to the subsidization of loss-making enterprises, the ultimate source of inflation does not<sup>lie</sup> within the bounds of the public sector. In these cases it is unlikely that iiiflation will<sup>be</sup> stopped by measures that, dealing exclusively with the financial system, aim<sup>at</sup> eliminating the central bank's deficit. An increase in central bank real interest rates<sup>to</sup> positive levels does not necessarily correct the fundamental problems that require subsidization'<sup>8</sup> . If the enterprises fail to adjust by cutting wages or investment, or by increasing efficiency, they will have to continue receiving resource flows. These<sup>flows</sup> 181f these higher rates are reflected in higher commercial bank lending rates the financial problems faced by enterprises may actually be aggravated.

29
usually take the form of distress borrowing, such as massive defaults on bank loans or greater recourse to inter-enterprise credits. Of course, in the medium or long run a wave of bankruptcies or subsidization through widespread debt forgiveness are the only possible outcomes.

Under these circumstances, a successful stabilization may require closing down some inefficient enterprises. Measures such as corrections of enterprise prices and the financial restructuring of potentially viable enterprises and banks may also be needed. Financial restructuring invariably requires some fiscal support. Therefore, the stabilization of inflation and the elimination of credit subsidies may ultimately require a fiscal adjustment, even when the need for such fiscal adjustment is not obvious.

# Case 3: Foreign Exchange Losses at the Central Bank

Suppose now that the central bank borrows abroad and provides credits in domestic currency. Suppose further that the foreign exchange losses incurred by the central bank are not properly taken into account. Instead, the central bank's cash profits are integrally distributed to the government. To focus on the consequences of excessive dividend payments, it is assumed that the domestic and foreign real interest rates are zero, the nominal interest rate on reserves is zero, and the real exchange rate remains constant: Note that in this case i. = _i + E_ , that is, there is no subsidy implicit in central bank credits. Thus, if the central bank interest revenues were internalized and reinvested, there would be no problem, since the foreign exchange losses would tend to be offset by the cash profits, resulting in a constant net worth. However, if the cash profits are 30
transferred to the government a serious situation may develop over time. To see this point, note that the changes in the central bank's net worth and in the base money are equal to:

## _N W,. = i,c, + (i + E) NFA - A_

# _H =Ct +ENFA' -(ic, +CMNFA)+A_

Here credits to the private sector are assumed to be zero for simplicity, and A = _max(a(i,c, + iNFA),O)_ ( a > _O),_ where a indicates the proportion of cash profits that is distributed as dividends to the government. Notice the asymmetry in the determination of _A:_ if cash profits are negative there are no payments from the government to the central bank; instead, the central bank dividend is set at zero. Thus, there are two possible cases. First, if cash profits are nonnegative _(i,C. + iNFA >_ 0), the changes in base money are given by:

### _H =_ (a _- l)(i,C + iNFAE) + C, + ENFA._

On the other hand, if there are cash losses _(i,C. +i'NFA <0)_ , the expression giving changes in base money is:

### N _= C, -i,,C, + E NFA -i*NFAKE._

Suppose that i) cash profits are initially positive _(i.C. (0) + i'NFA(O)>_ 0) _,_ ii) they are fully distributed (a = 1) , and iii) the country is unable to obtain further real foreign finance _(NFA =_ 0). Under these conditions,

### _N=C,_

and 31
_h+Ph=cg +APc ._ If also h is assumed constant, _e8 = P(h - c8 )_ c and hence

# _c, (t) = h + [c, (O) - hJe-h ._

_So c,_ converges asymptotically to _h,_ and _nw - nfa_ converges asymptotically to zero. Assuming that initially _nw >_ 0 _> nfa, c8_ exceeds _h_ at time zero. This means _nw_ and **_c 8_** are decreasing in time, and _nw_ may become negative. In the long-run cash profits _i,C, + iNFA E_ will be positive, since _nfa_ converges to zero. However, they can become temporarily negative'<sup>9</sup> . As long as foreign liabilities are large, so that _IhAE=L-E ,nfa_ I _P is_ cash profits will be decreasing<sup>20</sup> .

1<sup>9</sup> Notice that when this happens the regime of the system of differential equations changes. This is because the government does not compensate the central bank for negative cash profits. Assuming that the domestic inflation rate exceeds the foreign inflation rate, a necessary condition for the negativity of cash profits is that the assets _c, + nfa_ of the central bank become negative. Indeed, it is easy to show that _i,c, +i nfa = -Enfa_ + _P(c,, + nfa) ._ If Po _<P_ P,then _E>_ 0, and the negativity of cash profits requires cg + _nfa <_ 0 . 2<sup>0</sup> To see this, notice that _i,C8 +i'NFA = P[i8 (c, + cg)+iEnfa] = [i8h+iE nfal ._ 32
Of course, it is doubtful that such developments could take place. The simultaneous decrease of the government dividend revenues and of the<sup>real value of the</sup> government's liabilities towards the central bank can only be accomplished<sup>either in the</sup> presence of a primary surplus, or through increasing borrowing<sup>from the private sector21.</sup> Thus the failure to take into account the valuation losses leads to a situation<sup>that is</sup> unsustainable, and creates a need for larger fiscal adjustments<sup>in the future.</sup> Figures 2 and 3 illustrate the problems that may result from the failure to cover foreign exchange losses. Figure 2 illustrates the case A where<sup>the interest rate charged on</sup> domestic credits covers the depreciation-adjusted cost of foreign liabilities,<sup>but the</sup> central bank distributes all its cash profits to the government. Figure<sup>3 shows the case B</sup> where no profits are transferred to the government, but<sup>the interest rate is significantly</sup> below the cost of foreign liabilities. In both cases the exchange<sup>rate is assumed to follow</sup> PPP. The initial conditions and all other parameters are assumed<sup>to be the same in the</sup> two cases, as shown in Table 1. The exercise also assumes that base money<sup>is constant in</sup> real terms, and that the nominal stock of foreign liabilities<sup>is constant in dollars. It</sup> foliows that the real stock declines at the rate of foreign<sup>inflation.</sup> In both cases there is a strong initial decline in the real stocks of domestic credits and net worth. The decline in domestic credits relative to the stock of foreign<sup>liabilities</sup> leads to a rapid decline in the real cash profits of the central<sup>bank (the nominal cash</sup> Also, when the domestic inflation rate is very high, _(P'/P)E_<sup>m</sup> _P ._ 21Assuming that the government does not borrow abroad or lend to the private sector, _Ce = d, +b_ and _d, = d -J ._ Since _e'._ < O, either there is a fiscal surplus (dg _<_ 0),<sup>or the</sup> government is increasing its debt towards the private sector _(b >_ O). As<sup>the dividends</sup> paid by the central bank to the government dwindle, a fiscal surplus requires<sup>a primary</sup> surplus _(d >_ 0).

33
profits divided by the price level) , which become negative. Note that in both cases the stock of credits also becomes negative during several periods. These trends are eventually reversed due to the continuous decline in the real stock of foreign liabilities. Note also that the parameters values imply that real stocks ultimately converge.

Table 1

# Simulation Parameters

|______|_C(m_|_O)_<br>_H(O)_|_FL(O)_|_NW(O)_|<br>P'|_E_||**jA**|_D_|
|---|---|---|---|---|---|---|---|---|---|
|Case A|100|10|90|0|30% 3%|26%|35%|7%|100%|
|Case B|100|10|90|0|30% 3%|26%|20%|7%|0%|

34
<!-- Start of picture text --> Figure 2<br>Simulation: Case A<br><!-- End of picture text --> <!-- Start of picture text --> Balance Sheet +Base Money<br>of the a Foreign Uabilitios<br>Central Bank e Net Worth<br>. '-- Credits<br><!-- End of picture text --> <!-- Start of picture text --> Real Cash Profits of the Central Bank<br><!-- End of picture text --> 35
Figure 3 Simulation: Case B <!-- Start of picture text --> Balance Sheet B"anMoney<br>of the F-omlgn UabiliUse<br>Central Bank =Nt WodUh<br><!-- End of picture text --> <!-- Start of picture text --> Real Cash Profits of the Central Bank<br><!-- End of picture text --> 36
The exercise is admitedly mechanistic, and generates some implausible results, such as a decline of real credits to negative levels. However, it does illustrate the continuous realization of foreign exchange losses through interest flows, and the resulting decline in central bank profits. The problems that may arise by overlooking the dynamic implications of foreign exchange losses are made evident. The decline in the stock of credits and cash profits usually leads the central bank to adopt expansionary monetary policies. This is inevitable if cash profits become negative and the central bank does not receive a fiscal support from the government. The monetary expansion may lead to an endogenous increase in inflation and domestic nominal interest rates, and a resulting increase in nominal interest revenues, masking a deteriorating financial situation within the central bank.

The situation of the central bank of Yugoslavia during the 1980s illustrates very well this point. As shown in Figure 4 and Table 2, the policy of negative real interest rates on credits and the distribution of a share of the revenues to the republican governments led to a sharp and continuous decline in the real stocks of credits and net worth. During the 1980s, the ratio of credits to net foreign liabilities declined from 174 to only 12 percent. During the same period inflation increased continuously, leading to an increase in nominal interest rates and the central bank's nominal interest revenues.<sup>Since</sup> the nominal income statements did not show deficits, various governments were misled into overlooking the quasi-fiscal problem in sucessive attempts to stabilize the<sup>economy</sup> during the 1980s. As mentioned before, the quasi-fiscal problem was only tackled<sup>in the</sup> stabilization program of 1990, when the stock of foreign exchange losses was<sup>replaced</sup> by a stock of interest-yielding bonds serviced by the government.

37
Figure 4 Central Bank of Yugoslavia _Real_ Dafatce Sheet _(Base_ = 1980)

|||I-e<br>I|--Credt|<br>--<br>_30_|Money--|*--NetFo<br>lJUa|w<br>--<br>Nt W<br>bUltt|orlh|
|---|---|---|---|---|---|---|---|---|
|1|Ra|Ce<br>to of<br>and S|1962<br>1<br>ntral<br>Domes<br>electe|<br>o<br>184<br>1<br>Table 2<br>Bank of Y<br>tic Assets to F<br>d Interest Rat|5<br>1<br>ugo<br>oreig<br>es, 19|9<br>19<br>slavia<br>n Liabil<br>80.198|67<br>1966<br>19<br> <br>ities<br>9||
|Net Dom<br>Asset/Net For.|1966<br>1.74|1961<br>1.67|1982<br>1.31|1983<br>1984<br>0.76<br>0.63|1985<br>_0.55_|<br>1986<br> <br>0.50|1987<br>1988<br>0.29<br>0.17|1989<br>0.12|
|Limb.<br>Average Interest<br>Rate on DomesUc<br>|3.5|3.5|3.5|_6.5_<br>20|38|48|61<br>100|1000|
|Assets<br>Interest on<br>Forign<br>Liabilltes (DM)<br>Domesllc|8.1<br>37.5|8.9<br>35.7|10.3<br>32.7|6<br>6.4<br>60.0<br>53.0|5.6<br>75.0|4.8<br>92.0|4.8<br>3.8<br>169.0<br>240.0|7<br>2685.0|
|Inflation(Dec.)<br>Domestic<br>Idflatdon (Avg.)|30.9|40.0|31.5|40.2<br>54.7|72.3|89.8|120.8<br>194.0|1240.0|

38
# Figure 5 Central Bank of Hungary Real Balance Sheet and Profits

<!-- Start of picture text --> Net Credits - Base Money N Net Foreign Net Worth<br>Liabilities<br>s 1 1982 1983 1984 1985 16-.J-87 1988 1989 190<br>-~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~4<br>Real Profits<br>Base 3 1965S<br>180.t<br>160.<br>140.<br>120<br>100.<br>40.<br>20.<br>1982 1983 1984 1985 1986 19t7 1988 1989<br><!-- End of picture text --> 39
The real balance sheet of the central bank of Hungary shows a similar pattern. As indicated in Figure 5, there was also a decline in the real stocks of credits and net worth during the second half of the 1980s, leading to a decline in central bank profits. The situation is less dramatic than in Yugoslavia, as indicated by a less pronounced decline in the stock of credits and net worth, and the fact that the stock of credits remained above the stock of foreign liabilities. Howe 'er, the trends indicate a deteriorating situation due to the same causes, namely, underpriced credits and an unwarranted distribution of cash profits.

# V. Conclusions and Further Thoughts.

In this paper we review and discuss a number of issues related to the relevant definitions of fiscal and quasi-fiscal deficits, as well as the consolidation of the two. The major issues discussed are the distinction between nominal and real deficits, the treatment of foreign exchange losses, and the treatment of public sector loans to the private sector.

Despite their limitations, real measures of the deficit provide a less distorted indication of the actual fiscal policy stance than nominal measures. The distinction between nominal and real definitons is even more relevant in the case of the central bank's quasi-fiscal deficit, given the financial nature of the central bank's operations. Central banks rarely recognize explicitly their losses in their income statements. Moie often, these income statements show sizable nominal surpluses, even in the cases where there is actually a real deficit in the operations with the private domestic and foreign sectors.

Real quasi-fiscal deficits usually reflect losses in other sectors of the economy and the need for a resource transfer. Therefore, a correction of these deficits may require more than a simple elimination of credit subsidies through an increase in real interest 40
rates to positive levels. In fact, the elimination cdf losses at their source requires in many cases a fiscal adjustment, even when the need for such adjustment is not obvious.

The accumulation of foreign exchange losses imposes a burden on the consolidated public sector's finances. The fact that this burden is partly transferred to future periods frequently leads policy-makers to overlook its consequences. This is particularly true in the case of the central bank's own foreign exchange losses. Scenarios where these losses are allowed to accumulate to very large amounts, while interest rates on domestic credits are kept low and the central bank keeps transferring its declining cash profits to the non-financial public sector, are not uncommon. The mounting burden of net interest expenditures may then constitute a significant source of monetary expansion. This situation worsens considerably when the central bank is faced with a net repayment of its foreign liabilities.

We argue that proper consideration of foreign exchange losses provides very important information for the evaluation of the fiscal policy stance, even in situations where these losses seem to be largely unrealized. The distinction between realized and unrealized losses becomes meaningless over time, as losses are continuously realized through interest flows. A systematic accumulation of foreign exchange losses indicates the need to adjust the interest rates on domestic credits and/or to stop transferring central bank cash profits to the government. Failure to implement these measures in time can lead to inflationary episodes like the one observed in Yugoslavia during the 1980s, where a large real quasi-fiscal deficit was the main factor leading to monetary expansion and accelerating inflation.

There are conceptual problems related to the treatment of central bank lending to the private sector that are similar to those related to government lending to the private sector. The existence of an element of subsidy in public sector credits does imply a 41
transfer of resources to the recipients of those credits. This subsidy component should be included in the deficit definition. Uncollected or uncollectable credits should also be included, since they also imply a transfer of real resources to segments of the private sector. However, if the extension of loans by the central bank or the government to the private sector does not imply a negative variation in the public sector's net worth, the justification for the inclusion of these loans in the deficit is less clear.

42