20859 1997 dr& Economic Development Institute 'M of The World Bank Macro-Financial Review: Policy and Program Formulation Tusania: A Case Study and Training Guide Shakil Faruqi EDI WORKING PAPERS REGULATORY REFORM AND PRIVATE ENTERPRISE DIVISION C PY Macro-Financial Review: Policy and Program Formulation Tusania. A Case Study and Training Guide Shakil Faruqi This case study is intended for those interested in macro-financial management, policy and program formulation. Topics covered include: approaches to macro-financial review; analysis of financial system structure and trends; linkages with economic trends; analysis and aggregates; financial resource mobilization and allocation; domestic and external financial requirements; operations of the central bank and its impact on the banking system, mechanisms and linkages; the regulatory framework and system of control; the role of financial markets; policies and program formulation at the macro-level, and interactions at the sectoral and institutional level. Economic Development Institute of The World Bank iii FOREWORD This case study and training guide is one of a series of training materials on banking and financial systems developed at the EDIRP. It is primarily intended for those responsible for macro-financial management, policy and program formulation, and operation of the regulatory and control mechanisms, as well as the practitioners in the financial and banking systems. As a training handbook, the study is also intended for trainers interested in enhancing their understanding of the framework, methodology, and analytical techniques underlying macro-financial review and the formulation of a program of policies and actions. The emphasis is on developing the basic elements of a macro-financial program, and at the same time provide an understanding of the nature of inter-links between the major economic and macro-financial aggregates. The study highlights the type of constraintes operative on the system of regulation and control and the degrees of freedom available to the authorities concerned while charting out and implementing a stabilization package and macro-financial program in a time of economic and financial crisis. While this case study will suffice for those interested at the macro-level in formulating the framework, the policy regime, bench-marks and broad-based guide posts, it will be inadequate for practitioners whose concerns go beyond policy- making. For them it is critical to have a deeper understanding of how banking and financial systems respond to policy changes and how effective is the mechanism of regulation and control. Therefore, the centerpiece of the case study is the illustration of linkages as feasible, between macro-financial policy bench-marks, and the response of the banking and financial system at the sectoral level, down to the impact at the institutional level. This case study is primarily based on lessons of experience of the author drawn from country cases and is interspersed by observations in similar situations elsewhere. The framework, analysis, results, and illustrations are forged as a composite of the two country cases. The data set has been stylized to spotlight the nature of interlinks, the control mechanisms, and the behavioral response at the sectoral and institutional level. Since the study spans a period of seven years, this may remind some readers of the parable of seven fat years, followed by seven lean years, yet even a parable must be ensconced in a continuum and a contextual relevance. This is attempted here in this case-study. Danny Leipziger Chief Regulatory Reform and Private Enterprise Division iv ACKNOWLEDGMENT The manuscript was initially prepared by the author at various stages in several training modules delivered in EDI training programs during 1992-1995. The author would like to thank all those who contributed to this publication. A draft of the manuscript was reviewed and edited by Professor John Crockett of George Mason University. Processing of earlier drafts was done by Elizabeth Crespo, John Yates, B6ndicte L6chen, and Robert McGee. Final processing, copy-editing and preparation for publication was done by Johanna Frontczak with skill and patience. V TABLE OF CONTENTS I. The Analytical Framework............................................................................ The Persppctvive .......................................................................................... The Issues................................................................................................... 5 Approaches to Macro-Financial Program and Policy Formulation...........6 In The Case of Tusania ... .......................................................................... 11 II. The Tusanian Financial System: Structure, Growth and Resource M obilization .................................................................................................... 15 A: The Financial System: Structure and Growth Financial System Assets and Structure................................................ 17 The Banking System ............................................................................ 20 Government Policy on Ownership ...................................................... 25 Non-bank Financial Institutions and the Informal Sector ................... 27 Laws, Rules, and Regulatory Framework ........................................... 29 B: The Financial System and Savings M obilization................................. 32 Financial Savings and Trends.............................................................. 33 The Banking System and Deposit M obilization.................................. 35 Savings and Financial Intermediation................................................. 40 IH. Genesis of the Economic and Financial Crisis ............................................ 49 IV. Requirements for External Finance............................................................. 57 The Balance of Payments Deficit............................................................... 59 The Emergence of Arrears......................................................................... 61 Short-Term Inflows ................................................................................... 63 Foreign Trade and Current Account Balance............................................ 67 Corrective M easures .................................................................................. 70 The Exchange Rate Policy.........................................................................71 Export Promotion....................................................................................... 74 The External Debt...................................................................................... 77 Rescheduling of External Debt .................................................................. 81 vi V. Financial Operations of the Public Sector: The Government and SEs ....87 Fiscal Operations of the Governm ent.........................................................87 The Deficits.................................................................................................89 Financing the Deficit-Borrow ing Operations .............................................94 Instrum ents of Borrowing and Costs ..........................................................97 Borrow ings by Ses ...................................................................................... 01 Dom estic Debt and Debt Servicing costs ...................................................103 Fiscal Operations of the Governm ent.........................................................107 Financial Operations of State Enterprises (SEs).........................................11 VI. M acro-Financial M anagem ent......................................................................123 Interest Rate and Price Trends ....................................................................127 M onetary growth.........................................................................................35 M onetary Control M echanism s .................................................................. I41 Open M arket Operations (OM O)................................................................141 Reserve Requirem ents ................................................................................l43 Liquidity Control ........................................................................................146 VII. The Credit System , G rowth and Allocation .................................................161 The Intervention M echanism ......................................................................162 The Layered System of Credit....................................................................64 Effectiveness of the Credit Guidelines ....................................................... 66 Credit Expansion and M onetary Control....................................................168 Credit Operations of the CBT and DFIs.....................................................171 Credit Operations of the Com m ercial Banks..............................................177 Credit A llocation and Sectoral Finance......................................................181 The D irected Credit System ........................................................................184 Term Financing...........................................................................................192 Financing of Priority Sectors......................................................................194 Lines of Credit ............................................................................................196 Agricultural and Rural Finance...................................................................199 Industrial Finance........................................................................................202 VIII. Financial M arkets ...........................................................................................219 M oney M arket.............................................................................................219 Capital M arket ............................................................................................224 IX A nnual Program for Y ..................................................................................233 Overall Objectives ......................................................................................233 The Process - Approach and Constraints....................................................234 Dimensions of the Y8 Annual Program - Benchmarks and Targets...........238 The M acro-Financial Program ....................................................................239 Dom estic Credit ........................................................................................ 239 M oney Supply Growth................................................................................243 The Fiscal Program .....................................................................................246 The Balance of Paym ents and External Debt .............................................251 Vil TABLES Table 2.1 Assets of the Financial System............................................... I8 Table 2.2 Institutionalized Financial Savings ........................................ 34 Table 3.1 GDP - Macro Accounts .......................................................... 52 Table 4.1 Balance of Paym ents .............................................................. 60 Table 4.2 External Debt Outstanding and Disbursed (DOD)................. 78 Table 5.1 Financing Public Sector Deficits- Government, State Enterprises ............................................... 90 Table 5.2 Domestic Borrowing Operations, Domestic Public Debt: Government, State Enterprises .............................................. 96 Table 5.3 Domestic Debt Public Sector: Government, SEs................... 104 Table 6.1 Price and Interest Rates .......................................................... 128 Table 6.2 M onetary Survey .................................................................... 136 Table 6.3 Summary Accounts, CBT....................................................... 139 Table 6.4 Reserve Requirements ............................................................ 145 Table 6.5 Liquidity of Commercial Banks ............................................. 147 Table 7.1 Sources of Credit .................................................................... 170 Table 7.2 Summary Accounts of Commercial Bank............................. 178 Table 7.3 U ses of Credit......................................................................... 182 Table 7.4 Banking System Credit to Sectors: Sectoral Distribution, Targets, A ctual Grow th .......................................................... 185 Table 8.1 M oney M arket ........................................................................ 220 Table 8.2 Tusanian Stock Exchange....................................................... 225 Table 9.1 Bench-Marks -- Annual Program for Y8 ................................ 238 Table 9.2 Banking Credit -- Annual Program for Y ............................. 241 Table 9.3 Fiscal Operations of the Government and the SEs Annual Program for Y........................................................... 248 Table 9.4 Foreign Financing and Balance of Payments Annual Program for Y8........................................................... 252 viii BOXES Box 4.1 Foreign Currency Deposits (fCDs)..........................................64 Box 4.2 Financing Imports - Suppliers' Credits ..................................66 Box 4.3 Foreign Exchange Auction System.........................................72 Box 7.1 Layered System of Credit Allocation......................................164 B ox 7.2 Lines of Credit ......................................................................... 197 ix CHARTS Chart 2-1 Asset Growth Rates......................................................... 19 Chart 2-2 Shares in Total Assets..................................................... 21 Chart 2-3 Deposit Growth............................................................... 36 Chart 5-1 Deficit Growth Trends .................................................... 92 Chart 5-2 Shares of Instruments...................................................... 98 Chart 5-3 Average Cost of Borrowing ............................................ 100 Chart 5-4 Fiscal Trends, Federal..................................................... 108 Chart 5-5 Quasi Deficit Trends....................................................... 113 Chart 6-1 Prices and Interest Rates................................................. 131 Chart 6-2 Growth of M onetary Aggregates.................................... 137 Chart 7-1 Credit Growth Rates ....................................................... 172 Chart 7-2 SourcesofCredi ............................................................. 1o7C6 Chart 7-3 Credit Growth ................................................................. 183 Chart 7-4 CreditShares ................................................................... 188 x ANNEXES ANNEX I: (Chapter I) ANNEX II: (Chapter II) Exhibit 1 The Financial System..............................................................41 Exhibit 2 Assets of the Financial System................................................44 Table 2.1 Assets of the Financial System................................................45 Table 2.2 Institutionalized Financial Savings .........................................47 ANNEX III: (Chapter III) Table 3.1 GDP - Macro Accounts...........................................................56 ANNEX IV: (Chapter IV) Exhibit 1 Balance of Payments...............................................................83 Table 4.1 Balance of Payments...............................................................84 Table 4.2 External Debt Outstanding and Disbursed (DOD)..................86 ANNEX V: (Chapter V) Exhibit 1 Financial Operations of the Government................................116 Table 5.1 Financing Public Sector Deficits- ...........................................117 Table 5.2 Domestic Borrowing Operations, Domestic Public Debt: Government, State Enterprises ............................................... 19 Table 5.3 Domestic Debt Public Sector: Government, State Enterprises......................................................................121 ANNEX VI: (Chapter VI) Exhibit I Monetary Aggregates ..............................................................150 Exhibit 2 Assets and Liabilities of the Central Bank..............................151 Exhibit 3 Liquidity of Commercial Banks..............................................152 Table 6.1 Price and Interest Rates...........................................................153 Table 6.2 Monetary Survey ..................................................................... I54 Table 6.3 Summary Accounts, CBT........................................................156 Table 6.4 Reserve Requirements.............................................................158 Table 6.5 Liquidity of Commercial Banks..............................................159 ANNEX VII: (Chapter VII) Exhibit I Consolidated Balance Sheet of Commercial Banks................205 Exhibit 2 Income and Expenditure of Commercial Banks .....................207 Exhibit 3 Financial Performance of Commercial Banks ........................209 Table 7.1 Sources of Credit.....................................................................1 Table 7.2 Commercial Bank Summary Accounts...................................212 Table 7.3 U ses of C redit..........................................................................215 Table 7.4 Banking System Credit to Sectors: Sectoral Distribution, Targets, Actual Growth ...........................................................217 xi ANNEX VIII: (Chapter VIII) Table 8.1 M oney M arket ........................................................................ 231 Table 8.2 Tusanian Stock Exchange....................................................... 232 ANNEX IX: (Chapter IX) Table 9.1 Balance of Payments .............................................................. 254 xii ABBREVIATIONS ADBT Agriculture Development Bank of Tusania AMLs Agencies: Multilaterals CenBank/CBT Central Bank of Tusania CDs certificates of deposit ComBanks Commercial Banks DFIs development finance institutions fCDs foreign currency deposits Finlns Financial Institutions FinSys Financial System GDP gross domestic product IDBT Industrial Development of Bank of Tusania IOUs financial obligations (I owe you) LIBOR London Interbank Offer Rate M< medium and long-term MoF Ministry of Finance Mol Ministry of Industries NBT National Bank of Tusania NICT National Insurance Corporation of Tusania NTF National Trust Fund QRs Quantitative Restrictions SBT Savings Bank of Tusania SEC Securities and Exchange Commission SEs state (owned) enterprises SME small and medium enterprises ST Siwat, Tusanian currency T-bills treasury bills TCs treasury certificate TNB Tusanian National Bank TSE Tusanian Stock Exchange Y year Copyright @ 1997 The International Bank for Reconstruction and Development/The World Bank 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. The World Bank enjoys copyright under protocol 2 of the Universal Copyright Convention. This material may nonetheless be copied for research, educational, or scholarly purposes only in the member countries of The World Bank. Material in this series is subject to revision. The findings, interpretations, and conclusions expressed in this document are entirely those of the author(s) and should not be attributed in any manner tp the World Bank, to its affiliated organizations, or the members of its Board of Executive Directors or the countries they represent. EDI Document Number: 340/083, Shelf Number: E9258 Shakil Faruqi is principal financial economist in the Regulatory Reform and Private Enterprise Division at the Economic Development Institute of the World Bank. EDI Working Papers are intended to provide an informal means for the preliminary dissemination of ideas with the World Bank and among EDI's partner institutions and others interested in development issues. Thebacklist of EDI training materials and publications is shown in the annual Catalog of Learning Resources which is available from:. Learning Resources Center, Room M-Pl-010 Economic Development Institute The World Bank 1818 H Street NW Washington, DC 20433, USA Telephone: (202) 473-6351 Facsimile: (202) 676-1184 1111 Ill11l1Il 340/)083E95 CHAPTER I THE ANALYTICAL FRAMEWORK The Perspective 1.1 This case study deals with the current economic and macro-financial situation of Tusania, focusing on the problems of the past couple of years which have continued to deteriorate despite attempts to reverse this trend. The main reason was that the corrective measures and policies were inadequate to cope with the underlying structural causes of imbalances in the Tusanian economy. Yet, the focus has to be on the short-term picture within the framework of the government's annual programs since these annual programs are the central mechanism of the implementation of policy packages. Therefore, following a detailed presentation of the operations of the financial system, and analysis of the current situation, this case study proceeds to outline a short-run economic stabilization program and examine the feasibility and consistency of macro-financial package of corrective measures, together with the supportive apparatus necessary to enable Tusania to achieve stability and economic growth. The broad economic trends, stabilization objectives and annualized targets provide the guideposts for the articulation of the macro-financial package, though 2 Macro-Financial Review: Policy and Program Formulation these guideposts themselves may be adjusted in iterative fashion during the implementation phase because of the constraints encountered. While the data base for this type of analysis and program formulation is invariably inadequate - especially for the latest years - this does not alter the salient conclusions or the broad direction of the economic and macro-financial program, given that the underlying economic and financial structure, the operations of the financial system, and the initial conditions remained unaltered. As the severity of the current situation varies, the intensity of the corrective measures is modulated -- it is more a matter of degrees rather than broad directions of policy response. 1.2 Since any short-run economic and financial program has to contend with overall resource constraints, both internal and external, one cannot chart out a macro- financial program isolated from a comprehensive program for economic stability and recovery, short-term or otherwise. On the domestic front, this involves ascertaining the domestic resource balance in financial terms, the macro-financial aggregates such as the supply of banking credit within the mechanisms of the financial operations of the banking system borrowings of the public sector and the credit needs of the private sector. However, the most important aspect of the domestic resource balance in Tusania has to do with the fiscal operations of the government and the financial operations of a large quasi-government sector that, together, determine the over-all size of the public sector deficit that must be financed by banking system credit on terms and conditions which may not reflect market-based costs. On the external front, these elements are closely intertwined with the analysis of the balance of payments, capital inflows, and foreign borrowings necessary to support the macro- financial package contained in the stabilization program. The determination of a sustainable level of foreign capital inflows involves first ascertaining the size of the current account deficit based on the trade balance and the underlying levels of imports, exports, and exchange rate movements. This is followed by an assessment of net medium- and long-term capital inflows, disbursements from the existing 2 The Analytical Framework 3 pipeline of foreign credits less repayments, the likelihood of new foreign borrowings on official accounts, and the outlook for private capital inflows, all of which are financing items for the balance of payment deficits. 1.3 This focus on the macro-level, both for the analysis of current trends and program formulation, has to be based on the operations at the institutional or unit level, and links have to be established in a direct fashion. How the financial institutions, the businesses, the enterprises, and the households behave in the face of changing economic and financial conditions and how they respond to various policy- led changes need not only be understood, but traced and followed. This traversing between the micro and macro levels is not easy, but is attempted here. The aggregation, however, poses two sets of analytical issues encountered throughout this case study. One set of issues relates to the statistical process of aggregation from the ground up, brick-by-brick, block-by-block, on the basis of financial statements originating at the micro-unit level, leading to the aggregation at the component level, and eventually, at the macro-level. Unless the data recording and reporting system is uniformly adhered to aggregation may not fully capture the subtleties of trends at the micro-level. A second set of issues relates to how faithfully the macro-level trends reflect the behavior of the constituent units, financial institutions, businesses, and enterprises. Quite often the unit level response to a given situation is driven by considerations inconsistent with those observed at the macro-level analysis. This cleavage, which arises especially in times of financial crisis, is sufficiently documented in this case study. Therefore, effort has been made to capture the behavior and functional response at the unit level in its microcosm and to establish analytical links with the outcome at the aggregate level. 1.4 Another major purpose of this case study is to present the underlying methodology and techniques of economic and financial reviews, the articulation of a short-term program, the determination of the size of financial resources needed, both 4 Macro-Financial Review: Policy and Program Formulation domestic and external, linkages at the unit level, simulations of feasibility of the program, and sensitivity analysis. This makes it possible to demonstrate the degrees of freedom in calibrating the levers of control and their impact, given the rigidities in the financial system that may render the operations of the control mechanism ineffective. Since these mechanisms have to interface with market-based signals, the central premise of this case study is that the Tusanian economy is fairly open, the basic economic and financial structures are reasonably responsive to market-based signals, and its regulatory system and corrective apparatus are sound and functioning. This may be too much to pretend, yet essential for the purposes of this study. 1.5 This case study presents a medium-term review spanning seven years, Y, through Y7, with focus on the crisis years of Y5 and Y7. The seven-year span may remind some readers of the parable of seven fat years followed by seven lean years. Yet, even a parable has to be ensconced in a continuum, therefore, the review presented here for the YI-Y7 years cannot be detached from developments in the years preceding the review period. As the case study demonstrates, the economic and financial trends during the review period are closely intertwined with the structure of the Tusanian economy prevailing before, and were shaped by the policy milieu and attempts at structural change and reform in the years preceding the review period. While the Tusanian economy remained buoyant during the first half of the review period, Y, -Y4, the seeds of economic and financial crisis of the years Y5-Y7 were deeply embedded in the long-term past. This became particularly evident when the annual program for Y8 was formulated as historical trends defined the set of constraints and degree of freedom available to policy formation. This case study, therefore, is not presented as a routine review and short-term stabilization program of a quick-fix variety. Instead, it offers a medium-term perspective with a focus on annual programs, since these are the only delivery mechanism available to the government. The Analytical Framework 5 The Issues 1.6 The macro-financial review has to contend with two broad issues. The first is the extent to which the macro-financial policies have been able to strike a balance between stimulating or directing an adequate and self-sustaining flow of financial resources to real sectors of the economy, while preserving confidence and financial strength in the institutions that make up the system. The second is, given that the financial system has undergone substantial changes, whether or not it has accomplished a major change in the pattern of financial resource mobilization and allocation. That is, to what extent have the reforms in the past succeeded? Further, if the distortions still exist, what is the source of these distortions? Do these remaining imperfections have their origin in the financial sector per se, in the real sectors, or in the structure of the government policy? The analysis of this element will help to identify distortions at their source, thus avoiding costly and inappropriate interventions. Specifically the review must focus on the following: 1. Issues relating to saving-investment balance, government finance, and public debt, both domestic and foreign; exchange and trade regime and its impact on the financial system; monetary and interest rate policies; and the evolution of money markets for the viability of open market operations and indirect instruments of monetary control for effective management of aggregate money demand. Simply put, who generates and supplies financial resources, both domestic and foreign? What is the source, composition, and size offinancial flows on the supply side? 2. Issues relating to the allocation and pricing of financial resources, term lending, financing of the priority sectors such as industry and agriculture, and attempts to provide credit to disadvantaged groups; the phenomenon of perverse lending; issues covering development of capital markets to promote vitally needed long-term finance to support investment growth; and massive privatization and commercialization of public sector enterprises (SEs). That is, who uses these resources and at what costs? What is the nature of resource allocation between users and suppliers, and what are the terms of allocation represented by the interest rate structure? 6 Macro-Financial Review: Policy and.Program Formulation 3. System wide issues related to financial intermediation and its efficiency, the viability and solvency of financial institutions and portfolio quality and management; and the establishment and strengthening of a supervisory and regulatory system capable of enforcing a uniform criteria for participation in the financial system. What is the mechanism of transfer of these resources between the suppliers and users and how efficient is it? 1.7 It is not possible in this case study to deal with all of these issues in an exhaustive fashion. Instead, these elements are used as guideposts. while outlining the macro-financial program and they are discussed in relevant sections to the extent possible. The data requirements are equally exhaustive. They are summarized at the aggregate level in four major accounts: macro-financial accounts; fiscal accounts; balance of payments accounts; and national accounts. These accounts are spelled out as exhibits in the Chapter Annexes. The exhibits, which provide a system of accounting identities, demonstrate the interlinks between the sub-components of a given account, as well as across the financial system, and their links with the macro- data set. In addition to these major accounts, there are four critical sets of prices: the general price level, the interest rate structure, the wage rate and the exchange rate. Availability of this basic data set, its reliability and quality, are critical to both the diagnostics and calibration of the levers of financial control. As mentioned above, this aggregate data set is built upon unit-based accounts and is constructed in building-block fashion, with progressive aggregation of its major components. Approaches to Macro-Financial Program and Policy Formulation 1.8 To recapitulate, a macro-financial program has to be a part of the overall program for economic stabilization, recovery, and growth. This has to be achieved in the context of a sustainable domestic resource base, especially the fiscal deficit and its financing, and a sustainable current account deficit within a viable balance of payments. The twin deficits, namely the fiscal deficit and the current account deficit, have to be satisfied in a consistent fashion with broad macro-financial targets, and The Analytical Framework 7 with funding from domestic and external borrowings. These interlinks come in to play primarily through the price level, interest rate structure, and the exchange rate, depending on how open the economy is and what the structure of these linkages is. 1.9 The usual approach to the articulation of a short-term program is to start with an evaluation of the size of the domestic resource gap, with some notions of price stability and a sustainable exchange rate consistent with the domestic price level, the interest rate, and viable financial flows through the banking system, as well as their allocation to private and public sectors. Alternatively, one could begin with the external deficit, given the structure of foreign trade, current account balance, and autonomous capital inflows on a net basis, determining the size of the domestic resource gap that will be sustainable with some degree of price stability, and estimating how much of the residual domestic resource gap can be financed by the government through gap-fill borrowings from overseas and multilateral agencies (AMLs). In both cases, the government is under the constraint of keeping the targets of economic growth and inflation in prices and wages at levels politically acceptable to the public. That is, GDP growth, inflation, and the wage level, are somewhat pre- determined - partly within the political and social constraints - and to the degree that they are specified independently of the considerations of technical viability of the resource gap. Herein lie the roots of conflicting policy objectives, posing a dilemma to those in charge of policy formulation and implementation. In any event, the economic stabilization program straddles all the major areas mentioned above and it hinges in a composite manner on both domestic and external resource availability, consistent with stable levels of exchange rates, interest rates, domestic prices, and a target of economic growth acceptable to the public. 1.10 In the first case, if we proceed with the domestic resource gap, defined as the excess demand of resources over and above those available to the government and the private sector, the need is to determine the size of this domestic deficit. The easiest 8 Macro-Financial Review: Policy and Program Formulation way is to start with public sector deficit emerging from fiscal operation as well as the quasi-deficit, which is the government-guaranteed deficit of the state economic enterprises (SEs). Having determined this, the next step is then to figure out what level of public sector deficit is sustainable and consistent with price and interest rate stability, with external resource flows and foreign trade, and above all, the exchange rate. The main elements of the macro-financial program, then, have to focus on government budget deficits and their financing together with the availability of financial resources to the private sector through the banking system. In this respect, demand for financial resources by the private sector is treated in an autonomous fashion. That is, reliance is placed on the market mechanism, as long as prices perform the market-clearing function, imperfectly or otherwise. 1.11 In the second case, one could begin with the determination of the size of the external deficit, both on the current account and the capital account of the balance of payments. Then, one would proceed to determine a feasible import capacity, given the present structure and prospects of exports, feasible inflows of external funds - feasible in the sense of generating a financing gap no larger than the likely flows of short-term funds and medium- to long-term capital. This feasible balance of payments alternative will, in turn, determine the short-term investment and output growth possibilities. In this scheme, the corrective actions are spear-headed by foreign trade and balance of payments measures. These steps must be accompanied by policies concerning exchange rate and short-term borrowings. These have to be supported by domestic demand management in the form of controls on money supply and banking credit without which the external balance would not be attainable, thereby jeopardizing the targeted short-term outcome. Thus, the demand management alternatives have to be tailored to the feasible balance of payments, which becomes the overriding concern 1.12 No matter which route is followed, the challenge is to find a convergence of these approaches while articulating the macro-financial program. The main elements The Analytical Framework 9 of the macro-financial program concern domestic resource availability which, in financing terms involves: money supply, banking credit and its allocation to government and private sector, i.e. the size and type of deficit financing and the inherent cost of this borrowing. These have to be linked with some normalized level of financial resources needed by the private sector and controlled mainly by the interest rate structure, both on the deposit and lending sides, and the institutional mechanisms employed to affect the allocation of financial resources. The time frame is typically the annual program cycle which, per force, is driven by short-term considerations. 1.13 As the transition is made from the short- to medium-term, structural forces of the economy take over. The balance of payments constraint remains a force to be reckoned with, though its severity is considerably diminished. Growth during the medium-term depends largely upon how quickly the economy is able to invest and accumulate capital and to internalize modem technology in its productive structure. In other words, over the medium term, supply constraints become operative with no major departures from the past growth policy and patterns, except in qualitative terms. For an economy like Tusania, the expansion of the modern industrial sector continues to enjoy priority in its growth policies, along with an increase in proportion of the manufacturing value-added in the GDP. This is accompanied by sufficient agricultural growth to provide for domestic food needs and exportables, mainly primary commodities and a few manufacturing items. The growth strategy during the medium term is envisaged as maintaining the tempo of long-term structural changes, interrupted by slow-downs, but once short-term dislocations have been overcome, the economy resumes its normal growth. 1.14 Given this scenario, the essence of program options lies in demand management accompanied by- appropriate measures of resource mobilization with mainly short-term consequences for the balance of payments. It would also affect 10 Macro-Financial Review: Policy and Program Formulation medium- to long-term growth. The short-term macro-financial actions and controls are expected to bring monetary and fiscal magnitudes in line with feasible balance of payments and economic growth, decrease inflation, and affect the finances of the government, the Central Bank and the SEs. The medium-term package consists of policies aimed at structural problems and at generating enough public sector resources to keep up with the financial requirements of investment and growth over the medium-term. Therefore, the focus of the stabilization program is to develop a package of internally consistent economic and financial policies, which must be technically feasible within the internal and external constraints of resource availability, as well as within the implementation capacities. Having developed the program, the next step is to evaluate the impact on the economy and to outline a short-run economic outlook, simultaneously ensuring that this economic outlook is "acceptable" in the sociopolitical context. 1.15 The requirement for the success of a program of this complexity and magnitude, is a broad-based consensus among the vital segments of the society, i.e., the lawmakers, the government, the opinion makers and the private sector. More often than not, the program's first impact on a wide segment of the population is negative, and this impact can easily become unbearable in the absence of a social safety-net. Even if the program is dutifully implemented, rather than in a checker- board fashion, there are significant lags in the economic recovery that will prevent any meaningful supplement across-the-board in the the general public's standards of living. So long as the roots of the economic and financial crisis lie in the systemic use of resources beyond what the resource base of the economy can support, and on terms not reflecting economic or opportunity costs, programs of this type will invariably cause severe belt-tightening, voluntary or otherwise. Attempts to circumvent this process will result in a fresh round of even more severe crises. That has been the experience of many countries over the past couple of decades. The Analytical Framework 11 1.16 While broad-based consensus is essential for the future direction, the implementation culture and capacity to execute and manage these programs are even more important. It is easy to formulate programs but implementation requires compliance at the institution level. Besides policy packages, authorities need to have a broad array of control levers affecting financial operations at the unit level. The need is not only that these control levers be properly operated and their impact understood, but also that they are applied to achieve the broad objectives of the program, preventing those affected from circumventing, diluting, or compromising the thrust of the program. For example, in times of a severe credit crunch stemming from a deliberate increase in the cost of credit through a general rise in the interest rate, or a straightforward denial of credit through the revamped system of directed credits, it is not uncommon for the SEs to issue quasi-private IOUs for other SEs to maintain their grip on the supplies. In time, these IOUs may begin to circulate in a "secondary market" of their own, thus thwarting any efforts at demand management in the public sector. In the Case of Tusania ... 1.17 Throughout the review period, the authorities' major concerns were monetary and exchange control to achieve price and interest rate stability, support to priority sectors, and resumption of growth, perhaps in that order. The launching of the structural adjustment program occurred afterwards when the severity of the economic and financial crisis of Y5-Y7 years became evident to all parties concerned, domestically and abroad. As the precursor, the government during the crisis years, initiated a system of more efficient financial resource mobilization and allocation through a liberalized interest rate and price structure, a realistic exchange rate and auctions throughout the financial system. However, as events unfolded, monetary stability remained elusive. As the reform measures took hold and protectionist arrangements were weakened, the economy faced increasing exposure to market 12 Macro-Financial Review: Policy and Program Formulation forces, both domestically and abroad. The financial system, previously shielded, came under pressure and the weaknesses of a good number of banking institutions became apparent. The authorities were then saddled with diagnostics and damage control, while pursuing economic and monetary stability in parallel. 1.18 Overlapping these objectives were equity, distributional, and indigenization' considerations which have been important factors behind various economic and financial policies. To what extent these objectives were achieved remains questionable. Tusania is a low middle-income economy with a per-capita GNP of $742, a level that provides a decent base for sustained growth. While income distribution in Tusania is not known with any precision, the impressions are that it is skewed, and that income disparities have grown over the years. A cardinal feature of the financial policies of successive governments has been the re-allocation of financial resources to disadvantaged groups and priority sectors through interest rates, sectoral credit targets, rural banking, and restrictions on regional deposit bases for bank lending. Similarly, indigenization objectives are likely to remain intact. In a more open and market-based financial system, it remains a challenge to see how these objectives can be accommodated. 1.19 In the future, with the continuation of structural adjustment, the economy is expected to accomplish the shift to a new environment ushered in during the crisis years with prospects for stable and sustained growth. A more efficient industrial sector, a revitalized agriculture sector, and a market-oriented trade regime, are likely to contribute to growth performance, provided there are no reversals in policy. Under these circumstances, the government must continue to emphasize the sustainability of market-based financial flows and the maintenance of a healthy and viable financial IIndigenization refers to policies aimed at enhancing domestic ownership and control of foreign-owned businesses, banks, and companies. The Analytical Framework 13 system as the center piece of this mechanism. This brings us to the review of the Tusanian financial system presented in the next chapter. CHAPTER II THE TUSANIAN FINANCIAL SYSTEM: STRUCTURE, GROWTH AND RESOURCE MOBILIZATION 2.1 The financial system of Tusania has undergone significant changes and experienced rapid growth over the past years. The basic features of the financial system, however, have remained intact. Periodic slowdowns in the Tusanian economy led the government to maintain the financial commitments of both the public and private sectors at historic levels through a series of interventions in the operations of the financial system. These interventions in the allocation and pricing of financial resources, driven by short-term considerations: prevented the financial system from achieving diversification and strength, increased dependence of major segments of the system on public-sector resources, and discouraged saving mobilization. Attempts were occasionally made to soften this interventionist regime, but these efforts were inadequate to enable the financial system to strengthen its base, increase its competitiveness and provide market-based financing. Moreover, this was done within a policy framework governing the real sectors which sought to maintain the protective structure of production, widespread price controls, and a licensing system on the procurement and allocation of commodities and inputs with unfavorable implications for the clients of the banking system. This policy framework adversely affected production and investment decisions, led to sectoral imbalances, and hurt the growth of the Tusanian economy. The attempt to redress these economic imbalances in later years through monetary, interest rate, 15 16 Macro-Financial Review: Policy and Program Formulation and fiscal policies was partially successful, but also affected the financial system in its primary role of mobilizing domestic savings and allocation of financial resources to the productive sectors of the economy. A: The Financial System: Structure and Growth 2.2 The Tusanian financial system consists of the Central Bank of Tusania (CBT) at the apex of the banking system, constituting the first tier, as in any other country. The second tier of the banking system consists of 37 commercial banks with more on the way. There are five development finance institutions (DFIs) - the Industrial Development Bank of Tusania (IDBT), the Agricultural Development Bank of Tusania (ADBT), the National Investment Bank of Tusania (NIBT), the Savings Bank of Tusania, (SBT), and the National Bank of Tusania (NBT). Strictly speaking, the SBT and NBT cannot be classified as development-finance institutions. The primary role of the SBT is on the funding side, in that it provides a fairly stable source of funds to the government from its deposit base. Funds are then passed on to the development banks for their lending operations. The NBT, as the commercial bank of the government, provides short-term financing for the operations of the state enterprises, the SEs, and also provides complimentary financing for development banks. Therefore, to keep the presentation simple, both the SBT and NBT are lumped together in the category of DFI. Further, the financial operations of the CBT are reported separately from the rest of the banking system, defined here to consist of commercial banks, which are the dominant part, and the DFIs. This has been done to isolate the CBT share of financial operations from the rest of the banking system, though in a purely technical sense, the term banking system includes both tiers - the central bank and all banking institutions in the formal sector. The formal banking system thus consists of the CBT, the commercial banks, and the DFIs 'constituting the core of the financial system (see ANNEXII, Exhibit 1). The Tusanian Financial System: Structure, Growth, and Resource Mobilization 17 On the banking system's periphery are a host of other small financial establishments which behave like banks in that they raise deposits and provide short-term financing to their clients. These are privately-owned finance and investment companies - of which there are about eighteen. However, these are not licensed banks; instead they are registered and listed under the Companies Act of Tusania and fall under the responsibility of the Ministry of Finance (MOF). In addition, there is a small but thriving informal segment engaged in deposit-taking and lending consisting of a large number of thrift societies, community banks, co-operatives, and the ubiquitous money lenders. They have a palpable presence in rural as well as urban areas. 2.3 There are a number of non-bank financial institutions consisting of six insurance companies, several pension funds, and a National Trust Fund (NTF). All were established under the Companies Act of Tusania and are registered with their respective government departments, depending on their line of activity. Only the banking institutions are required to report to the CBT and as part of its oversight function, while non-bank financial institutions, such as insurance companies, pension funds, and finance companies, are outside the reporting, regulatory, and supervision framework of the CBT. There is no self-regulation mechanism either. Financial System Assets and Structure 2.4 The Tusanian financial system grew substantially over the past decade. During the period under review, Y1 -Y7, the average growth rate of the assets of the financial system was 17.1 percent per year. A good deal of this growth is owed to the substantial monetary expansion that occurred during the second-half of the review period, Y5-Y7, when the rate of growth increased to 21.1 percent per year. There was substantial growth in CBT assets which increased at an annual rate of 18.1 percent during Yj -Y7, while its proportional share in total assets of the financial system, likewise, increased from 31.7 percent in Yi to 33.4 percent in Y7. Much of this 18 Macro-Financial Review: Policy and Program Formulation Table 2.1 Assets of Financial System Annual Indicators Average Annual Growth Rates YJ Y4 Y6 Y7 Y1 -Y7 Y1 -Y4 Y5 -Y7 (ST billions) (per cent) Total FinSystem Assets 501 749 1081 1294 17.1 14.3 21.1 Central Bank, CBT 159 220 349 432 18.1 11.4 29.1 Banking System 304 462 639 752 16.3 15.0 17.6 ComBanks 237 347 461 527 14.2 13.6 14.4 DFIs 67 115 178 225 22.4 19.7 26.3 Non-Banks 38 67 93 110 19.4 20.8 18.0 Annual Growth Rates (%) Total FinSystem Assets 12.1 14.7 22.6 19.7 Central Bank, CBT 8.7 14.6 34.7 23.8 Banking System 13.8 14.1 17.5 17.7 CornBanks 12.7 11.6 14.4 14.3 DFIs 14.9 22.3 26.2 26.4 Non-Banks 16.2 19.6 17.7 18.3 Shares (%) Total FinSystem Assets 100.0 100.0 100.0 100.0 Central Bank, CBT 31.7 29.4 32.3 33.4 Banking System 60.7 61.7 59.1 58.1 ComBanks 47.3 46.3 42.6 40.7 DFIs 13.4 15.4 16.5 17.4 Non-Banks 7.6 8.9 8.6 8.5 For details see Annex II, Table 2-1 increase, however, occurred during Y5-Y7 for reasons discussed in Chapter VI. The assets of the remainder of the banking system also increased, but at a rate lower than the CBT. This is because the banking system is dominated by commercial banks. But the growth of commercial banks' assets was 14.2 percent per year during the The Tusanian Financial System: Structure, Growth, and Resource Mobilization 19 Chart 2-1 Total FinSystem Assets Asset Growth Rates ..Central Bank, CBT Commercial Banks DFlS 35 30 25 20 15 10 5 0 Yj Y2 Y3 Y4 Y5 Y6 Y7 20 Macro-Financial Review: Policy and Program Formulation review period, slower than that of the CBT. Further, the growth rate of commercial banks' assets was higher than that of the CBT's assets in the early part of the review years, at 13.6 percent per year during YI-Y4. In later years during Y5-Y7, however, the CBT's assets increased 29.1 percent per year as compared to the 14.4 percent growth of assets for commercial banks. Because of this reversal in trends, the commercial banks' share in the total assets of the financial system decreased from 47.3 percent in Y, to 40.7 percent in Y7. The DFIs gained substantially as their assets increased much faster at 22.4 percent per year during the entire period. Likewise, their share in total assets of the system increased from 13.4 percent in Y to 17.4 percent in Y7. The DFIs and the non-bank financial institutions together currently constitute more than one-fourth of the financial system, and this gain has occurred at the expense of the more market-oriented segment of the financial system - the privately-owned commercial banks - as a group. This noticeable increase in the relative position of the DFIs in the Tusanian financial system is a more stylized event and is specific to this case study, though structural changes like this occur over a longer period. The Banking System 2.5 The growth of financial assets was not accompanied by significant improvements or diversification in the operations of the banking system, savings mobilization, or financial deepening. Likewise, there was no major improvement in the efficiency of the financial intermediation between savers and investors. This is evident in the analysis of the factors underlying the expansion of the financial system during review years, both at the system and institutional levels. The two major components of the second tier of the banking system, the commercial banks and the DFIs, had substantial growth, but the extent to which this growth was accompanied by qualitative improvements remains obscured and requires an in-depth review of performance indicators at the institutional level. Although, beyond the scope of this study, this is briefly touched upon in Chapter VII. The Tusanian Financial System: Structure, Growth, and Resource Mobilization 21 Chart 2-2 Shares in Total Assets Shares in Total Assets, Y Non-Banks DFIs 8% Central Bank, CBT 13% 32% Commmercial Banks 47% Shares in Total Assets, Y7 Non-Banks 9% DFIs Central Bank, CBT 17% 33% Commmercial Banks 41% 22 Macro-Financial Review: Policy and Program Formulation 2.6 The banking system of Tusania is concentrated in a handful of large and powerful banks, though it has a variety of institutions offering a reasonable range of financial services. There has been rapid growth in indigenous banking owing to free entry. Though a good number of banks were started as joint ventures with large overseas banks as technical partners, the number of banks has grown quickly, intensifying competition in the system. This rapid growth has not affected the prevailing concentration of banking business in half a dozen large banks with a large share of government ownership. There has been an ongoing debate over what kind of banking system government policies should promote over the long run. Should these policies assist the evolution of universal banks, or maintain the current hybrid system consisting of large mono-banks, the DFIs, and a number of commercial banks mainly for short-term financing, supplemented by small regional banks? That is, should Tusania follow the British, the German, or the Japanese system of banking for its mainstream activities? Should it encourage the DFIs to evolve into investment banks, or should it promote universal banking? To date, this debate is inconclusive. 2.7 Given this structure of the banking system, and significant growth in the CBT's assets during the review period, the CBT has emerged as an even more powerful financial institution. It wields a pervasive influence in the way the financial system mobilizes resources and allocates them among the final users. The CBT, both as the monetary authority and as a regulatory authority, has all the levers of control at its disposal to affect the growth and evolution of the financial system, not just routine operations of its constituent components. Yet the CBT remains beholden to the government in that the CBT lacks a truly autonomous mandate with freedom of independent action. Lately, the CBT has become more assertive, but this does not imply that the CBT now enjoys autonomy and can act independently in critical matters. The debate regarding the exercise of its powers has been ongoing for quite some time, but true autonomy for the CBT is unlikely to occur as it is simply not in the interest of the major power groups - the government, the SEs, the parliamentarians, and, curiously, even the large commercial banks - to have an The Tusanian Financial System: Structure, Growth, and Resource Mobilization 23 independent CBT. Any change in that direction will not come from piecemeal actions; instead, it will require a change in the Central Banking Act. Meanwhile, the CBT continues to perform its traditional roles. As the monetary authority, it is responsible for ensuring public trust in the Tusanian currency, controlling money, credit ,and banking operations of the Tusanian banking system, and is responsible for operating the official foreign exchange system and managing foreign exchange reserves. As the regulatory authority, the CBT is responsible for keeping public confidence in the banking system, maintaining the solvency and health of financial institutions, is the lender of the last resort to banks in trouble, and is the eventual safety net provider. 2.8 Significant growth in the number of commercial banking institutions over the past 10 years has occurred in spite of economic problems, austerity, and in some years, even recession. Today there are 37 commercial banks. The stimulus to this growth has come from various factors. In recent years, the stimulus was partly provided by the foreign exchange allocation system, which conferred upon the banks an economic rent in direct proportion to the differential between the official exchange rate and the parallel market exchange rates. Most of these new and small banks, which opened during the last five years of the review period, are derisively dubbed as backyard foreign exchange traders, unworthy of the banking license, because the major functions of banking such as deposit mobilization and rendering financial services are marginal to their activities. They remain mostly one-branch banks located in the main Tusanian city, and are likely to remain so given competition and slow growth prospects. The total number of banks is likely to grow further as several new banks may be granted licenses, with more applications pending. 2.9 Even with the proliferation of banks, the authorities believe, perhaps justifiably, that the Tusanian economy is under-banked. As of the end of Y7 , there were about 160,000 people to one commercial bank branch, which is rather low, even though the number of bank branches has increased rapidly over the past years. Most 24 Macro-Financial Review: Policy and Program Formulation of the branches are located in urban areas and belong to the major old banks, rather than to the new banks, which are essentially one-branch operations. The distribution of branches is highly skewed. The top five commercial banks have 100 branches or more per bank, and control half of the entire branch network. Clearly, more branches are needed rather than more banks, especially in outlying regions. Government regulations require banks to open branches in outlying regions, but banks regard this rule as a financial and managerial burden. While it does help to extend financial services to the outlying areas, it imposes a net financial cost upon the banks since most of these branches are running at a loss. Whether this requirement increases access to borrowers to the banking system, or promotes greater deposit mobilization, is unclear. 2.10 Because commercial banks are at the core of the financial system, much of this case study is devoted to the analysis of their operations. They are by far the largest financial intermediaries in terms of their assets, loans, advances, and branch networks. Their assets are really half of the of the financial system's total assets, and they have a large share in the total deposit liabilities and the total branch network of the banking system. There is substantial concentration of credit activities in a few large dominant banks which control the bulk of credit and thereby exert strong influence over economic activities. As a result, the significant increase in the total assets of commercial banks during the review years had little to do with the proliferation of banks, mentioned above. Most of the asset growth was concentrated among the large, well-established banks, partly because of their strong links with the private and even the public sector. The assets of the top eight banks increased faster, as these banks held more than two thirds of the entire banking system's total assets at the end of the review period. While the DFIs grew faster, gained in relative share, and enjoyed preferential access as a group, the commercial banks still retained their dominance in the financial system. The Tusanian Financial System: Structure, Growth, and Resource Mobilization 25 Government Policy on Ownership 2.11 An important aspect of Tusania's financial system is the extensive government ownership and control of banking institutions, including commercial banks, development finance institutions (DFIs), and major non-bank financial institutions such as insurance companies. These government-owned institutions together control a significant proportion of financial resources. Lately, the government has pursued the policy of indigenization - increasing Tusanian ownership - of the banking system, with significant impact both on the pattern of ownership and management of the banks. The law requires that at least 60 percent of banks' shares must be indigenous. The indigenization policy, however, has led to a significant controlling interest of the government in major banks, as the private sector has lacked sufficient resources to buy the 60 percent. Thus, besides its direct ownership of the DFIs and other financial institutions, the government ended up owning 6 of the 37 commercial banks operating at the end of Y7. The total assets of these government-owned banks in Y7 was about half of the assets of the entire commercial banking system. Their loans and advances were even higher - nearly 55 percent of total loans and advances outstanding of the banking system. As the major shareholder, the government nominates the management and board of directors, and therefore has a great deal of impact on the activities of these major banks. Though it has restrained from interfering in their daily operations, the government, by and large, regards these banks as sources of readily-available loan finance to the public sector. This attitude of easy finance has engendered a lack of proper accountability and financial discipline, which in later years turned out to have disastrous results for some of the banks in this group. In addition, the government also has significant controlling shares and ownership in non-bank financial institutions. It wholly owns Tusania's largest insurance company, the National Insurance Corporation of Tusania (NICT), with 38 percent of the premium income of the whole insurance industry. The government also has a strong presence in the money market in that government 26 Macro-Financial Review: Policy and Program Formulation papers and instruments, Treasury Bills and Treasury Certificates, dominate money market trading. 2.12 The indigenization policy, therefore, has resulted in a preponderance of government ownership and direct control over financial institutions. Only recently have new, privately-owned banks emerged, but they are fairly small and their operations are yet to have much impact on the conduct of the financial system as a whole. This pattern of indigenization and government ownership of major banks, together with regulatory authority and monetary control through the CBT, has conferred upon the government an unprecedented array of controls over the financial system and its resources. This, in turn, has had serious implications for resource allocation and financial intermediation, as discussed in the relevant chapters of this case study. 2.13 The government, however, recently decided to partially divest its ownership in some of these banks, and is embarking on a program of restructuring state-owned banks in response to their poor operating records. State-owned large commercial banks are generally healthy, but their cost effectiveness is another issue. At the other end, some of the small banks are facing financial distress and need restructuring. Given the number of banks involved, it is not clear how this divestiture and restructuring will proceed, especially at a time when the government is already conducting a major privatization drive of state-owned enterprises (SEs). The sale of these SEs to the public is already beginning to stretch the private sector's capacity to absorb new ventures and ,in any case, it is beyond the ability of the rudimentary capital market in Tusania to mobilize the indigenous equity finance to accommodate the divestiture of state-owned enterprises. On top of this, if a large number of state- owned banks are to be privatized, it is unlikely that the indigenous private sector could afford such a massive capital outlay to acquire public sector assets. For these reasons, the ownership structure of these banks will continue unchanged in the foreseeable future unless the government relaxes the rules of foreign ownership. The Tusanian Financial System: Structure, Growth, and Resource Mobilization 27 Besides, since the present ownership structure has enabled the government to materially impact the allocation of financial resources in the economy through financial, monetary, and economic policies, as well as through a system of control down to the institution level, it is not likely that the state will relinquish its control so easily. Non-bank Financial Institutions and Informal Sector 2.14 Non-bank financial institutions have grown substantially, as well, over the past few years, but consistent data is unavailable on the size of their operations excepting insurance companies and pension funds. A good number of them, especially the finance companies, are quasi-banking institutions, as mentioned earlier, in the sense that they operate like banks on the credit side. On the deposit side, while legally they are not allowed to take deposits, they circumvent the regulations and 'manage' a good amount of deposits on behalf of their clients for collateralized lending on the deposit base of'their clients - just as commercial banks do. These institutions often engage in group-linked activities, have an inside track on large businesses, and often engage in a variety of discriminatory practices. The growth of finance companies is attributable in part to the relatively lenient registering and regulatory rules embodied in the Companies Act as compared with the bank licensing system. While the government has strictly-controlled bank licensing, the registration of finance companies provides a medium to bypass these restrictions. Yet these quasi- banking institutions are in effect part of the formal banking system with a dilutive impact on the system of monetary and credit control. 2.15 As regards contractual savings institutions, mainly the insurance companies and pension funds, their assets are included in the category 'non-bank financial institutions' reported here. Among these, as of Y7, there were 6 insurance companies with assets of about ST52 billion, dominated by a couple of large companies. Among them, NICT is the largest with assets totaling ST22 billion - nearly five times larger 28 Macro-Financial Review Policy and Program Formulation than the assets of the next largest firm, the Tusania Reinsurance Company. NICT is wholly government-owned and has nearly half of Tusania's insurance business. Profitability is poor, however, as its return to asset ratio is one of the lowest in the industry. Some of the mid-size firms seem to be more profitable, with a high return to asset ratio, but most others in this category have a ratio closer to 8 percent. Most insurance companies seem to be sufficiently capitalized as shown by fairly high capital adequacy ratios. Earlier on, all life insurance companies were required by the CBT to invest no more than 25 percent of their funds in.government instruments and at least 25 percent of their funds in real estate. The absence of regular financial reporting requirements precludes an accurate assessment of insurance companies' financial status, but major companies for whom data is available are apparently doing quite well. In comparison, the number and size of pension funds is fairly small, and they have a smaller asset base than insurance companies, though it is difficult to accurately determine their holdings. The National Trust Fund (NTF) is the largest among them with total assets estimated at 3.5 billion. It is a compulsory savings scheme for workers which provides cash benefits to their contributing members upon retirement or disability, although the coverage is limited. Both insurance companies and pension funds are outside the supervision and regulatory framework of the CBT. There is a need to strengthen the supervision of the activities of both the pension funds and insurance companies. They could potentially play an enhanced role in the capital market and assist in savings mobilization. 2.16 There is a vibrant informal sector operating in rural areas known as the 'curb- market.' Subsistence farmers and small businesses rely a good deal on this informal sector for their credit needs since while credit societies and cooperatives offer incentives for saving while at the same time providing a form of financial insurance for participants, their costs are prohibitive. Credit societies are essentially a credit club where members collect agreed amounts and loan them at no interest to each other on a rotating basis. No collateral is required since defaults would result in social ostracism. A portion of the contributions is lent to non-members at a nominal The Tusanian Financial System: Structure, Growth, and Resource Mobilization 29 rate of interest. As regards lending, however, money lenders are at the opposite end of the informal sector. The main source of funds for money lenders is the union of money lenders or even loans from commercial banks. Interest charges can amount to 3 to 5 percent per month and the margin between lending and borrowing rates can be very high. Money lenders curiously enough often belong to credit associations; in fact, some credit associations are promoted by local money lenders. However, their activities put a heavy financial burden on the unfortunate borrower. Laws, Rules and Regulatory Framework 2.17 The legal framework of the Tusanian financial system is fairly well established and an exhaustive discussion of the framework is not intended here. In outline, the Central Bank Act -and Currency Act were promulgated at the time of the establishment of the CBT. Since then, there have been substantial changes in the operations of the financial system, which have been managed through periodic enunciation of rules and regulations implemented by the CBT. The system of control as exercised by the CBT is fairly good, as the directives issued by the CBT department concerned, carry significant clout and are binding on the operations of the banking institutions. The system of licensing and entry of banking institutions is governed by the Banking Act, which has seen several amendments, rendering it more stringent with regard to the licensing of new banks. These amendments, however, have not prevented the proliferation of banking institutions in spite of increased equity requirements and the adoption of more rigorous 'due diligence' procedures. The DFIs, however, were established through the enunciation of separate laws for each one of them. These laws were enacted by the legislature from time to time, similar to the Banking Act, but with special provisions with regard to their status, funding, and mode of operation. The non-bank financial institutions were established under the Companies Act of Tusania, are licensed by the Ministry of Finance, and are registered with the Ministry of Commerce. The insurance companies and pension 30 Macro-Financial Review: Policy and Program Formulation funds were also established under the Companies Act, and are registered with the Ministry of Commerce. 2.18 The legal structure underlying the financial system is fairly comprehensive, but the regulatory system is weak and needs major improvements. The operations of the financial system need strong regulatory control to ensure system-wide stability, financial strength, and solvency. The regulatory and supervision system, as operated by the CBT, is not strong enough nor vigilant enough to spot the emergence of financial distress and deal effectively with troubled financial institutions. There is a need to chart an orderly system of exit, parallel to the system of entry with due regard to solvency concerns. The CBT does intervene with a body of rules and regulations, but most often these interventions are too little, and too late. The regulatory and supervision system of the CBT has not been effective both because the provisions of the system were loosely chartered to begin with, and because CBT's implementation has been inadequate to cope with the rapidly enlarging banking system. The Banking Supervision Department of the CBT has been understaffed, ill-equipped, and simply too small to carry out meaningful off-site surveillance and on-site examination of the banks. The staff needs to be expanded and trained and the facilities need major improvement. 2.19 A major reason for the lack of effectiveness of the regulatory and supervision system lies in the inadequacy of the reporting and disclosure requirements embedded in the- accounting and auditing system currently in practice. The system of reporting, disclosure, accounting, and auditing, needs upgrading to bring it into line with international standards. In particular, an early warning system needs to be installed backed by sufficient financial resources to allow timely action by the authorities to prevent the emergence of financial distress and insolvency at the institutional level. A system of self-regulation by the Banking Association needs to be encouraged to supplement the CBT's regulatory and supervisory activities. The Tusanian Financial System: Structure, Growth, and Resource Mobilization 31 2.20 Given the structure of the Tusanian financial system, its organization, major components, and the legal and regulatory framework governing their operations, let us return, briefly, to the issues of the macro-financial program, policy formulation and implementation, and the system of controls operative on major components of the financial system. In general, the state-owned banks, whether DFIs or commercial banks with majority ownership by the government, were much easier to control through a system of directives, either issued by the CBT or the government department concerned. In these cases, the concerns of financial strength and viability were subservient to over-arching considerations of sustaining the operations of strategic SEs at desired levels. If there was sluggishness in the response behavior of state-owned financial institutions, it had little to do with policy targets, or the control levers of the CBT; rather it had more to do with administrative inefficiencies within the institutions concerned. But the privately-owned segment of the financial system, in particular, the commercial banks, guided by the market tests of profitability and financial solvency, were more difficult to control, though on paper, they did show some compliance with the macro-financial guidelines. The underlying reason for this segmentation in response to policy controls had to do with the client-base of the public sector financial institutions and privately-owned banks. For example, as discussed in Chapters VI and VII, when the government belatedly began its reform program in the late review period, increasing competitiveness and re-aligning interest rates and prices, all coinciding with the liquidity and credit crunch, the state-owned banks could afford to overlook the financial status of their clients, but the privately- owned commercial banks could not. In the first case, the state came to the rescue by keeping the financial flows to the public sector clients intact or enlarged. In the second case, the private commercial banks had to find ways to keep their clients afloat at a financial cost because they could not afford to let their clients go under. These clients had no safety net, as did the public sector clients. Thus, the CBT tried to implement the same type of monetary control across the board with a similar response to controls, but the manner in which the response was executed by the banking institutions, relative to their client base, was substantially different between 32 Macro-Financial Review: Policy and Program Formulation the privately-owned and public-sector banking institutions. An understanding of this dichotomous response is critical to charting out the macro-financial program. B: Financial System and Savings Mobilization 2.21 The next step is to explore the performance of the financial system in generating financial resources for the Tusanian economy. In particular, how effective has it been at mobilizing financial savings? This issue at the macro level is related to the policies governing consumption and saving behavior in real terms. Given a stable and growing economy, how good has the incentive regime been in stimulating that part of financial savings which is responsive to the interest rate structure given price stability? At the institutional level, the issue is how aggressive have the deposit- taking institutions been in mobilizing deposits, given the economic and macro- financial environment, nexus, the structure and organization of the financial system, the incentive regime, rules and regulations governing the financial operations of the deposit-taking institutions - especially on the funding side - and the financial base of the institutions concerned. That is, one could look at the aggregate savings at the macro-economic level, analyze the trends, tinker with the policy regime, and be done with it. The other alterative would be to step down to the sector level, review the structure and the incentive regime facing the depositors and institutions alike, prescribe the necessary changes in the incentive regime, and stop there. The problem, however, is that both of these 'givens' facing a financial institution describe only the necessary conditions, while the institutional constraints and responses reveal the sufficient conditions governing savings mobilization. Therefore, the need is to step down further to the institutional level and analyze their financial needs and cost structure to review how the institutions secure their financial base through deposit mobilization efforts and then to link it at the sectoral or the macro-financial level. This traversing back and forth at these separate levels is difficult to encapsulate in a base study of this type, but it is attempted here, though in an indicative fashion. The Tusanian Financial System: Structure, Growth, and Resource Mobilization 33 Financial Savings and Trends 2.22 From the vantage point of the financial system, the deposit mobilization efforts of the Tusanian financial system have been fairly respectable, as shown by growth in total deposits during the review period, Y1-Y7 . These consist of the deposits of the banking system - by far the largest proportion of the total - while contractual savings institutions are also relevant though marginal to the savings mobilization effort. During YI-Y7, financial savings increased at an annual average rate of 13.9 percent from ST237 billion in Yj to ST527 billion in Y7. The financial savings rate of growth was 14.2 percent per year during YI-Y7 , and increased to 16.2 percent during Y5-Y7 . That is, financial savings were not only sustained but increased, and at a significant rate, during the later part of the review period. This could imply that Tusanians began to save more during the period of high inflation, economic crisis, and declining incomes, however, this was not the case because savings in real terms declined. The growth rate of real domestic savings was less then 1 percent to begin with, during YI-Y3, turned negative in Y4, and was -2.9 percent in Y6, and -2.0 percent in Y7. As a result, the ratio of real domestic savings to real GDP declined from 16.2 percent in Y to 15.1 percent in Y, (see Table 2-2 next page, and for details see Annex II, Table 2-2). 2.23 Thus, from the macroeconomic perspective, Tusania was already in a deep imbalance with regard to resource generation and resource use, since no country can sustain declining real savings for very long. That the real savings of the public sector declined is abundantly clear from the size of public sector deficits, as discussed in Chapter V, and was significantly negative in real terms. Further, real household savings also declined owing to declining real incomes. Moreover, rapid inflation in Tusania during Y5-Y, may have put downward pressure on the private propensity to save through creating a relative price effect that made current coisumption favorable over future savings. Besides, having reached a plateau, real consumption did not decline commensurate to the loss of real income. The macro level policy response 34 Macro-Financial Review: Policy and Program Formulation Table 2.2 Institutionalized Financial Savings Annual Indicators Average Annual Growth Rates Y, Y4 Y6 Y, Y,-Y' Y1-Y4 Y6-Y' (ST billions) (per cent) Financial Savings 237 330 448 518 13.9 11.7 16.3 Total Deposit of FinSystem 199 280 398 465 15.2 12.1 18.5 Demand Deposits 135 183 269 320 15.5 10.7 20.9 Time and Savings Deposits 64 97 129 145 14.6 14.9 13.8 Other Savings 38 50 50 53 5.7 9.6 1.0 Total BankSys Deposits 191 269 384 439 14.9 12.1 17.3 of this: CornBank Deposits 184 255 365 417 14.6 11.5 16.9 Demand Deposits 124 165 249 288 15.1 10.0 19.7 Growth Rate (%) (per cent) Financial Savings 9.1 13.8 17.0 15.6 Deposit of FinSys 9.0 14.8 20.2 16.8 BankSys Deposit 9.8 14.5 20.4 14.3 ComBanks Deposit 9.5 13.8 19.7 14.2 DDs of ComBanks 7.8 13.0 23.9 15.7 Domestic Savings (real) 0.3 2.2 -2.1 -1.6 Shares, Ratios (%) 100 100 100 100 Deposits of BankSys / Financial Savings 80.6 81.5 85.7 84.7 ComBanks/Financial 77.6 77.3 81.5 80.5 Savings Other Savings/FinSavings 16.0 15.2 11.2 10.2 DD/ComBank Deposit 67.4 64.7 68.2 69.1 Savings/ComBank Deposits 12.0 12.9 11.0 10.6 FinSavings/GDP (nominal) 18.5 18.3 17.2 17.2 For details see Annex II, Table 2-2 called for major adjustments on the resource use side to accommodate the shrinking domestic savings base, but an immediate turn-around was not possible, mainly The Tusanian Financial System: Structure, Growth, and Resource Mobilization 35 because not much can be done over the short run of a year or two to cause a significant increase in real savings in both the public and private sectors. 2.24 Based on the macro-economic picture, institutionalized financial savings showed a respectable performance because commercial banks continued to mobilize deposits at a rate of about 14.6 percent per year during YI-Y7 . Consequently, the share of commercial bank deposits in total savings increased from 77.6 percent in Yj to 80.5 percent in Y7, at the expense of the contractual savings institutions whose share declined correspondingly. This type of change normally does not occur over such a short period, because underlying saving behavior is fairly complex and does not depend solely on nominal interest rate levels. Rather, it depends on time preference, expectations of real purchasing power, attitudes towards thrift, and expectations. Banking System and Deposit Mobilization 2.25 Further, whether financial variables affect savings is still open for debate, though the effect of interest rates on the form in which people save is clear. This is partially exemplified by trends in the components of commercial bank deposits. At the aggregate level, commercial bank deposits are nearly three-fourths of total financial savings in Tusania and are dominated by demand deposits - nearly 67 percent of the total - yet demand deposits earn the lowest rate of interest, if any. At the other end, savings deposits of longer maturity at commercial banks have the highest interest rate, yet their proportion is low, and their rate of growth was slower than the demand deposits during YI-Y7. At any rate, as discussed in Chapter VI, real interest rates turned negative during the crisis period, which may have contributed to this trend. Finally, rapid inflation and depreciation of the Siwat may have depressed savings, but they did not cause a switch in asset preferences, and banks had no difficulty in mobilizing savings at a level that they perceived adequate for their funding needs up until the liquidity crunch in Y7. 36 Macro-Financial Review: Policy and Program Formulation Chart 2-3 -.* Total Deposit Liabilities Deposit Growth Demand Deposits Time Deposits 25 20 15 10 5 YI Y2 Y3 Y4 Y5 Y6 Y7 The Tusanian Financial System: Structure, Growth, and Resource Mobilization 37 2.26 That commercial banks have been at the center of the deposit mobilization effort, is quite clear. As mentioned above, their deposits increased from STI84 billion in Y1 to ST417 billion in Y7, an average annual growth rate of 14.6 percent during Yj-Y7. In fact, the rate of deposit growth increased from 11.6 percent per year during Y1-Y4 to 17.8 percent during Y5-Y7 in spite of negative real interest rates, a diversion in profit sources away from traditional to foreign exchange dealings which occupied the attention of bankers, and enough liquidity, at least up to Y6. As banks had enough funds to lend throughout the period, they did not attempt to aggressively expand the deposit base and, in any case, they could not exceed the annual credit ceilings. Further, given the impact of the financial squeeze on borrowers during YS-Y7, the banks did not want to increase their exposure to a large segment of their clients adversely affected by the crisis. In spite of these factors, which would normally be expected to have put downward pressure on the growth of financial savings, banking deposits posted a fairly respectable gain and were not perceived as inadequate by the deposit-taking institutions. 2.27 The increase in the number of banking institutions and the increase in their financial operations may also have been a factor in the growth of institutionalized- financial savings. The number of banks, their branch networks, access, range of banking services and deposit instruments, all affect banking deposits, even though over the long-run, savings growth depends on income, interest, and expectations and preferences. While there was some diversification in financial instruments available to savers, there was not any particular improvement in their range or attractiveness. About two-thirds of the deposits were demand deposits throughout these years, while savings deposits were 12.0 in Yj and dropped to 10.6 percent of total deposits in Y7. Clearly, commercial banks, as well as the specialized savings banks, mobilize most of their loanable funds from short-term deposits predominantly held by households and small businesses, with a portion of demand deposits held by large businesses and, until Y7, the public sector SEs, for similar purposes. Time deposits, and more 38 Macro-Financial Review: Policy and Program Formulation recently, certificates of deposit with a maturity greater than three months, serve as an instrument for short-term investment by public and private corporations and are preferred by depositors. The CDs, however, constitute a fairly small portion of total deposits mobilized by the banking system. 2.28 Normally, in an uncertain and inflationary environment, households attempt to safeguard their savings against a loss of purchasing power by switching to short- term financial assets and away from longer-term savings instruments by minimizing their contractual savings obligations. If opportunities are available, savers prefer to switch to real assets or 'safe havens' through capital flight abroad. This asset preference, however, may be available only to large and sophisticated savers, not to ordinary-household savers, even though they are facing near zero or negative real yields on financial savings. This seems to have been an important factor underlying the preponderance of demand deposits in Tusania. A more rigorous analysis of the major determinants of demand for financial assets by households might be undertaken by estimating demand functions for money, and time and savings deposits. This would help in ascertaining the impacts of nominal yields and the rate of inflation, aside from income levels, on the demand of financial assets. Given the limited choice of financial instruments and the attraction of real assets, including illegally held foreign currency balances, nominal yield is unlikely to be an important factor relative to expectations of inflation in determining the composition of financial assets in savers' portfolios. 2.29 Further, since all of the money market instruments are held by the CBT, private savers or corporations have few satisfactory alternatives to holding their financial balances as cash or deposits with the banking system (see Chapter VIIIfor details). Besides, the largest proportion of government-backed securities is held by financial institutions in the public sector because private savers will not voluntarily invest in low-yielding government securities. There has been some growth and diversification in the capital market instruments available to private savers, but data is The Tusanian Financial System: Structure, Growth, and Resource Mobilization 39 not available on the holdings of private debentures and equities. However, considering that the securities market has been fairly small, that the growth in active trading has been modest, and that there is little secondary market trading, the combined share of these assets in financial savings is likely to be small, if not negligible. 2.30 Commercial banks have been in the vanguard of financial savings mobilization for the reasons discussed above. Savings mobilization through financial markets, specialized institutions like the Savings Bank of Tusania (SBT), contractual savings institutions, markets for real assets - all are peripheral to the savings effort. The SBT, in particular, did not have any noticeable impact given its client base of government employees. Since the SBT holds the monopoly on payroll disbursements for public service organizations, it has a captive clientele, whose 'savings' are in reality a residual after their routine expenditures, rather than the result of conscious effort on the part of depositors to hold voluntary savings balances. The absence of other alternatives for their balances reinforces this position. 2.31 In summary, given the rapid growth of the deposit base, deposit-taking institutions felt fairly comfortable with their deposit mobilization efforts throughout the review period, except in Y7 when they faced a liquidity crisis. This behavior of financial institutions was at odds with the macro-level need to expand the savings mobilization effort. Therein lies another major cause of the financial crisis facing Tusania during the Y5-Y7 period. The households, likewise, felt no reason to significantly change their savings behavior. In fact, all economic, financial and institutional factors they faced militated against any significant change in their historical savings behavior. In circumstances like these, changes in the incentive regime, incremental at that, could hardly lead to any perceptible improvement in savings performance. 40 Macro-Financial Review: Policy and Program Formulation Savings and Financial Intermediation 2.32 The pattern of the savings mobilization discussed above suggests that the base for financial intermediation has been reasonably good in spite of unfavorable policies. On the deposit side, these policies, put restraint through managed interest rates until liberalization in later years. On the lending side, the policies constrained the banking system through a rather rigid credit system as discussed in Chapter VII. So long as the banking system could generate substantial earnings on activities other than pure financial intermediation, such as the sale of foreign exchange, inter-bank lending and off-balance sheet activities, the weaknesses of the financial intermediation process remained obscure. Once these profits began to fall as happened-during the Y5-Y7 period, the banking system found it increasingly hard to maintain its financial strength. This is borne out by a review of the summary accounts of the commercial banks, which demonstrate a substantial growth both in domestic credit and deposit liabilities throughout the review years. The analysis of banking credit in Chapter VII shows that there was a compression in the financial intermediation activities of commercial banks during the crisis years, owing to the drastic controls imposed by the authorities in a bid to stem inflation and speculative activities financed, in part, by the banking credit. But, as a long-term trend, there has been a healthy growth in the deposit liabilities of the commercial banks, even though there was not much diversity in the range of financial instruments available to depositors. This growth provided a reasonably strong base for the banking system to expand its activities. The Tusanian Financial System: Structure, Growth, and Resource Mobilization 41 ANNEX H - Exhibit 1 FINANCIAL SYSTEM F. FINANCIAL INSTITUTIONS F.1 CENTRAL BANK F.2 BANKING (FORMAL) INSTITUTIONS COMMERCIAL BANKS INVESTMENT (MERCHANT BANKS) SAVINGS BANKS SAVINGS AND LOANS (USA) F.3 SPECIALIZED FINANCIAL INSTITUTIONS (FORMAL) DEVELOPMENT FINANCIAL INSTITUTIONS (DFIS) AGRICULTURE BANKS INDUSTRIAL SME BANKS - MORTGAGE/IIOUSING BANKS F.4 QUASI-BANKING INSTITUTIONS POSTAL SAVINGS FINANCE COMPANIES CREDIT CO-OPERATIVES I OTHER DEPOSITORY INSTITUTIONS -F.5 INFORMAL SECTOR I CURB-MARKET OPERATORS I MONEY LENDERS, PAWN BROKERS I CHIT-FUNDS / SOCIETIES 42 Macro-Financial Review: Policy and Program Formulation F.6 NON-BANK (FORMAL) FINANCIAL INSTITUTIONS K INSURANCE COMPANIES I PENSION FUNDS * I MUTUAL FUNDS SOCIAL SECURITY FUNDS F.7 SAFETY-NET DEPOSIT INSURANCE INSTITUTIONS . LEGAL AND REGULATORY INFRASTRUCTURE L.1 ACTS AND LAWS - CENTRAL BANK ACT o COMMERCIAL BANKING ACT I SPECIALIZED INSTITUTION A /L COMPANIES ACT/CHARTERING ACT I INSURANCE ACT 0 CURRENCY ACT -L.2 RULES, REGULATIONS, DIRECTIVES p BANKING SUPERVISION AND REGULATION BANKING OPERATIONS RULES AND REGULATIONS DOMESTIC CURRENCY REGULATIONS - AUDITING/ACCOUNTING STANDARDS I INSURANCE REGULATIONS - ENTRY (CHARTERING) PROCEDURES 0 ExIT (BANKRUPTCY) PROCEDURES The Tusanian Financial System: Structure, Growth, and Resource Mobilization 43 L.3 CENTRAL BANK DIRECTIVES I FOREIGN EXCHANGE OPERATIONS - BANKING RESERVES, LIQUIDITY, CREDIT + L OVERSIGHT COMMISSIONS SECURITIES AND EXCHANGE COMMISSION BANKING COMMISSION INSURANCE COMMISSION e REGULATORY COMMITTEES M. FINANCIAL MARKETS M.1 MONEY MARKET (Short-term Securities) IDEBT MARKET o Treasury Bills and Government Papers P Commercial Papers (Business Firms) Certificates of Deposit, Bankers' Acceptances, Others (Banks) --*-+M.2 CAPITAL MARKET (Medium- & Long-Term Securities) 0 DEBT MARKET - PRIMARY AND SECONDARY 0 Bond Market o Mortgages o Bank Loans (Firms and Households) EQUITIES MARKET - PRIMARY AND SECONDARY - Primary Market: Underwriting, Initial Public Offers P Secondary Market: Stock (Stock Exchanges) 44 Macro-Financial Review: Policy and Program Formulation ANNEX II - Exhibit 2 ASSETS OF THE FINANCIAL SYSTEM TOTAL ASSETS (Amounts) 1. Central Bank 2. Banking Syste a. Commercial Banks b. Investment Banks c. Specialized Banks/Development d. Finance Institutions 3. Non-Bank Financial Institutions a. Insurance Companies b. Finance Companies c. Other Institutions TOTAL ASSETS (Shares, Growth) 1. Central Bank 2. Banking syste 3. Non-Bank Financial Institutions The Tusanian Financial System: Structure, Growth, and Resource Mobilization 45 ANNEX II Table 2-1 Assets ofFinancial System (I of 2) Y, Y2 1Y3 Y4 Y5 Y Y7 (ST billions, end ofperiod) Total FinSystem Assets 501 569 653 749 882 1081 1294 Central Bank, CBT 159 174 192 220 259 349 432 Banking System 304 350 405 462 544 639 752 ComBanks 237 272 311 347 403 461 527 DFIs 67 78 94 115 141 178 225 Non-Banks 38 45 56 67 79 93 110 Annual Growth Rates (%) Total FinSystem Assets 12.1 13.6 14.8 14.7 17.8 22.6 19.7 Central Bank, CBT 8.7 9.4 10.3 14.6 17.7 34.7 23.8 Banking System 13.8 15.1 15.7 14.1 17.7 17.5 17.7 ComBanks 12.7 14.8 14.3 11.6 16.1 14.4 14.3 DFIs 14.9 16.4 20.5 22.3 22.6 26.2 26.4 Non-Banks 16.2 18.4 24.4 19.6 17.9 17.7 18.3 Shares (%) Total FinSystem Assets 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Central Bank, CBT 31.7 30.6 29.4 29.4 29.4 32.3 33.4 Banking System 60.7 61.5 62.0 61.7 61.7 59.1 58.1 ComBanks 47.3 47.8 47.6 46.3 45.7 42.6 40.7 DFIs 13.4 13.7 14.4 15.4 16.0 16.5 17.4 Non-Banks 7.6 7.9 L8.6 8.9 9.0 8.6 8.5 Average Annual Growth Rates YI-Y7 YI-Y4 Y4-Y7 Y5-Y7 Total FinSystem Assets 17.1% 14.3% 20.0% 21.1% Central Bank, CBT 18.1% 11.4% 25.2% 29.1% Banking System 16.3% 15.0% 17.6% 17.6% ComBanks 14.2% 13.6% 14.9% 14.4% DFIs 22.4% 19.7% 25.1% 26.3% Non-Banks 19.4% 20.8% 18.0% 18.0% Total Domestic Credit 16.4% 13.3% 19.6% 21.8% Central Bank, CBT 18.7% 9.1% 29.2% 34.6% ComBanks 12.6% 13.4% 11.9% 12.4% Total Deposits of FinSys 15.2% 12.1% 18.4% 18.5% ComBank Deposits 14.6% 11.5% 17.8% 16.9% 46 Macro-Financial Review: Policy and Program Formulation ANNEX II Table 2-1 Assets of Financial System (2 of 2) Y, Y2 Y3 z Y4 Y Y Y (ST billions, end ofperiod) Total Domestic Credit 321 361 410 467 538 665 798 Central Bank, CBT 114 123 134 148 176 255 319 ComBanks 164 187 215 239 265 298 335 Other Financial Institutions 43 51 61 80 97 112 144 Total Deposits of FinSys 199 217 244 280 331 398 465 ComBank Deposits 184 202 224 255 305 365 417 Other Financial Institutions 15 15 20 25 26 33 48 ComBank Total Assets 237 272 311 347 403 461 527 ComBank Domestic Credit 164 187 215 239 265 298 335 Claims Private Sector 138 156 176 195 215 238 267 Claims Public Sector 26 31 39 44 50 60 68 Total Assets, CBT 159 174 192 220 259 349 432 CBT Domestic Credit (Net) 114 123 134 148 176 255 319 Public Sector 102 108 112 121 146 236 296 Ratios (%) FinSys Deposits/Liabilities 39.7 38.1 37.4 37.4 37.5 36.8 35.9 FinSys Credits/Assets 64.1 63.4 62.8 62.3 61.0 61.5 61.7 ComBank Deposits/Liabilities 77.6 74.3 72.0 73.5 75.7 79.2 79.1 ComBank Credits/Assets 69.2 68.8 69.1 68.9 65.8 64.6 63.6 The Tusanian Financial System: Structure, Growth, and Resource Mobilization 47 ANNEX H Table 2-2 Institutionalized Financial Savings (1 of2) YI f 2 3 1 4 Y. ~ Fia a S(ST billions, end ofperiod) Financial Savings 237 [259 290 330 383 448 518 Total Deposit of FinSystem 199 217 244 280 331 398 465 Demand deposits 135 145 160 183 219 269 320 Time and Savings deposits 64 72 84 97 112 129 145 Other Savings 38 42 46 50 52 50 53 Total BankSys Deposits 191 211 235 269 319 384 439 Demand deposits 130 141 154 176 211 260 302 Time and Savings deposits 61 70 81 93 108 124 137 of this: ComBank Deposits 184 202 224 255 305 365 417 Demand Deposits 124 134 146 165 201 249 288 Time Deposits 38 43 49 57 67 76 85 Savings Deposits 22 25 29 33 37 40 44 Other Banks 7 9 11 14 14 19 22 Nominal GDP 1280 1413 1575 1806 2149 2604 3010 Constant (real) GDP 1280 1321 1362 1400 1434 1451 1454 Constant (real) Savings 207 208 210 209 206 200 196 AnnuaL Growth Rate (%) Financial Savings 9.1 9.3 12.0 13.8 16.1 17.0 15.6 Constant (real) Savings 0.7 0.5 1.0 -0.5 -1.4 -2.9 -2.0 Deposit of FinSys 9.0 9.0 12.4 14.8 18.2 20.2 16.8 BankSys Deposit 9.8 10.5 11.4 14.5 18.6 20.4 14.3 ComBanks Deposit 9.5 9.8 10.9 13.8 19.6 19.7 14.2 DDs of ComBanks 7.8 8.1 9.0 13.0 21.8 23.9 15.7 Shares, Ratios (%) Financial Savings 100.0 100.0 100.0 100.0 100.0 100.0 100.0 BankSys / Financial Savings 80.6 81.5 81.0 81.5 83.3 85.7 84.7 ComBanks/ Financial Savings 77.6 78.0 77.2 77.3 79.6 81.5 80.5 Other Savings/Financial Savings 16.0 16.2 15.9 15.2 13.6 11.2 10.2 Savings/ComBank Deposits 12.0 12.4 12.9 12.9 12.1 11.0 10.6 Fin Savings/GDP (nominal) 18.5 18.3 18.4 18.3 17.8 17.2 17.2 Dom Savings/GDP (real) 16.2 16.2 16.3 16.2 15.9 15.4 15.1 48 Macro-Financial Review: Policy and Program Formulation ANNEX II Table 2-2 Institutionalized Financial Savings (2 of2) Average Annual Growth Rates _YI-Y Y-Y4 Y4-Y7 Ys-Y7 Financial Savings 13.9% 11.7% 16.2% 16.3% Real Savings -0.9% 0.3% -2.1% -2.5% Total Deposit of FinSystem 15.2% 12.1% 18.4% 18.5% Demand deposits 15.5% 10.7% 20.5% 20.9% Time and Savings deposits 14.6% 14.9% 14.3% 13.8% Other Savings 5.7% 9.6% 2.0% 1.0% Total BankSys Deposits 14.9% 12.1% 17.7% 17.3% Demand deposits 15.1% 10.6% 19.7% 19.6% Time and Savings deposits 14.4% 15.1% 13.8% 12.6% of this: ComBank Deposits 14.6% 11.5% 17.8% 16.9% Demand Deposits 15.1% 10.0% 20.4% 19.7% Time Deposits 14.4% 14.5% 14.2% 12.6% Savings Deposits 12.2% 14.5% 10.1% 9.0% Other Banks 21.0% 26.0% 16.3% 25.4% _ CHAPTER III GENESIS OF THE ECONOMIC AND FINANCIAL CRISIS 3.1 Many of Tusania's current economic and financial problems are a legacy of the past. The structure of the economy and operations of the financial system were shaped largely by the policy milieu and the framework of regulations and control mechanisms that have prevailed for a long period of time. Many of the structural imbalances of the Tusanian economy and the systemic weaknesses of the financial system in the past originated in this framework. Tusanian authorities periodically undertook attempts at reforms and adjustments in response to changing economic conditions, but these efforts were inadequate to cope with the magnitude of the changes required. In addition, Tusania embarked upon a major transition from a public-sector dominated command-based economy to a more open, market-based economy. This transition, however, coincided with a severely retrenched domestic resource base, poor export performance, low foreign exchange earnings, and dwindling capital inflows. Since the essence of the adjustments was to instill market discipline, the retrenchment in the resource base had the opposite impact. Major segments of the economy attempted to circumvent instead of operate within these limits, thereby compromising the economic and financial situation facing Tusania. Before long, economic and macro-financial stability became a prime concern, and the government was forced to take drastic measures. 49 50 Macro-Financial Review: Policy and Program Formulation The government resorted to direct controls, which temporarily provided relief, but some of these actions were in contravention of adjustments needed to deal with the underlying structural weaknesses of the Tusanian economy. Since these stopgap measures were grafted upon the surviving shell of an economic framework inherited from the past, the ensuing macro-financial stability proved ephemeral. The efforts to keep the old structure intact made the adjustments and transition more difficult. 3.2 The development strategy of Tusania in the past emphasized rapid modernization that could not be sustained from domestic resources alone, thus enhancing dependence on foreign savings and requiring infusions of imported capital. The drive for modernization was characterized by capital-intensive and domestic market-oriented industrial development, supplemented by large investments in infrastructure, communications, and transport, mostly imported. Development of the agricultural sector provided the backbone for the economy in terms of essential foodstuffs and exportables, but this also contributed to the need for foreign financing to sustain production levels. This led to large import requirements, both capital goods and raw materials, which could not be sustained by the Tusanian structure of foreign trade and its productive base. The culmination was a balance of payments crisis. The government intervened, but short-term stabilization packages provided only temporary relief. Monetary expansion caught up with the real economic base, and structural weaknesses took over. Further, the government erroneously perceived these crises as episodic, as the one occurred during the review period of this case study, occupying much energy and attention and diluting their focus from underlying structural imbalances. The realization was late in coming that the government was facing two sets of overlapping challenges: first, recovery from short-term crises; and second, initiation of structural changes and a transition to a system that would be more responsive to market forces. The resources needed to cope with these two challenges were way beyond the Tusanian economic and financial capacity, and the gap could not be closed with the best of efforts. Genesis ofthe Economic and Financial Crisis 51 3.3 Over the past decade, and prior to the crisis years of Y5-Y7, Tusania grew quickly, as compared with other countries similar in size and economic structure, without having to make the major adjustments that many other economies had to make in the face of mounting balance of payment pressures. Despite an increase in import prices and general world inflation, Tusania managed to grow by 4 percent per annum, apparently absorbing the increased burden. There followed increased balance of payment deficits and the development of manageable domestic resource constraints limited to a few sectors. The economy remained buoyant, but steady deterioration of the balance of payments continued and could not be halted by periodic devaluations of the Siwat. In Y5, Tusania found itself in a serious balance of payments squeeze, combined with rapid inflation, declining real incomes, the erosion of real wages and salaries, and economic instability. This was widely perceived as a short-term financial crisis. The prevailing view was, with some justification, that the Tusanian economy was reasonably diversified, had a good resource base, and had the potential for sustained growth. All that was needed were a few corrective measures over the short-term to ensure stable economic environment, and recovery would follow. That major actions were needed to redress structural imbalances and to usher in a more open and market-based economy was not materially recognized. Attention was devoted to coping with immediate needs and improving responses to the exigencies of the situation at hand. Besides, the government was too preoccupied with surviving the relentless pressures of opposition groups and maintaining its grip on governance. It could not afford to take steps that would further weaken its position. This failure of response proved too costly as the crisis unfolded in later years of the review period. 3.4 In the early review years YI-Y4 , Tusanian growth was reasonable at around 3.0 percent per year, but it began to slow during Y4 and Y5. Investment and output growth in real terms in the later years was nearly half of the long-term historical growth rates (see Table 3.1 below). The growth of real GDP was 2.4 percent in Y5, declined to 1.2 percent in Y6, and to near zero level in Y7. On the heels of this 52 Macro-Financial Review: Policy and Program Formulation decline in output in constant value terms, domestic savings in real terms declined to 0.4 percent in Y5 and became negative in Y6 and Y7. The slowdown of the growth rate in GDP during the Y4-Y7 years was largely attributed to a severe compression in imported raw materials and spare parts to maintain industrial production. This does not fully account for the decline in the GDP since the industrial sector contributes about one-third of total output, while the agricultural sector constitutes nearly half of the Tusanian economy. Table 3.1 GDP - Macro Accounts Annual Indicators Average Annual Growth Rates Y, Y, Y6 Y7 Y1-Y7 Y1-Y4 Y5sY7 (ST billions) (per cent) Current Values GDP 1280 1806 2604 3010 15.3 12.2 18.3 Exports 93 147 199 231 16.4 16.5 13.9 Imports 175 263 352 398 14.7 14.5 14.0 Domestic Savings 207 293 401 455 14.0 12.3 15.3 Constant Values, Y1=100 GDP 1280 1400 1451 1454 2.1 3.0 0.7 Exports 93 114 111 112 3.1 7.0 -3.1 Imports 175 204 196 192 1.6 5.2 -2.9 Domestic Savings 207 227 223 220 1.0 3.1 -1.8 Annual Growth Rates (per cent) GDP 3.1 2.8 1.2 0.2 Exports 2.3 8.0 -6.6 0.7 Imports 1.5 6.6 -3.9 -2.0 Domestic Savings 3.1 2.2 -2.1 -1.6 Ratios (%) Constant Values, Y1=100 Domestic Savings/GDP 16.2 16.2 15.4 15.1 Exports / GDP 07.3 ' 7.7 7.6 7.7 Imports / GDP 13.7 14.0 13.5 13.2 For details see Annex III, Table 3-1 Genesis ofthe Economic and Financial Crisis 53 Agricultural output showed a modest growth but was not sufficient to compensate. for the decline in industrial output. The agricultural sector also suffered from a drop in fertilizer imports, rising petroleum prices, and a lack of maintenance of farm machinery and equipment. The main negative impact on farm output, however, came from the relative price structure where, with rapid inflation, agricultural prices - especially food items - were kept much lower in relative terms, thus worsening incentives to farmers. Historically, the agriculture sector had faced a repressed price regime, and it was worsened by rapid inflation during Y5-Y7. Thus, the roots of an economic crisis were already present, and, as such, were simply reinforced and hastened by rapid shifts in the supply of inputs, availability of foreign liquidity, and external finance. 3.5 For quite a long time, Tusania had pursued a development strategy with emphasis on self-reliance, especially self-sufficiency in food production, development of indigenous industrial capacity, and import-substitution - in short, an autarchic model of growth as pursued by many other countries. In good measure, it succeeded, as Tusania did not have to rely much on foreign capital to sustain its investment program or to finance its domestic resource gap. But Tusania did have to find external finance to cover its foreign trade deficit, which could not be sustained over the long-term. The inflows of foreign capital in the early years of the review period provided a cushion for these foreign trade deficits. With deepening balance of payments problems during Y5 and Y6, however, this external financing mechanism collapsed, and foreign trade deficits could no longer be covered in a conventional manner. These aspects are analyzed in Chapter IV in detail. In summary, foreign creditors - banks and suppliers - not only applied the brakes on new exposure, they also began to demand repayment, or at least that Tusania keep their loans current. Tusania increasingly found it difficult to borrow overseas, and in such circumstances it could finance only part of its trade deficit thrbugh routine capital inflows. As the external debt burden mounted, with little prospect of repayment, arrears began to build up. Eventually this shut down even the routinely available 54 Macro-Financial Review: Policy and Program Formulation foreign financing cover, thus precipitating a balance of payments crisis which could not be resolved through conventional processes. 3.6 On the domestic front, the external financing mechanism generated counterpart domestic liabilities that were lodged with the financial system. As discussed in Chapter VI, to offset these liabilities, financial resources had to be generated domestically in various ways. For example, the holders of financial assets had to be taxed sooner or later through either direct tax or inflation tax. The asset holders could, however, escape the burden through capital flight, for which both the official and the parallel market provided easy mechanisms. The banking system provided easy access to credit to large borrowers at rates of interest that were below market level. This easy access to credit allowed large borrowers to speculate against the Siwat, creating self-fulfilling devaluations in the parallel market. Consequently, this forced devaluations in the official market, as authorities attempted to keep the differential narrow between the two exchange rates. This, in turn, worsened the foreign debt-servicing burden in local currency, thus reinforcing the impact on the financial system. 3.7 At the same time, growing financial difficulties of the banks, owing either to default by borrowers engaged in speculative activities or capital flight, or to the failure of the SEs, imposed a further burden on the financial system. The CBT was forced to provide liquidity to the banking system to prevent banking collapse. At the same time, it tried to control inflation through tight monetary policy, liquidity control and credit expansion by fiat, thereby raising interest rates to levels such that borrowers in the real sector began to fail, leaving the banking system with large losses. For a while, the government tried to sustain the commitments of the public sector by incurring large deficits. Eventually, it began pulling away from its over- extended commitments, thus compounding the financial difficulties of a large number of companies, both state- and privately-owned. Those SEs that were operating on the brink of insolvency, floundered, and their insolvency eventually found its way to Genesis ofthe Economic and Financial Crisis 55 the financial system. The government's claim on the aggregate financial resources increased, since a good portion of financial resources originate through the monetization of net capital inflows. This crowding out occurred at a time when companies needed a cushion to ride out imminent financial failure, adversely affecting their capacity to maintain production and employment, which in turn led to the recession discussed in paragraph 3.4 above. 3.8 This was the genesis of the economic and financial crisis that gripped Tusania during the years of Y6 and Y7. The crisis was of domestic origin and was rooted in the way the Tusanian economy and its financial system operated within a policy framework that could no longer cope with the crisis analyzed in the next two chapters. The common refrain was that "the Tusanian balance of payments were in crisis, not the Tusanian economy." The reason for this public perception was that problems of foreign financing received widespread publicity and media coverage both at home and abroad. Foreign banks and creditors stopped lending to Tusania and began demanding repayment. The Siwat came under severe pressure, but devaluations were perceived as a betrayal of confidence, though parallel markets confirmed the weakness of the Siwat. Vital import of items like oil and petroleum, pharmaceuticals, and essential consumer goods, could no longer be financed. Subsequently, the AMLs became involved, and their efforts to ease the crisis of external finances received even greater inedia coverage. On the extreme, a political frenzy held that this crisis was nothing but the making of the international financial community in consort with the foreign enemies of Tusania and that there was not much wrong with the Tusanian economy or its structure of foreign trade. In other words, the prevailing view was that a fix on the balance of payments through a short- term stabilization package should be sufficient to cope with a situation seen primarily as sparked by a foreign exchange liquidity crisis. Subsequent events proved otherwise. t 56 Macro-Financial Review: Policy and Program Formulation ANNEX III Table 3-1 GDP - Macro Accounts Y Y2 Y3 Y4 Ys Y Y (ST billions, end of period) Current Values GDP 1280 1413 1575 1806 2149 2604 3010 Exports 93 109 122 147 178 199 231 Imports 175 198 221 263 306 352 398 Domestic Savings 207 229 257 293 342 401 455 Annual Growth Rates (%) GDP 10.0 10.4 11.5 14.6 19.0 21.1 15.6 Exports 11.2 17.2 11.9 20.5 21.1 11.8 16.1 Imports 8.6 13.1 11.6 19.0 16.3 15.0 13.1 Domestic Savings 9.8 10.6 12.2 14.0 16.7 17.3 13.5 Constant Values, Y,=100 GDP 1280 1321 1362 1400 1434 1451 1454 Exports 93.0 101.9 105.5 114.0 118.7 110.9 111.6 Imports 175.0 185.0 191.2 203.9 204.1 196.1 192.3 Domestic Savings 207.0 214.0 222.3 227.1 228.2 223.4 219.8 Annual Growth Rates (%) GDP 3.1 3.2 3.1 2.8 2.4 1.2 0.2 Exports 2.3 9.5 3.6 8.0 4.2 -6.6 0.7 Imports 1.5 5.7 3.3 6.6 0.1 -3.9 -2.0 Domestic Savings 3.1 3.4 3.9 2.2 0.4 -2.1 -1.6 Ratios (%) Constant Values, Y, =100 Domestic Savings /GDP 16.2 16.2 16.3 16.2 15.9 15.4 15.1 Exports / GDP 7.3 7.7 7.7 8.1 8.3 7.6 7.7 Imports / GDP 13.7 14.0 14.0 14.6 14.2 13.5 13.2 GDP deflator index 100.0 107.0 115.6 129.0 149.9 179.5 207.0 E Average Annual Growth Rates YI-Y7 YI-Y4 Y4-Y7 YS-Y7 Constant Values GDP 0.0215 0.0303 0.0127 0.0069 Imports 1.6% 5.2% -1.9% -2.9% Domestic Savings 1.0% 3.1% -1.1% -1.8% Current Values GDP 0.1532 0.1216 0.1856 0.1835 Exports 16.4% 16.5% 16.3% 13.9% Imports 14.7% 14.5% 14.8% 14.0% Domestic Savings 14.0% 12.3% 15.8% 15.3% CHAPTER IV REQUIREMENTS FOR EXTERNAL FINANCE 4.1. The need for external finance in Tusania emerged from two sources: First, to finance the foreign trade deficit given import levels and export performance; and second, to finance long-term investment needs, i.e. the need for foreign savings to cover the shortfall between domestic savings and investment. Foreign financing of the trade deficit and domestic investment generated two streams of outflows over time: a) the interest obligations of foreign loans and dividends on foreign investments lodged in the services account, and b) amortization and repayments of principal lodged in the capital accounts of the balance of payments. Traditionally, Tusania's capacity to meet these foreign liabilities had been sufficient to prevent a balance of payment crisis, but over time two disturbing trends occurred. First, Tusania's foreign trade deficit kept growing and could no longer be sustained, and second, in order to cover the financing needs of the trade deficit as well as investment needs, Tusania relied on short-term capital inflows which subsequently proved volatile with disastrous consequences. 4.2 In summary, the balance of payments situation of Tusania was fairly manageable during the decade prior to the review period. The overall deficit in the balance of payments historically, and prior to the review period, ranged between $250-$350 million annually. This could easily be financed by foreign borrowings of two types: the medium and long-term borrowings guaranteed by the government (M<), and short-term borrowings from international financial markets. Later on, 57 58 Macro-Financial Review: Policy and Program Formulation the government allowed the CBT to attract foreign currency deposits (fCDs) pegged at a premium above the international market interest rates. These were denominated in major foreign currencies, much stronger than the Siwat, with explicit repayment obligations in foreign currencies and implicit government guarantees covering both the credit risk and foreign exchange risk. These fCDs were overseas institutional deposits of short-term maturity placed by nearly 300 foreign banks in the foreign accounts of the CBT. These fCDs were a major source of financing for the overall balance of payment deficits through the early years of the review period. Later on, with the growing current account deficit, a reversal of major proportions took place and net fCD inflows dropped dramatically causing a major foreign liquidity crisis. Within a period of 18 months during Y4 and Y5, Tusania found itself with mounting arrears on the fCDs and other short-term obligations which could not be met. Later on, these had to be managed through rescheduling organized by international agencies. In the early phase of the crisis, the loss of foreign liquidity continued to be perceived as a financial phenomenon. It was a classic case of a mismatched maturity structure where long-term funding requirements were financed through short-term inflows that were both volatile and expensive relative to medium- and long-term (M<) capital inflows. To begin with, the bulk of foreign financing needs were to cover the trade deficit. Only a small part was used to finance domestic borrowing needs of the public sector apart from investment financing, which were justified as contributing to growth, import substitution, or to export potential. While financing the trade deficit with short-term foreign borrowings through instruments like fCDs, suppliers' credits, or other trade financing instruments, was regarded as imprudent by the government and the CBT; the volatility of fCD inflows did not register until it was too late. The underlying causes of the balance of payment deficit, however, were structural and were rooted in the domestic structure of production, investment, and foreign trade. A related factor was Tusania's need to cover the short-fall in domestic savings through foreign savings to close the savings investment gap, originating from a development strategy that could not be sustained by domestic resources. This Requirements for External Finance 59 linkage was obscured by fairly steady inflows of foreign finance that appeared to be quite manageable in the early years. 4.3 The external financing requirements can be viewed two ways. The usual approach is to look at the current account deficit and to ascertain how much of that deficit is covered by autonomous M< capital inflows on a net basis. If these capital inflows (net) are insufficient to cover the current account deficit, the resulting deficit, defined as the balance ofpayments deficit, is usually financed by short-term capital inflows and borrowings from international financial markets. Another approach, followed here, is to take the balance of payments deficit as given, and then focus on the short-term inflows, because that is where the link is forged between the foreign borrowing operations, financial markets, and the banking system. In particular, since the crisis of Y5-Y7 in Tusania was perceived largely as a financial crisis spawned by foreign illiquidity, we need to focus on the causes of this liquidity crunch, relate it to both the medium and long-term capital movements, short-term inflows and arrears, and then step back to review the current account deficit emerging from the structure of Tusanian foreign trade. Balance of Payments Deficit 4.4 The Tusanian balance of payments deficit was a manageable $237 million in Y1, but rose swiftly to reach $686 million in Y4, $715 million in Y5, $876 million in Y6, and $815 million in Y7 (see table below and Annex IV Table 1 for details). In later years, a good part of this deficit occurred because of the increase in debt servicing obligations, both interest and amortizations, as recorded by the CBT and the Treasury, and not as recorded by the creditors in their books on Tusanian accounts. The deficit began to rise during Y5 through Y7 because it could not be financed above the line by autonomous capital movements, defined as medium and long-term (M<) borrowings of the government and direct foreign investment. The M< borrowings on a gross basis were $292 million in Y1, rising to $414 million in 60 Macro-Financial Review: Policy and Program Formulation Table 4.1 Balance of Payments Annual Indicators Y, Y2 Y3 Y4 Y5 Y6 Y7 (US$ millions) Balance of Payments Deficit -237 -465 -504 -686 -715 -876 -815 Financed by: Short-Term Inflows (net) 714 812 919 679 571 497 558 fCDs 527 558 531 267 112 21 8 Arrears Rolled-Over 0 0 114 228 312 357 382 Negotiated Foreign $ Credits 0 0 0 163 251 458 462 Reserves -266 -194 -231 -42 -12 39 -38 Net errors/omissions -211 -153 -184 -114 -95 -118 -167 Total Foreign Finance 237 465 504 686 715 876 815 Exports 1163 1313 1403 1561 1741 1805 1834 Imports 2188 2388 2537 2793 3000 3196 3118 Trade Balance -1025 -1075 -1134 -1232 -1259 -1391 -1284 Invisibles (Services, net) 629 567 403 315 282 254 220 Current Account Balance -396 -508 -731 -917 -977 -1137 -1064 Capital Movements Public M< (net) 121 148 178 180 210 207 194 Direct Private Investment 38 43 49 51 52 54 55 Net M< Inflows 159 181 227 231 262 261 249 Balance of Payments Deficit -237 -465 -504 -686 -715 -876 -815 Arrears Outstanding 92 169 268 508 657 1013 1236 BoP Deficit -adjusted -329 -634 -772 -1194 -1372 -1889 -2051 For details see Annex IV, Table 4-1 Y4. After the amortization payments, the net M< borrowings were $121 million in Y1, and $180 million in Y4, rising to about $200 million during the Y5-Y7 period. Direct private investment amounted to $35 million in Y, and increased to $51 million in Y4, but then stayed in the range of $52-$55 million during Y5-Y7. As a result, total net M< flows increased from $159 million in Y1, to $231 million in Y4 and then Requirements for External Finance 61 stagnated around $258 million through Y7. This stagnation coincided with the rise in the current account deficit and was a contributing factor to the liquidity crisis. M< flows are linked with long-term investment trends and are financing items for the domestic savings and investment gap, rather than the trade financing gap or a gap- filler item for short-term foreign financing undertaken by the central bank or the banking system. These short-term inflows were market-based, and were provided by multi-national banks and other financial institutions. These short-term inflows also included the net position with the IMF as year-end balance on purchase and re- purchase operations authorized as balance of payments support within the framework of the annual economic program agreed upon by the Tusanian government. Emergence of Arrears 4.5 Short-term inflows are recorded as below the line (the balance of payments deficit line) financing items for the balance of payment deficit. They consist of short- term borrowings of the banking system and the private sector, such as bankers acceptances and suppliers' credits of typically less than a year in maturity. The central bank may also borrow short-term funds from the financial markets. In the case of Tusania, the CBT borrowed heavily from the financial markets. When these liabilities were not met, they emerged as arrears. Moreover, the arrears acknowledged by the CBT were much smaller than those recorded by creditors overseas. Here is the cleavage between unit-level and aggregate-level reporting on something as volatile and expensive as short-term foreign borrowings in times of rising interest rates and depreciating currency of the borrower. The foreign creditors recorded a higher level of Tusanian liabilities arising out of non-payment of the original obligations, refusal to roll over existing liabilities into new 'short-term instruments, hence accrued interest and fees; or adverse exchange rate movements between the loan currency and the Siwat. The default led creditors to impose severe penalties and charges, lumped into fresh liabilities against Tusania by creditors, even though these were unconfirmed by the CBT. Routinely, there is always a small 62 Macro-Financial Review: Policy and Program Formulation amount of arrears which are bundled almost automatically into new short-term liabilities on creditors' books. But beginning in Y3, the creditors started to refuse this voluntary roll-over and arrears began to rise swiftly. By the middle of Y5, Tusania was found in default by its foreign creditors, thus drying up fresh inflows of foreign capital. The CBT took the position that these arrears were "obligations in dispute," or part of the "reporting mismatch" owing to foreign exchange movements and thus were part of external debt accounts, not a part of the balance of payment accounts. The arrears reported here and included in the balance of payments accounts were aggregated from the financial statements of overseas creditors but were not officially recognized, much less resolved, by the borrower - the CBT. The size of the arrears was too large to be ignored, consisting mainly of obligations on fCD accounts, the direct liability of the CBT and the trade financing arrears, mainly the liabilities of the private sector channeled through the banking system. 4.6 In Y1, total arrears were $92 million, increasing to $382 million by Y3. In Y4, the arrears rose to $736 million, consisting primarily of fCD obligations of $468 million and trade financing and other arrears of $268 million. Since Tusania's creditors voluntarily rolled over $228 million of these obligations in Y4, the net arrears outstanding were $508 million in Y4, nearly double the $268 million in arrears outstanding in Y3. This worsening trend intensified and by mid-Y5 the creditors declared Tusania in default. Thereafter, the total arrears rose swiftly to $1,370 million in Y6, and in spite of the voluntary rollover of $357 million, arrears outstanding in Y6 were $1,013 million, nearly twice the level of Y4 (see Annex VI, Table 4.1). In Y7, total arrears reached $1,618 million, of which $1,028 million were in fCDs and $590 million were in trade financing and other arrears. Again, creditors were obliged to roll over $382 million of these arrears, making arrears outstanding in Y7 $1,236 million. The rolled-over arrears were short-term obligations of less than one year, hence they appear as financing items in the short-term inflows. As mentioned above, since Tusanian authorities had taken the position that these liabilities were "in dispute," the arrears outstanding were not included in the balance Requirements for External Finance 63 of payments. But if the adjustment is made for these arrears outstanding, the balance of payments deficit (BoP Deficit -- adjusted) increases dramatically from $329 million in Y1, to $1,194 million in Y4, to $1,889 million in Y6, and to $2,051 million in Y7, more than twice the deficit reported on official accounts. Short-Term Inflows 4.7 The net amount of short-term inflows was much larger than the balance of payments deficit in early years (Y-Y3). These were used for the build-up of foreign reserves, as well as to cover net outflows recorded as errors and omissions. The short-term (net) inflow was $714 million in Y] and rose to $919 million in Y3, largely because of the sustained inflows of fCDs to the CBT as overseas deposits. In the early years Y1-Y3, fCDs were at historic levels, in the range of $530-$550 million, however, in Y4, with the growing repayment inability of the CBT, the fCDs inflows dropped by half to $267 million. By Y7, they had dramatically dropped off to near zero levels. As deposits in the CBT foreign accounts, and thus foreign liabilities of the CBT, the drop-off was a significant decline in CBT's recorded liabilities, but in effect, part of the fCDs turned into rolled-over short-term debt on a voluntary basis, while the larger part of the remaining accumulated balance of fCDs turned into foreign arrears (see Box 4.1: Foreign Currency Deposits, next page). The rolled over liabilities emerged in Y3 at $114 million, rising to $357 million in Y6 and $382 million in Y7. These rolled over amounts were resolved liabilities and no longer "in dispute," therefore they were recorded as part of short-term inflows. Owing to the drop-off in fCDs, however, the total short-term inflows, inclusive of roll-overs, decreased from $919 million in Y3 to $679 million in Y4, to $497 million in Y6, and to $558 million in Y7. 4.8 A similar trend was seen in the suppliers' credits extended to Tusanian importers, which typically are not the liability of the banking system; and banker's acceptances, which are the liability of the banking system. Both these inflows were 64 Macro-Financial Review: Policy and Program Formulation Box 4.1 Foreign Currency Deposits (fCDs) The fCDs were considered by the CBT as a relatively easy instrument for borrowing short-term funds from international banks without going through a lengthy process of documentation, negotiations, and pledging of world class collateral. As the name suggests, these were deposits made by lending banks, in a currency of the borrower's choice, into CBT accounts opened at the lending bank for typically three to six months, and in rare cases up to a year. As it turned out, this was a most expensive form of short-term borrowing for the CBT, and, by the same token, a lucrative lending mechanism for overseas banks. This was because the lending banks charged a hefty loan origination fee up front ranging between two to four percentage points, on top of a lending rate typically 0.75 to 1.00 per cent above LIBOR. Financially, these were the best terms banks could get on their international lending operations. The banks would look at the financial statement of the CBT with sizable foreign reserves fairly clean of any arrears, a good record of sustained foreign exchange earnings as cash inflow, and reasonable foreign liability-structure, though not so much from its traditional exports, rather from regular remittances of overseas Tusanians to support their families and businesses at home. Above all, lending to the CBT through fCDs came with an implicit guarantee of the Tusanian government against risk of default - there was no foreign exchange risk, given that repayments were denominated in the currency of deposits. The loan documentation procedures consisted of a letter of intent tendered by the CBT and a fairly standard loan agreement to allow finalization of processing in a few days, hence direct lending costs for the banks were minimal. All these factors conjured up a powerful incentive for overseas banks to take part in the fCD arrangement. Within a matter of a few months, the average level of the fCDs reached the equivalent of nearly half a billion US$, and as many as 300 banks ended up with deposits as small as $1.5 million on up to $15 million for large banks. As long as the CBT made good on its' payments, the banks felt safe. Therefore, for a single bank looking at its' own net exposure against total foreign exchange inflows, this mechanism of short-term foreign finance was financially viable. Several things went wrong, however, at the macro-financial level. While for a single bank the exposure was tiny relative to the total foreign exchange earnings of Tusania, the total size of fCD liabilities for the CBT was fairly large. Further, the banks felt fairly secure when comparing their exposure to the total foreign exchange .earnings, but they did not realize that the fCD's servicing burden in the aggregate, together with other debt-service obligations, was a fairly large proportion of total foreign exchange earnings. Major issues lurking beneath the structural imbalances of the Tusanian economy were even more obscure to these overseas banks and certainly the banks were not aware of how the foreign trade structure would perform under strain. When the crash came, CBT began to offer even higher upfront fees to pay off previous obligations bringing the fCD system, fairly quickly, into financial insolvency. Several bankers caught in this insolvency felt betrayed by the CBT and the Tusanian government despite the fact that the lack of "due diligence" on their part and the lucrative lending terms induced them to indulge in this type of lending arrangement. As subsequent events confirmed, this was neither the first time, nor would it be the last, that the "hard-nosed bankers" found their noses bloodied in the process. They came out intact, however, even ahead, though it took a few years. Requirements for External Finance 65 market-based, carried premium rates in international markets, and were of a maturity of one year or less. The suppliers' credits to Tusanian importers were in part guaranteed by overseas export credit guarantee agencies, such as Eximbank, and totaled $115 million in Y1, rising to $178 million in Y3. As the foreign liquidity position began to worsen, suppliers' credit began to decline and dropped to $77 million in Y6. With the resolution of external debt and adoption of a stabilization program in Y7, there was some turn around, and suppliers' credits stood at $110 million. More or less, the same trend was observed in the case of bankers' acceptances which rose from $72 million in Y, to $96 million in Y3, then dropped off to $42 million in Y6, with some increase in Y7 due to the restoration of credit cover in Y7 by foreign auditors (see Box 4.2 Financing Imports). 4.9 Alarmed by this reversal, the CBT, with the government's approval and support, feverishly tried to negotiate several types of bridge financing, including multi- institution syndicated loans with government guarantees. These negotiated foreign credits were first obtained from a group of large private foreign banks and were later supplemented by short-term financing from the AMLs as part of the stabilization program. These negotiated foreign loans increased from $163 million in Y4, to $458 million in Y6, and $462 million in Y7. The AMLs' financing was large and wa predicated on implementation of economic programs aimed at curbing the aggregate demand through stringent controls, controls on domestic credit, public sector price reforms, trade liberalization, and exchange rate adjustments. Thus, short- term foreign financing was directly linked with the economic program, with the performance to be monitored and authenticated by the AMLs. As discussed in Chapter IX, these AML agreements in Y7 for Y8 became the basis for resolving the overhang of the short-term liabilities of the CBT, the banking system, and private Tusanian borrowers. Prior to the enactment of a stabilization program for Y8, the Tusanian government was obliged to implement annual economic programs endorsed by the AMLs during Y5, Y6, and Y7. These were seen by foreign creditors as an endorsement of the Tusanian economy by the AMLs - a vote of confidence. On these reassurances, and as part of 66 Macro-Financial Review: Policy and Program Formulation Box 4.2 Financing Imports--Suppliers' Credits Suppliers' credits for Tusanian importers, like in any other country, were almost routinely extended by overseas exporters. These credits were a short-term financing instrument on market terms, typically for one to two years, at interest rates higher than those prevailing in financial markets. For exporters, the incentive was to complete their sales to Tusanian importers, which were extended as a part of a financing package, including financing by banks, but more importantly, with the export credit guarantees by agencies like ECGD (British), Hermes (German), Cofas (French), Saache (Italian), and Eximbank (Japan, U.S., and others). Tusanian foreign exchange regulations do not allow suppliers' credits for import of consumer goods which are financed from foreign exchange purchases from the CBT and may be covered through bankers' acceptances. Suppliers' credits, therefore, were used mainly to import raw materials and spare parts by manufacturing units to maintain their capacity utilization. In some cases, large suppliers' credits were arranged for new plants and machinery, both by the private sector and the SEs. In any event, suppliers' credits were an important source of short-term financing, but dried up owing to the default and were shut off when the credit guarantee agencies declared Tusania off-cover. The exporters invoked the credit guarantee and were paid off by the covering agency, who ended up as the creditor to Tusania. These credits were then declared in arrears, with attendant penalties and charges, were bundled together at the time of rescheduling negotiations and became the sovereign liability of the Tusanian government with medium-term negotiated interest rates and grace periods. In some cases, Tusanian importers had deposited Siwats with the CBT through their banks to purchase foreign exchange to pay off their liabilities. But the CBT didn't have enough foreign exchange to sell, and in those cases, the suppliers' credit ended up being CBT's liability. Some of these liabilities were cleared but a good part ended up as arrears and eventually as part of the CBT. a financial assistance package, foreign creditors were co-opted to extend syndicated loans during Y5-Y6, in parallel to the financial assistance committed by the AMLs, but almost all of it in short-term funds. That these annual programs for Y5-Y7 proved to be ineffective in stemming the crisis, is a separate matter. 4.10 There were two other factors at work, especially in the early years: reserve build-up and capital flight. During YI-Y3, buoyed by short-term fCD inflows and Requirementsfor External Finance 67 other financing, both the CBT and the banking system engaged in the net build-up of reserves of $266 million in Y1, $194 million in Y2, and $231 million in Y3. As foreign financing became difficult, this trend reversed and some of the foreign obligations were met by reserves. The private sector, however, continued to engage in capital flight throughout these years for several reasons, though mainly spurred by the exchange rate differential between the official and parallel markets. While the level of capital flight, included in the "net errors and omissions" in the balance of payments accounts, was modest, it contributed to a negative perception of the Tusanian economy, a vote of no-confidence for the Siwat, and the failure of exchange rate management. The reserve build-up dramatically dropped off during Y4-Y7, while the errors and omissions item remained a net outflow, though it declined as the shortage of foreign exchange became acute during the crisis years. 4.11 In the preceding paragraphs, an effort has been made to analyze short-term inflows since the shift in these inflows led to Tusanian foreign illiquidity in later years. To begin with, M< inflows were inadequate to cover over the balance of payments deficit, much less compensate for the sheer size of the adverse shift in short-term inflows. Consequently, the balance of payments deficits, adjusted for these short-term liabilities, became unmanageably large during Y5-Y7. Thus, while a large part of the deficit emerged from the financing side, the foreign trade gap and current account deficits were the initial source of the financial crisis. Let us now turn to these items. Foreign Trade and Current Account Balance 4.12 The foreign trade balance of Tusania ran at a deficit throughout the period of analysis. During the review period, the trade deficit began in the range of $1.0-$1.2 billion during Y-Y4, rising to $1.4 billion in Y6, then declining somewhat to about $1.3 billion in Y7. This increase in the foreign trade deficit occurred in spite of reasonable export performance. Tusanian exports in value terms increased considerably from $1,163 million in Y, to $1,834 million in Y7, growing at an annual average rate of 7.9 percent during these years. Imports increased from $2,118 million 68 Macro-Financial Review: Policy and Program Formulation in Yj to $3,118 million in Y7, a slower average annual growth rate of 6.1 percent. All things considered, the trade performance of Tusania was quite reasonable as compared to countries with a similar production base, economic structures, historical trends and stages of economic development. During the early years (YI-Y4), the average rate of growth of exports in US dollars was 10.3 percent and those of imports 8.5 percent; however, the export growth dropped off to 5.5 percent during Y4-Y7, and growth of imports dropped off even faster to 3.7 percent, all in US dollar value terms. 4.13 There was an even more disturbing trend in that both exports and imports in constant value terms decreased, the only difference being that imports decreased faster than exports. Much of this decline occurred during Y5-Y7. In the early part of review years Y1-Y4, exports in real terms increased by 3.1 percent per year, faster than the rate of increase of imports at 1.4 percent per year. But during Ys-Y7, exports in real terms decreased at the rate of 2.9 percent per year, while real imports decreased by 3.6 percent per year. This compression in import demand is credited to demand management policies during the crisis years. But a persistent real drop in the quantity of exports and poor export performance pointed to the inadequacy of the foreign trade regime and exchange rate policy pursued by Tusania. The popular view was that given Tusania's reliance on agricultural commodity exports like cotton, wheat, dried fruits; and light manufacturing, such as textiles and leather products, tinkering with the trade regime and exchange rate alone would not lead to a sizable improvement in trade performance. This "export pessimism" is widely shared by primary commodity exporters and is not unique to Tusania. 4.14 As a result of the trends in foreign trading in real terms, export to GDP ratio hovered around 7.7 percent over the review period, while import to GDP ratio stayed around 12 percent over the same period (for details see Annex IV Table 4-1). As regards the composition of trade, on the exports side, agricultural commodities contributed nearly two thirds of export earnings. On the import side, machinery, spares, and industrial raw materials constituted about 38 percent of the total; oil and Requirementsfor External Finance 69 petroleum about 24 percent; pharmaceuticals and essential consumer goods about 12 percent, the remainder being miscellaneous items. Imports of luxury consumer items were almost negligible given outright import bans and a steep custom duty structure. 4.15 Given this structure of trade, it is no surprise that in a bid to improve foreign exchange earnings, the government strove to provide financial incentives to the non- traditional segment of Tusania's export sector. Reliance was placed on quantitative restrictions (QRs) and custom duties to curb imports. With the onset of the crisis in Ys, government response to deteriorating trade and the current account balance was largely in the form of short-run crisis management steps such as QRs and licensing on imports, increases in import duties, and cutbacks in excise duties on manufactured goods destined for exports. These efforts, however, did not succeed in assisting the fast deteriorating current account balance. With an overvalued Siwat, appreciating real exchange rate, and a system of selective QRs, the foreign trade regime became even more distorted. Pressures on the domestic price level and nominal exchange rate intensified. The trade deficit began to rise swiftly in the mid-years, and eventually became non-sustainable, choking off the short-term inflows that had been the main source of financing the trade deficit. 4.16 The impact of the trade deficit was softened by increased inflows on services accounts of remittances of Tusanians based overseas. These remittances were fairly large, reaching at an all time high of $865 million in Y2, dipping to $708 million in Y5, and thereafter increasing to $762 million in Y7. These remittances of Tusanians overseas were fairly stable, as these inflows were mainly to support families and business. Whenever the differential between the official and curb market exchange rate increased, part of the remittances were shifted over to unofficial sources of transfer. Nonetheless, the remittances, which provided a much-needed cushion for the trade deficits throughout the period, were regarded as a fairly reliable source of foreign exchange earnings and were a major factor in attracting fCDs, as discussed above. 70 Macro-Financial Review: Policy and Program Formulation 4.17 What aggravated the current account deficit during the review period was that interest payments began to rise swiftly from a net of $211 million to $398 million in Y4, and to $542 million in Y7. This increase in interest charges was partly offset by remittances, but given the size of the trade deficit each year, the current account deficit swiftly increased from $396 million in Yj to $917 million in Y4, and then to $1.0 billion in Y7. No amount of stopgap efforts to improve trade performance could offset deficits of this magnitude. Foreign exchange earnings did increase significantly during Y1-Y7, but they were more than offset by an increase in imports and net interest payments on the services accounts. Corrective Measures 4.18 With a steadily deteriorating economic situation and no improvement in sight, the government gingerly embarked upon long-needed reforms in Y5 consisting of devaluation of the Siwat, the introduction of a market-based auction system for foreign exchange, abolition of some QRs, and reduction in effective protection - all pointing towards a realignment of the foreign trade regime. In tandem, in mid-Y5 the government imposed some control on public sector outlays, small but much needed increases in utilities' tariffs, and intensified revenue-raising measures as part of its annual economic program. These efforts, however, did not lead to a manageable balance of payments position. In spite of roll-overs, the size of short-term obligations created an overhang of liabilities both on trade and external debt accounts. At the same time, the revaluation of external liabilities by creditors due to devaluations of the US dollar and adverse cross-rate movements led to mounting arrears, externally. On the domestic front, the counterpart Siwat obligations of the private sector rose faster owing to devaluation, thus contributing to a severe financial squeeze on the private sector, already overburdened by rising interest rates, the tightening of domestic credit, and other adverse domestic financial trends. The Tusanian economy was forced to endure severe belt-tightening due to the financial squeeze as service payments wiped out foreign exchange availability for critical economic needs. Import compression and Requirements for External Finance 71 rising import costs forced several businesses to close down, and the general public faced severe hardship in the absence of any meaningful safety net. The government was forced to take a number of steps to control the growing foreign trade imbalance, starting with exchange rate policy and tariff structure aimed at revamping its trade regime. Exchange Rate Policy 4.19 The CBT operated a fixed exchange rate system pegged to the US dollar up to Y4. Under this fixed system, the CBT did periodically adjust the exchange rate and devalue the Siwat against the dollar, but the Siwat remained overvalued and the real effective exchange rate appreciated throughout the review period. The nominal exchange rate set by the CB was 80 Siwats to the US dollar at the end of Y1, and with the devaluation during Y2 and Y3, the official rate by the end of Y4 increased to 94 Siwats to the US dollar (see Annex IV, Table 4-1 for details). Thus, during the YI-Y4 period, the Siwat was devalued by nearly 17.5 per cent - a substantial devaluation. But Tusanian inflation was running high, and the domestic price level had risen by 57 percent as measured by the cost of living index, much higher than the 15 percent inflation in trading partner countries over the same period. The real exchange thus appreciated by 12 percent during the YI-Y4 period. In Y5, the Siwat was devalued again to 102 to the dollar, followed by yet another devaluation in Y6 to 110 Siwats to the dollar. By then, however, Tusanian inflation had gained substantial momentum, and the Tusanian price level rose by nearly 22 per cent per year. Despite yearly efforts to maintain the value of the Siwat, CBT authorities were unable to stabilize the exchange rate. Periodic devaluations became almost routine and much awaited each November at the time of the announcement of the Annual Programs. In mid-Y5, the government finally gave up on the fixed exchange rate regime, as discussed in Chapter IX, and adopted a crawling peg system. This was backed by sizable foreign exchange reserves provided by the CBT as part of the stabilization package and with the financial support of the AMLs. The nominal exchange rate at 72 Macro-Financial Review: Policy and Program Formulation Box 4.3 Foreign Exchange Auction System In the third quarter of Y5, the CBT introduced a foreign exchange auction system to provide for a smooth adjustment in the official exchange rate denominated in US dollars, and based on a basket of major currencies. It was a variant of a managed floating system that allowed the CBT to undertake periodic devaluation in measured steps, instead of the large discrete devaluations of the past. Tusanian banks licensed for foreign exchange trading were asked to submit their bids twice weekly for an amount of foreign exchange predetermined by the CBT for each bank, depending on the size of its operations, ownership, and concentration of activities. The auction started off with the prevailing exchange rate of 96 Siwats to the US dollar, which was already over-valued. The CBT let it be known to the banks that it would not accept wild swings, that is, it predetermined the range of acceptable bids. The banks were tempted to tender higher bids based on the spread between parallel market and official rates and other considerations, but they did not want to lose their eligibility for auctioned amounts. As a result, the bids stayed within 1.0-1.5 percent of the prevailing official exchange rate. This was the crawling peg part of the float. Whether it was a managed float or a dirty float depends on how it was perceived by the participating banks. In effect, the auction system transferred the foreign exchange eligibility and distribution authority to the banks, away from the previous system of access to foreign exchange by import license holders, and the Ministry of Commerce that used to grant these licenses. the end of Y7 was 126 Siwats to the US dollar, still well below the parallel market rate of 149 Siwats to the US dollar. 4.20 The exchange rate in the parallel market exerted tremendous pressure on the official exchange rate, foreign capital inflows and movement of funds, banking credit and, indirectly, on the interest rate structure. In Tusania, the Siwat is easily convertible, but at unofficial rates, and flows of funds are not necessarily constrained by the size of cross-border illegal trade, which is rather large. The massive size of the parallel market can be gauged by' cross-border illegal trade in consumer goods, electronics, foodstuffs, textiles, light machinery, and vehicle spare parts. No one knows the true size of the parallel market, but it is not an adjunct curb-side activity. Its Requirements for External Finance 73 presence is palpable and has a strong impact on the economy which cannot be ignored. As a result, throughout the review years the parallel market rate remained higher than the official rate. In Y1, it was 92 Siwat to the dollar, as compared to the official rate of 80 Siwats; in Y4, the parallel rate was 115 Siwats to the dollar against the official rate of 94 Siwats. After that, it began to rise faster and was 138 Siwats to the dollar in Y6, against the official rate of 110 Siwats. In Y7, the gap narrowed somewhat, as the parallel market rate stood at 149 Siwats against the official rate of 126 Siwats. 4.21 The sliding Siwat provided the opportunity for "round tripping" in the parallel market and was financed, in part, by the banking system as interest rates remained affordable and banking credit expanded sharply. Each time the Siwat took a slide, speculators gained on currency trade and came back through the financial system for the next round. The mechanism employed was fairly simple. Since Tusanian banks readily advanced credit against foreign currency accounts as collateral, the speculators tendered their balances in foreign banks to obtain Siwat credit, purchased foreign currency in the parallel market with these credits, and then remitted it overseas. When the Siwat depreciated, the speculators converted their foreign balance to pay off banks and obtain fresh credits, thus starting the cycle all over again. As the pressure on the Siwat in the parallel market continued unabated, the differential between the official and the parallel rate widened significantly, forcing authorities to devalue, thus reinforcing speculative behavior in a recursive fashion. This cycle was interrupted in late Y6, when the government took draconian liquidity control measures by prohibiting foreign account guarantees for credit and freezing the accounts of all SEs with the banking system. These steps, together with a rising interest rate, choked off the (formal) banking finance feeding the parallel market activities and stabilized the Siwat, but only after a good deal of instability in the markets and at a cost to the Tusanian economy and banking system. 4.22 A major re-alignment of the exchange rate and an overhaul of the system of operation was needed in the foreign exchange market of Tusania, and was eventually implemented in Y5. But while the exchange rate policy was aimed at realigning 74 Macro-Financial Review: Policy and Program Formulation relative prices and improving the foreign trade position and balance of payments, it also profoundly affected the banking system. The reforms, taken together, rendered the weaknesses of the banking system more acute. The relative price shift adversely hit overextended borrowers and aggravated their financial distress. The immediate impact of these policies was negative for the over-extended borrower, to whom the banking system was sufficiently exposed. The revamped price structure - the subsidy and incentive regime - adversely affected the financial position of many of these borrowers. This adverse impact was transmitted to the financial institutions. Further, the exchange rate policy and its auction system, to the extent that it had a built-in economic rent, led to a perverse allocation of foreign exchange by the banking system at the enterprise level. Already reeling under economic and financial pressures, the private sector now found access to foreign exchange very difficult and simply could not compete with the traders, and others, in service sectors because they could not afford the economic rent. Worse yet, to the extent that access to foreign exchange was tied to banking credit, those who could pay the premium for foreign exchange obtained easier credit. This contributed to a perverse lending phenomenon by the banking system in which the private sector was crowded out with severe consequences for economic revival and growth. As will be seen later, the financial system was at the center of this process. Export Promotion 4.23 The government had for a long period provided incentives and financing to promote non-traditional exports, mostly benefiting light manufacturing, and agro- processing industries. These industries were established under a protective structure, a 1i infant-industry promotion. Once established, the government offered export rebates to manufacturers and exports on classified items declared eligible under an export rebate scheme. In parallel, the government classified exporting activities as a priority sector requiring the banking system to provide credit for exports under the directed credit system, discussed in detail in Chapter VII. Both of these promotional policies Requirements for External Finance 75 had financial implications. The export-rebate scheme was funded from the federal budget, and apart from the merits of the scheme, it added to federal expenditures, hence federal deficits which were covered by borrowings. In effect, the government provided subsidies at a financial cost to the funding arrangement.I The priority credit scheme through the banking system did not involve explicit subsidies on direct financial costs to the banks, in so far as these credits were market-based and didn't replace other eligible borrowers. 4.24 The export rebate scheme has been in operation for nearly a decade inclusive of the review period. It is intended to offset the excise taxes paid by manufacturers, and import duties and charges on the import content of exports - a sort of duty drawback arrangement, but not as sophisticated and effective as a stand-alone scheme of this type in other countries. The rebate is expressed as a percentage of the f.o.b. export price or the c.i.f. price where goods are carried by Tusanian transport. The eligibility of exports for rebates is periodically revised by the Ministry of Commerce and is classified under several lists, with rebates ranging between 10 to 40 percent of the f.o.b. price for exporters with an annual turnover of $1.0 million or more and up to 30 percent for exporters with smaller turnovers. Nearly one-third of merchandise exports were thus eligible for rebates and the average rate of the rebate was around 20 percent during the first five years of the operation of the scheme. At the aggregate level, it is difficult to establish whether the rebate scheme contributed to exporting performance. For textiles and leather goods manufacturers, however, the rebates had a significant impact and assisted considerably in exporting. Though it could be argued that the rebates are generous, their implementation and coverage need improvement. In particular, the scheme should weed out opportunities for its misuse and cut back on the cost to the government. The rebate amount paid by the government was in the range of Siwats 3.5-4.5 billion per year, a fairly small amount relative to total government expenditures during Y,-Y,. 76 Macro-Financial Review: Policy and Program Formulation 4.25 Export financing by the banking system was fairly adequate as exporters had priority access to banking credit (see Chapter VII for details). Exporters needed two types of financing: for export trading and for export manufacturing. Export trading finance never posed any serious problems for the banks, whether for traditional agricultural commodities or light manufacturing items consisting mainly of textiles and leather goods. Occasionally, exporters ran into import quota restrictions, especially on textiles, but this did not pose any insurmountable financing difficulties either for the bankers or exporters. Credit for manufacturing, especially medium- and long-term credit by the banks, did create issues of viability for the proposed credit. Banks circumvented this, however, by granting short-term loans and then roll overs, thereby mitigating both the credit risk and interest rate risk. The targeted share for exporting was specified under manufacturing, to which the banks were required to lend 30 percent of their total credit. The target shares in the directed credit system were easily met, since the cash flow of exporters was superior to those of other manufacturers limited to the domestic market. Domestic financing of export manufacturing was not a serious constraint on export performance. 4.26 A meaningful reform of the foreign trade regime had to come to grips with the import policy and the structure of protection. As mentioned earlier, to curb imports for balance of trade concerns and to promote indigenous industries, the government relied on an extensive system of import duties and quantitative restrictions which needed a major overhaul. This could not be achieved, however, within the short-term horizon of successive Annual Programs and did not result in demonstrable improvements in trade performance. The government's policy response in this area was to resort to adjustments in the tariffs, more as a revenue measure than as a trade policy move. This task began in Y8, beyond the review period, as part of a broader program of structural changes initiated in late Y7. Requirementsfor External Finance 77 External Debt 4.27 The short-term financing of the balance of payments deficit, arising out of the foreign trade deficit, interest payments, and liabilities on medium- and long-term debt and arrears, had a drastically negative impact on Tusania's external debt position. The downward slide began in Y4 and had snowballed by Y7. Tusania had a comfortable external debt position in the early years of the review period which had been fairly manageable because the external debt consisted largely of the public and publicly- guaranteed medium- and long-term (M<) debt. The short-term debt, basically trade financing obligations of less than one year, was relatively small and manageable. In Y1, the short-term debt was $806 million, of which $601 million was in fCDs and $187 million was in trade financing instruments of suppliers' credits and bankers' acceptances. The M< debt in Y, was $2,549 million, amounting to about 76 percent of total external debt outstanding and disbursed (DOD). Thus the total external debt (DOD) was $3,355 million in Y, (see Table 4-2 below). By Y4, the DOD had risen to $4,368 million, of which $3,018 million was in M< debt and $1,350 million was in short-term debt, with more than half ($735 million) in fCD accounts. By Y7, the overall picture had changed considerably, as short-term debt rose to $2,256 million, or about 38 percent of a total outstanding debt of $5,885 million, while the M< debt was $3,629 million or about 62 percent of total debt. In other words, not only did the amount of external debt increase substantially, but there was also a major shift in the structure of external debt outstanding. 4.28 The source of the shift in the structure of the external debt was the emergence of arrears on short-term liabilities, discussed earlier - mainly the fCDs. As the figures show in Table 4-1, new fCDs held on to their historic levels of around $530 million up until Y3, but by Y4 there was a sharp decline. New fCD inflows began to dry up, while at the same time fCD arrears began to rise from 74 million in Y1, to $468 million in Y4, $849 million in Y6 and $1,028 million in Y7, amounting to about 46 percent of the total short-term liabilities of Y7. At the same time, arrears rolled over in new short- term liabilities emerged in Y3 totaling $228 , million in Y4, 78 Macro-Financial Review: Policy and Program Formulation Table 4.2 External Debt Outstanding and Disbursed (DOD) Annual Indicators YI Y4 Y5 Y, Y7 Y8 (US$ millions, end of period) Total External Debt (DOD) 3355 4368 4707 5403 5885 6750 Medium & Long-Term (M<) 2549 3018 3228 3435 3629 6065 Multilateral 871 1012 1066 1092 1130 1466 Bilateral (governments) 1526 1774 1898 2061 2183 2840 Private Banks (multinationals) 108 145 174 191 219 1657 Others 44 87 90 91 97 102 Short-Term Debt 806 1350 1479 1968 2256 685 Foreign Currency Deposits (fCDs) 601 735 746 870 1036 0 )CDs (new) 527 267 112 21 8 0 fCDs in Arrears 74 468 634 849 1028 0 Arrears Rolled -Over 0 228 312 357 382 0 Other Arrears 18 40 23 164 208 0 Negotiated Credits 0 163 251 458 462 470 Suppliers Credits and Acceptances 187 184 147 119 168 215 Amortizations on M< Debt 171 234 267 289 310 258 Interest on M< Debt 102 137 148 162 174 369 Average Interest on M< Debt (%) 4.0 4.5 4.6 4.7 4.8 6.1 Debt Service on M<Debt 273 371 415 451 484 627 Interest on Short-Term Debt 92 180 198 268 312 82 Average Interest on Short-term Debt(%) 11.4 13.3 13.4 13.6 13.8 12.0 Penalties and Charges on Arrears 4 18 24 35 43 0 Average cost of Short-Term Debt (%) 11.9 14.7 15.0 15.4 15.7 12.0 Service Charge on Short-Term Debt 96 198 222 303 355 82 Total-Debt Service 369 569 637 754 839 709 Debt Service Ratios (%) Debt Service/Exports 31.7 36.5 36.6 41.8 45.7 34.5 Debt Service/Exports & Remittances 18.4 24.9 25.8 29.7 32.7 25.2 For details see Annex IV, Table 4-2 increasing to $357 million in Y6, and $382 million in Y7. To finance the balance of payments, as mentioned earlier, the Tusanian government borrowed short-term gap-fill Requirementsfor External Finance 79 amounts in negotiated credits. These credits increased from $163 million in Y4 to 458 million in Y6 and to $462 million in Y7. 4.29 As regards the M< portion of the external debt, the main sources of these borrowings were, 1) long-term loans obtained from multilateral agencies and, 2) bilateral loans, mainly for financing investments of both the public and private sectors. The multilateral loans outstanding were $871 million in Y1, increasing steadily to $1,130 million in Y7, predicated as they were on considerations other than balance of payments financing. The larger part of the M< debt, however, was in bilateral obligations of the Tusanian government. These amounted to $1,526 million in Y1, or about 45.5 percent of the total M< debt. This proportion increased to about 58 percent in Y4 when the bilateral debt was $1,898 million. Although M< debt increased to $3,629 million in Y7, the bilateral debt increased faster to $2,183 million in Y7, - about 60 percent of total M<. As a result, the major source of M< debt was bilateral borrowings of the Tusanian government from other governments, followed by multilateral loans, while borrowings from private foreign banks and other sources were a negligible proportion. 4.30 The substantial increase, as well as the shift, in the structure of the externat debt liabilities had a drastic impact on the debt servicing burden. In Y, the debt servicing burden was about 31.7 percent of exports, defined as the ratio of interest payment ($198 million) and amortization ($171 million) on M< debt divided by exports ($1,163 million) in Y1. Creditors, however, looked at foreign earnings from exports ($1,163 million) and remittances ($805 million) as roughly the foreign cash inflow available for debt servicing, and by this reckoning the debt service ratio was 18.4 percent in Y1. As a result, their incentive to continue lending through fCDs and other short-term incentives went unabated, given the very attractive lending terms they obtained. The average interest charge on short-term obligations in Y, was 11.4 percent, consisting of interest rates of 8.5 to 10.0 percent and the remainder consisted of front-end fees. With the penalties and charges on arrears, however, the average interest cost of short-term debt was 11.9 percent. In comparison, the average interest 80 Macro-Financial Review: Policy and Program Formulation on M< debt in Y1, was much lower - nearly 4.1 percent. This cost structure of foreign borrowings prevailed throughout the review years. In Y4, total debt service was an estimated $569 million, of which $335 million was interest and $234 amortization of M< debt. The debt service ratio in Y4, therefore, increased to 36.5 percent on export earnings and to 24.9 percent on export plus remittances. By Y7, the average interest on short-term debt had risen to 13.8 percent, inclusive of fees. When penalties and charges are added on arrears outstanding, the average cost of short-term debt rose to 15.7 percent, in comparison with the average cost of M< borrowings of about 4.8 percent in interest charges. That is, short-term liabilities were nearly three times more expensive than M< liabilities. As a result, the debt service ratio in Y7 became an unbearable 45.7 percent of export earnings and 32.7 percent of exports and remittances. 4.31 No matter how it is looked at, the debt service burden became nonsustainable. Tusania could not afford these debt service obligations, hence the emergence of arrears during Y5-Y7, as discussed earlier. Moreover, these service obligations included penalties and charges associated with default, thus raising the effective cost of defaulted obligations more than three times the average cost of the M< borrowings. Reliance on the short-term borrowings to finance the current account deficit not only caused a debt overhang but was also very costly as all the due amounts eventually became sovereign obligations through debt reschedulings in late Y7. Further, since the CBT and other authorities insisted on dealing with creditors individually, and until a resolution was found, they regarded the outstanding liabilities in dispute. Therefore, the full size of these obligations, in the aggregate, was never recognized up front. But when defaults began to appear, together with stiff penalties and charges, Tusania had no choice but to declare a moratorium on its debt obligations, short-term or otherwise. This created a panic among its creditors and precipitated a crisis at home and abroad. Requirements for External Finance 81 Rescheduling of External Debt 4.32 With mounting repayment obligations in Y6, Tusania declared a moratorium, thus bringing external financing to a grinding halt. As a result, efforts began to deal with the debt burden. In the beginning, creditors were left to their own devices, but soon it was obvious that a major joint effort was needed by the creditors to sort out these obligations. Therefore, in mid-Y7 (as discussed in Chapter IX), under the auspices of the Paris Club, the multilaterals, together with the short-term creditors consisting of a consortium of bankers, the export credit agencies and others; began a series of negotiations to reach an agreement on terms of rescheduling for Tusania. The lynch-pin of the agreement was to be a stabilization package, with implementation by Tusania as a pre-condition for any debt relief, and rescheduling, along with $670 million in fresh credits to finance the balance of payments deficit. This balance of payments assistance was woefully inadequate to keep Tusania current on its liabilities. The stabilization package failed to bring about a significant turn-around, both domestically and in the external debt position, mainly because no comprehensive agreement could be reached on arrears outstanding. 4.33 In early Y7, it was clear that the only way out of the impasse was to put together a far-reaching debt rescheduling agreement containing debt relief as well as a moratorium on amortizations that covered the short-term liabilities and arrears estimated at about $1,900 million. The negotiations, culminating in the third quarter of Y7, converted $1,236 million of short-term arrears into M< liabilities guaranteed by the government. It also converted part of the bilateral liabilities of about 620 million into new M< debt, under an umbrella arrangement to reschedule the Tusanian external debt of $1,856 million. As part of the rescheduling agreement, Tusania was provided a grace period of three years on its repayment obligations in order to provide some headroom for essential imports and economic recovery. This was also largely because Tusania simply could no longer attract foreign financing from international markets, and even if it did, it could not afford the high cost of financing. The arrangement was that during the three-year grace period, the total debt 82 Macro-Financial Review: Policy and Program Formulation service of Tusania would not exceed 35 percent of foreign exchange earning from exports, or 25 percent of earnings from exports plus remittances. The agreement further stipulated that the interest rate on the rescheduled short-term debt was to be variable, pegged at LIBOR plus 0.75 percent on the $1,236 million of arrear liabilities. The interest on the rescheduled bilateral debt was agreed to at 5.0 percent, with some maturity structure as mentioned above. This agreement provided measurable debt relief and improved the grant element of bilateral debt outstanding. The AMLs did not reschedule their obligations, but they agreed to provide additional loans for balance of payments support, provided Tusania initiated a far-reaching program of economic reforms and structural adjustment through its annual programs. The first program to incorporate elements of structural adjustment was the Y8 program, discussed in detail in Chapter IX. Eventually, this short-term overhang of external debt was converted through rescheduling into M< debt. Tusania's short-term creditors ended up being long-term creditors, first involuntarily, and later willingly, realizing that not only would they recover their amounts outstanding but at a reasonable return - though perhaps not as high as before. 4.34 It was no wonder, then, that the crisis of Y5-Y7 was perceived in Tusania essentially as a balance of payments crisis, originating as it did from the overhang of external debt and culminating in an unprecedented squeeze on foreign exchange balances, while drying up external liquidity. Foreign creditors were seen using leverage to wrench economic and financial concessions from Tusania that would not have been possible otherwise. But the underlying factors responsible for landing Tusania in this situation were obscure to many except for a handful of officials at the MoF and the CBT. It was not popularly realized that the crisis was rooted in the domestic processes of generating and allocating financial resources in a policy regime that needed major changes, thereby making the task of policy makers doubly difficult in dealing with the aftermath of the crisis. This is discussed in the section below and the next two chapters. Requirementsfor External Finance 83 ANNEX IV - Exhibit 1 BALANCE OF PAYMENTS and EXTERNAL FINANCING 1. Exports 2. Imports 3. Trade Balance 4. Interest (Net) 5. Others Services (overseas remittances, profits) 6. Services Balance 7. Current Account Balance ( 3 + 6) 8. Capital Account Balance i. Borrowings by Government from: Multilaterals, Bilaterals, Private Banks less: Amortizations ii. Borrowings by State Enterprises/banks (Guarantees) from: 'Foreign Sources (banks, companies) less: Amortizations iii. Direct Foreign Investment (Equity Capital) less: Repayments iv. Capital n.i.e. (not included elsewhere) 9. OVERALL BALANCE (7 + 8) (if negative, then) Financed By: (Short-term Net Inflows as Below) i. Foreign Deposits with Banking System (net) ii. Foreign Supplier's Credits (net) to: Enterprises, Companies, Traders iii. Central Bank Borrowings (from Central Banks, BIS, Overseas Private Banks and Foreign Money Markets) iv. Banking System Foreign (Bankers' Acceptances, Others) v. Borrowings from IMF vi. Foreign Exchange Reserves (Draws) vii. Errors and Omissions 84 Macro-Financial Review: Policy and Program Formulation ANNEX IV Table 4-1 Balance ofPayments (1 of 2) Iv I , Y2 vn ofy r, (TS$ millions, end ofyear) Balance of Payments Deficit -237 -465 -504 -686 -715 -876 -815 Financed by: Short-Term Inflows (net) 714 812 919 679 571 497 558 fCDs 527 558 531 267 112 21 8 Suppliers Credit 115 167 178 117 92 77 110 Banker's Acceptances 72 87 96 67 55 42 58 Arrears Rolled-Over 0 0 114 228 312 357 382 Negotiated Foreign $ Credits 0 0 0 163 251 458 462 Syndicated Loans 0 0 0 163 137 118 134 AML & Others (net) 0 0 0 0 114 340 328 Reserves -266 -194 -231 -42 -12 39 -38 Net errors/omissions -211 -153 -184 -114 -95 -118 -167 Total Foreign Finance 237 465 504 686 715 876 815 Memo Items YI Y2 Y3 Y4 Ys Y6 V Balance of Payments (US$ millions, end ofyear) Exports 1163 1313 1403 1561 1741 1805 1834 Imports 2188 2388 2537 2793 3000 3196 3118 Trade Balance -1025 -1075 -1134 -1232 -1259 -1391 -1284 Invisibles (Services,net) 629 567 403 315 282 254 220 Remittances 840 865 764 713 708 741 762 Interest (net) -211 -298 -361 -398 -426 -487 -542 Current Account Balance -396 -508 -731 -917 -977 -1137 -1064 Capftal Movements (Autononu afows &of MediinandLong-lerm inance) Public M< (net) 121 148 178 180 210 207 194 Amortization 171 192 211 234 267 289 310 Public M< (gross) 292 340 389 414 477 496 504 Direct Private Investment 38 43 49 51 52 54 55 Net M<Inflow 739 191 72 23T T262 21 249 Balance of Payments Deficit -237 -317 -504 -686 -715 -876 -815 Arrears Outstanding 92 169 268 508 657 1013 1236 BOP Deficit --adjusted -329 -486 -772 -1194 -1372 -189 -2105r Total Arrears 92 169 382 736 969 1370 1618 of this: fCDs 74 127 215 468 634 849 1028 Trade and Others 18 42 167 268 335 521 590 Arrears Rolled -Over 0 0 114 228 312 357 382 Arrears Outstanding 92 169 268 508 657 1013 1236 Requirements for External Finance 85 ANNEX IV Table 4-1 Balance of Payments (2 of 2) Memo Items Y, I Y Y, Y. Ys_ Y, Exchange Rate (nominal) US$1.00 = Swnat Official Exchange Rate 80 83 87 94 102 110 126 Parallel Market Rate 92 97 102 115 127 138 149 Sumat Values (ST billions, end ofperiod) Foreign Trade and GDP Exports, current values 93 109 122 147 178 199 231 Imports, current values 175 198 221 263 306 352 393 Export Growth Rate 10.6 17.1 12.0 20.2 21.0 11.8 16.4 Import Growth Rate 9 13 11 19 17 15 12 EWorts, constant (real) values 93 102 106 114 118 11 112 Imports, constant (real) values 175 185 191 204 204 196 190 Export Growth Rate 8.7 9.5 3.7 7.7 4.1 -6.6 0.9 Import Growth Rate 5.3 5.8 3.1 6.6 0.3 -4.1 -3.1 GDP constant (real) values 1280 1321 1362 1400 1434 1451 1454 Exports/GDP ratio 7.3 7.7 7.8 8.1 8.3 7.6 7.7 Imports/GDP ratio 13.7 14.0 14.0 14.5 14.2 13.5 13.1 GDP deflator index 100.0 107.0 115.6 129.0 149.9 179.5 207.0 Foreign Fnancing Public M< (net) 9.7 12.3 15.5 16.9 21.4 22.8 24.4 Direct Private Investment 3.0 3.6 4.3 4.8 5.3 5.9 6.9 Net M<Inflow 12.7 15.9 19.7 21.7 26.7 28.7 31.4 Short-Term Inflows (net) 57.12 67.4 80.0 63.8 58.2 54.7 70.3 fCDs 42.16 46.3 46.2 25.1 11.4 2.3 1.0 Suppliers Credit 9.2 13.9 15.5 11.0 9.4 8.5 13.9 Banker's Acceptances 5.8 7.2 8.4 6.3 5.6 4.6 7.3 Arrears Rolled-Over 0.0 0.0 9.9 21.4 31.8 39.3 48.1 Negotiated Foreign $ Credits 0.0 0.0 0.0 15.3 25.6 50.4 58.2 Syndicated Loans 0.0 0.0 0.0 15.3 14.0 13.0 16.9 AML & Others (net) 0.0 0.0 0.0 0.0 11.6 37.4 41.3 Total Foreign Finance T9.0 38.6 438 64.5 -72.9 96. 10O2T7 Average Annual Growth Rates Exports, current values 7.9% 10.3% 5.5% 2.6% Imports, current values 6.1% 8.5% 3.7% 1.9% Exports, constant (real) values 3.1% 6.9% -0.6% -2.9% Imports, constant (real) values 1.4% 5.2% -2.3% -3.6% 1 1 1 86 Macro-Financial Review: Policy and Program Formulation ANNEX IV Table 4-2 External Debt Outstanding and Disbursed (DOD) Y, Y Ys Y6 Y, Ys (US$ millions end ofyear) Total External Debt (DOD) 3355 4368 4707 5403 5885 6750 Medium & Long-Term (M<) 2549 3018 3228 3435 3629 6065 Multilateral 871 1012 1066 1092 1130 1466 Bilateral (governments) 1526 1774 1898 2061 2183 2840 Private Banks (multinationals) 108 145 174 191 219 1657 Others 44 87 90 91 97 102 Short-Term Debt 806 1350 1479 1968 2256 685 Foreign Currency Deposits (fCDs) 601 735 746 870 1036 0 fJCDs (new) 527 267 112 21 8 0 fCDs in Arrears 74 468 634 849 1028 0 Arrears Rolled -Over 0 228 312 357 382 0 Other Arrears 18 40 23 164 208 0 Negotiated Credits 0 163 251 458 462 470 Suppliers Credits and Acceptances 187 184 147 119 168 }_215 Memo Items Amortizations on M< Debt 171 234 267 289 310 258 Interest on M< Debt 102 137 148 162 174 369 Average Interest on M< Debt(%) 4.0 4.5 4.6 4.7 4.8 6.1 Debt Service on M&L TDebt 73 T371 415 4TI 484 627 Interest on Short-Term Debt 92 180 198 268 312 82 Average Interest on Short-term Debt (%) 11.4 13.3 13.4 13.6 13.8 12.0 Penalties and Charges on Arrears 4 18 24 35 43 0 Average cost of Short-Term Debt(%) 11.9 14.7 15.0 15.4 15.7 12.0 Service Charge on Short-Term Debt 96 198 222 303 355 82 Total Debt Service 369 569 637 754 839 O9 Debt Service Ratios (%) Debt ServiceExports 37 3 36.6 41. 45. 34. Debt Service/Exports & Remittances 184 23 26. 2 32. 2. (US$ millions, end ofyear) Exports 1163 1561 1741 1805 1834 2054 Remittances 840 713 708 741 762 760 Exports and Remitttances 2003 2274 2449 2546 2596 2814 Interest and Charges 198 335 370 465 529 451 CHAPTER V FINANCIAL OPERATIONS OF THE PUBLIC SECTOR: GOVERNMENT AND THE SEs 5.1 The financial operations of the Tusanian public sector have consistently generated deficits throughout recent history, but the trend worsened during the mid- years of the review period and reached crisis proportions in later years. The consolidated public sector deficit was ST185 billion in Y1, increased to ST269 billion in Y4, and by Y7 had grown to ST552 billion. The rate of growth of the public sector deficit during Yl-Y7 was very high at 20 percent per year. This average rate of growth during Yi-Y7, however, belies the nature of the financial burden the public sector faced during Y5-Y7, when the deficit's rate of growth was 29.7 percent per year as compared to 13.3 percent during Yl-Y4. This led to a more than three-fold increase in the level of public sector deficit over the Yl-Y, period. Further, the budget deficit as reported by the federal government, the federal deficit, does not capture the demand for financial resources by the entire public sector unless the quasi-deficit is also accounted for. This consists of the deficits of public sector enterprises, SEs, local governments on their financial operations, other public organizations, and quasi-government institutions. In the presentation scheme followed here, the deficits of the local government are not shown separately, rather they are included in the federal deficit, while the quasi-deficit is defined primarily as 87 88 Macro-Financial Review: Policy and Program Formulation the deficits of SEs and other public organizations. Thus, the financial operations of government, whether federal, provincial or local, are consolidated in federal government accounts; while the financial operations of SEs, the parastatals, and other public sector organizations are treated as quasi-government accounts. This classification is not a strict fiscal reporting convention but is followed here to keep matters simple and straightforward. The term 'quasi-deficit" is used here synonymously with 'SE's deficit' for purposes of this case study. 5.2 In addition to the above, for fiscal accounts the need is to capture the arrears and revaluation loss on external liabilities of the government and quasi-government borrowings, which later became sovereign liabilities as a result of the guarantees extended by the government. During the crisis years, as discussed in Chapter IV, a part of the increase in these external liabilities occurred on the foreign borrowings of quasi-government organizations and also on the external financial operations of the banking system. The counterpart Siwat liabilities of these arrears are not separately identified in these fiscal accounts. Instead these are included partly in the investment program, and partly in the operations, to the extent that the original external liabilities were incurred to finance these items. With these adjustments in the fiscal accounts of the federal government and quasi-government, the public sector deficit increases to the levels reported here. 5.5 To recapitulate, the total public sector deficit as shown here includes two items. First, it includes the federal deficits estimated from the routine budget operations strictly on the basis of federal revenues, expenditures, and transfers together with the financial operations of the state and local governments. This recognizes that the deficits of state and local governments in large measure became the responsibility of the federal government. The financial operation of states, local governments, and quasi-government institutions are not fully known, hence a clear picture of their financial operations is not possible. However, given that there are few revenue sources of state and local governments, besides their revenue share in the Financial Operations of the Public Sector: Government and SEs 89 budget and extra-budgetary allocations from the federal government, their net fiscal operations are added to federal accounts and appear as federal deficits. Second, the public sector deficit includes the quasi-deficit, largely based on the financial operations of the SEs and other public sector organizations. The Deficits 5.4 On this basis, the federal deficit was STI 12 billion in Yj or 60.5 percent of the total public sector deficit, while the SEs deficit was ST73 billion or 39.5 percent of the total. These proportions changed, however, because the federal deficit increased by 10.5 percent per year during YI-Y4, while the quasi-deficit increased faster at the rate of 17.4 percent over the same period. As a result, the proportion of federal deficit in the total public sector deficit declined to 56.1 percent in Y4. These proportional shares of both the federal and SE deficits in total public sector deficit were sustained through later years. 5.5 This is somewhat misleading, however, because the government provides support of various kinds to the SEs, which is formally not a part of the SE's financial operations and does not appear as a line item of federal support on the SE's financial' statements. The support may consist of subsidized inputs such as petroleum, electric power and transport, the cost of auxiliary infrastructure to enable SEs to carry out their operations, and indirect subsidies on SE's products and services. These items are not part of a direct financial transaction between the government and SEs. They are transfer items, and their costs need to be traced as they are spread out in various departmental budgets. The aggregate of these transfer costs is shown in Table 5-1 as 'transfer to SEs,' separate from federal expenditures. The size of these transfers, which has been fairly significant throughout the years, was an estimated ST42 billion in Y1. These transfers increaped to ST74 billion in Y7, amounting to nearly 26.8 percent of the government's total revenues. That is, for each Siwat of revenue collected by the government, 0.27 Siwat ended up being used for SE support from the 90 Macro-Financial Review: Policy and Program Formulation Table 5.1 Financing Public Sector Deficits- Government, State Enterprises Annual Indicators Average Annual Growth Rates Y, Y4 Y6, Y7 Y, - Y, - Y5 Y7 Y4 Y7 (ST billions) (per cent) Public Sector Deficit 18U 2[2 427 552 20.0 13.3 29.7 Federal Deficit 112 151 236 304 18.1 10.5 28.9 Revenues 212 235 260 276 4.5 3.5 5.9 Expenditures 255 295 390 453 10.1 5.0 16.8 Transfers to DFIs (net) 27 37 44 53 11.9 11.1 15.1 Transfers to SEs, Other (net) 42 54 62 74 9.9 8.7 13.9 Quasi Deficit; SEs 73 118 191 248 22.6 17.4 30.8 Investment 42 58 80 102 15.9 11.4 25.3 Operational Losses, SEs 31 60 111 146 29.5 24.6 35.1 Financed by: Domestic borrowings: 168 239 283 486 19.4 12.5 31.5 Foreign Borrowings 5 7 11 15 20.1 11.9 22.5 Arrears and Others 12 23 33 51 27.3 24.2 17.6 Annual Growth Rates (%) Public Sector Deficit 9.5 15.9 30.2 29.3 Federal Deficit 8.3 12.7 29.0 28.8 Revenues 3.0 4.0 5.7 6.2 Expenditures 3.2 7.3 17.5 16.2 Transfers to DFIs (net) 12.6 15.4 30.8 22.1 Transfers to SEs, Other (net) 7.3 9.4 10.6 11.0 Quasi Deficit; SEs 9.6 20.4 31.7 29.8 Investment 10.4 11.5 23.1 27.5 Operational Losses 12.1 30.4 38.8 31.5 Ratios of GDP Public Sector Deficit / GDP 14.5 14.9 16.4 18.3 Federal Deficit 8.8 8.4 9.1 10.1 Quasi Deficit; SEs 5.7 6.5 7.3 8.2 For details see Annex V, Table 5-1 Financial Operations ofthe Public Sector: Government and SEs 91 federal budget as transfers, over and above support provided through the CBT and DFI credits to SEs at preferential interest rates. When these federal transfers are added to the net operational losses of SEs, and simultaneously, deducted from the federal finances, the proportion of SE deficits becomes larger than the government deficit at the aggregate level. On this basis, the SE's deficits, re-defined as consisting of transfers plus operational losses and investments, become STI 15 billion in Y1, rising to ST241 billion in Y5, and to ST352 billion in Y7 - more than half of the total public sector deficit throughout these years. 5.6 No matter how one looks at the public sector deficit, its growth was phenomenal and could not be sustained. As mentioned in the opening paragraph of this chapter, the average rate of growth of the deficit during the review period YJ-Y7 was 20 percent per year. This increase simply could not be absorbed by the fiscal or financial system, or by the Tusanian economy. The ratio of the total public sector to the GDP was fairly high to begin with at 14.5 percent in Y1. Then, after marginally increasing to 14.9 percent in Y4, it jumped to 18.3 percent in Y7. Of this, the ratio of federal deficit to GDP was 8.8 percent in Y1, declining slightly during Y2-Y5. Thereafter, it rose to 9.1 percent in Y6 and then to 10.1 percent in Y7. The ratio of quasi-deficit to GDP was 5.7 percent in Y1, rose to 6.5 percent in Y4, and to 8.2 percent in Y7 (see Table 5.1). That is, the SE's deficits significantly contributed to the fiscal burden, with serious implications for the overall financial resource requirements of the public sector as a whole. The government, while attempting to reduce the fiscal imbalance through reducing expenditures, had not pursued policies of fiscal adjustment on the revenue side. During the crisis years, rapid inflation and the erosion of real salaries and wages severely constrained the revenue mobilization effort. In addition, the fiscal operations of the states and quasi-government agencies, together with direct subventions and net lending to the SEs, substantially added to the financial needs of the public sector. In the face of growing deficits, the federal government borrowed substantially to finance transfers, subventions, and direct budgetary support to public sector organizations and SEs. 92 Macro-Financial Review: Policy and Program Formulation Chart 5-1 0 Public Sector Deficit Deficit Growth Trends Federal Deficit - - Quasi Deficit; SEs 30 25 20 15 10 5 0 YI Y2 Y3 Y4 Y5 Y6 Y7 5.7 Essentially, the same was true for SEs because their own revenue generation efforts were stymied by a pricing and tariff structure which did not enable them to cover their operating costs. As a group, the SEs had running losses throughout, Financial Operations ofthe Public Sector: Government and SEs 93 though these losses had been manageable in the past. However, owing to their rigid price structure, and the inability or unwillingness to adjust their operations, SE losses began to increase in Y3. By Y7, the losses were more than twice their Y4 level, way beyond the capacity of federal finances to absorb them. In Y1, the SEs operational losses were ST31 billion on a revenue base of ST67 billion. In Y4, those losses doubled to ST60 billion on a revenue base of ST78 million. This happened because expenditures rose from ST98 billion in Y, to ST138 billion in Y4. By Y7, the SE's expenditures had increased to ST240 billion, while revenues were ST94 billion. As a result, the SEs losses in Y7 were ST146 billion (see ANNEX V Table 5-1). The growth rates provide a better understanding of these magnitudes. During Y-Y7, expenditures increased at an average rate of 16.1 percent - nearly three times faster than- the 5.8 percent average rate of growth revenues. As a result, the SE's losses increased at an average rate of 29.5 percent over the entire review period. The growth of SE's losses was slower in early years but still fairly high at 24.6 percent per year during Yi-Y4, accelerating to 35.1 percent during the Y5-Y7 period. 5.8 In addition, the development strategy of Tusania called for growing levels of investment by SEs. The investment program of SEs was regarded as almost sacrosanct - and every effort was made to maintain it in the belief that any reduction in SE investment levels would be tantamount to deliberately reducing economic growth. The pressures to keep these investments high increased in the face of deteriorating economic conditions, precisely during those years when public sector finances could not sustain it. As a result, the financial needs of the SEs increased more than three times and the quasi-deficit went out of control, growing from ST73 billion in Y1, to STl 18 billion in Y4, and then to ST248 billion in Y7. 94 Macro-Financial Review: Policy and Program Formulation Financing the Deficit - Borrowing Operations 5.9 How was this consolidated public sector deficit financed? It was financed mainly from domestic borrowings through the financial system, the CBT, the DFIs and commercial banks - in that order, and in small part from foreign borrowings. The domestic borrowings from the financial system provided nearly all of the finance to cover the public deficit throughout the review period. Foreign borrowings were fairly small in this picture at the aggregate level, though for some public sector organizations at the unit level - especially the SEs in communication and transport - foreign borrowings were critical for their operations and investment needs. The point is that foreign borrowings were not used to finance the gap between public sector revenues and expenditures. The shortfall in public sector savings was met domestically by transferring financial savings of the general public and the private sector to the public sector. This transfer was affected through operations of the financial system and through domestic borrowing operations, as discussed below. 5.10 The consolidated borrowing operations of the public sector, both the federal government and SEs, provide a measure of the pressure put on the financial system to allocate financial savings at the macro-level. The consolidated domestic borrowings of the public sector were ST168 billion in Y1. Of this, CBT provided STIO2 billion, the DFIs ST28 billion, and commercial banks ST26 billion while the remaining STI2 billion was borrowed from other sources like non-bank financial institutions and the public. In Y4, these consolidated borrowings were ST239 billion, of which CBT provided ST121 billion, DFIs ST53 billion, and commercial banks ST44 billion. By Y7, consolidated borrowings of the public sector were ST486 billion, nearly three times the borrowings in Y1. The bulk was borrowed from CBT, which provided ST296 billion, while DFIs provided ST94 billion, mostly to SEs, and commercial banks ST68 billion.I It is true that commercial banks provided less than before For CBT credit to the government and to SEs, see ANNEX V, Table 5-1. The total of these two lines is reported above. Financial Operations of the Public Sector: Government and SEs 95 proportionately, but clearly the banking credit system yielded to the public sector at the private sector's expense and thus provided the mechanism for the resource transfer. These borrowings by the government were done through money market instruments such as treasury bills, securities, and development stocks. These were subscribed to mainly by the CBT, and to a lesser extent by the banking system. The quasi-government institutions also borrowed both domestically and abroad, mainly with guarantees of the government. Non-bank borrowings of the public sector were minimal. 5.11 These consolidated borrowing operations of the public sector are given in Table 5.2 below. As shown there, federal government borrowing was ST1O8 billion in Y1, of which CBT credit to the government was ST90 billion, while commercial bank credit, mainly the holdings of T-bills, was ST18 billion. These proportions held, roughly, throughout the review period. In Y7, federal government borrowings were ST242 billion, of which CBT credits were ST224 billion, and commercial bank credits were again ST18 billion. That is, CBT was the main creditor to the federal government throughout. The SEs had a more diverse borrowing base, in that the CBT and DFIs together provided the bulk of the credit, but based on an entirely different set of lending arrangements and costs. The SEs also borrowed from the commercial banks, other financial institutions, and commercial credits from those willing to extend short-term financing. For example, in Y1, total SE borrowings were ST60 billion. CBT credit, mostly in priority credits for medium to long-term was ST12 billion; the DFIs credit was ST28 billion to finance SE's investments; commercial bank credits, mostly short-term overdrafts, were ST8 billion; and other commercial credits were ST 12 billion. This pattern of SE borrowings prevailed throughout the period. That is, the investment program of the SEs was financed mainly from medium- to long-term priority-based credits of the CBT and DFIs, both provided at below-market interest rates. The commercial creditg, mainly to support the routine operations of the SEs, were extended at market cost in short-term loans. 96 Macro-Financial Review: Policy and Program Formulation Table S.2 Domestic Borrowing Operations, Domestic Public Debt: Government, State Enterprises Annual Indicators Average Annual Growth Rates Y, Y4 Y6 Y7 Y1-Y, Yl -Y4 Y5-Y7 (ST billions) (per cent) Total Deficit 185 269 427 552 20.0 13.3 29.7 Federal Deficit 112 151 236 304 18.1 10.5 28.9 Quasi Deficit; SEs 73 118 191 248 22.6 17.4 30.8 Financed by: Domestic Borrowings 168 239 383 486 19.4 12.5 31.5 Foreign Borrowings 5 7 11 15 20.1 11.9 22.5 Arrears and Others 12 23 33 51 Domestic Borrowings 168 239 383 486 Government borrowings 108 120 203 242 14.4 3.6 31.9 SEs and Others' borrowings 60 119 180 244 26.3 25.6 31.1 Borrowing Instruments 168 239 383 486 19.4 12.5 31.5 Government Papers, <6 mos 73 102 174 198 18.1 11.8 22.9 Preferred Credits,CBT,1-2 yrs 41 40 77 126 20.6 -0.8 77.5 Priority Credits, DFIs,1-5 yrs 28 53 72 94 22.4 23.7 25.2 Commercial Credits, <6 mos 26 44 60 68 17.4 19.2 16.6 Borrowings Costs (amounts) 9.3 15.7 26.3 33.1 23.6 19.2 31.0 for Government 4.9 6.9 12.7 15.6 21.3 12.1 34.7 for SEs, and Others 4.4 8.8 13.6 17.5 26.0 26.3 28.0 Government Papers, <6 mos 4.4 6.6 12.2 14.9 22.6 14.8 32.1 Preferred Credits,CBT,1-2 yrs 0.6 0.6 1.3 2.3 25.7 3.7 88.2 Priority Credits, DFls, 1-5 yrs 2.1 4.2 6.5 8.5 26.1 26.4 28.8 Commercial Credits, <6 mos 2.2 4.2 6.3 7.5 22.5 23.7 22.3 Average cost (Rate, %) 5.5 6.6 6.9 6.8 for Government 4.5 5.8 6.3 6.4 for SEs, and Others 7.3 7.4 7.5 7.2 Government Papers, <6 mos 6.0 6.5 7.0 7.5 Preferred Credits,CBT,1-2 yrs 1.4 1.6 1.7 1.8 Priority Credits, DFIs, 1-5 yrs 7.5 8.0 9.0 9.0 Commercial Credits, <6 mos 8.5 9.5 10.5 11.0 Instruments; Share (%) 100 100 100 100 Government Papers, <6 mos 43.5 42.7 45.4 40.7 Preferred Credits,CBT,1-2 yrs 24.4 16.7 20.1 25.9 Priority Credits, DFIs,1-5 yrs 16.7 22.2 18.8 19.3 Commercial Credits, <6 mos 15.5 18.4 15.7 14.0 For details see Annex V, Table 5-2 Financial Operations of the Public Sector: Government and SEs 97 5.12 Overall, the general pattern of financing the public sector deficit from domestic borrowing is common to many countries and is not typical of Tusania. This rise in deficit-financing did not cause alarm in official circles, partly because full information was only available to a select few, and partly because it was not seen as anything out of the ordinary. There was little debate on the underlying issues, or even on the size of the public sector deficit, let alone the level of borrowing and the size of the domestic debt. Since most of the government borrowings were rolled over in new issues at the time they were due for repayment, the borrowing did not carry any amortization burden on government finances in a given year. The rollover simply added to the stock of the government debt. Even the interest cost in some cases was rolled over into new debt obligations, therefore, the government did not face any serious financial burden of its domestic debt. That is, there was no 'retirement' or net reduction in the stock of government debt. Rollovers of earlier liabilities and new borrowings simply ended up as part of the total domestic debt. This practice represented an inter-temporal transfer, a time preference but not a financial burden, commensurate to the annual level of borrowings. Instruments of Borrowing and Costs 5.13 The most commonly used instrument of borrowing for the public sector was government papers, mostly T-bills. These are short-term obligations of the federal government of less than six months. In the early years of YI-Y4, government papers were 43.5 percent of total borrowings, and then decreasing to around 41 percent in Y7. In Y1, the federal government borrowed ST73 billion through these papers out of total borrowings of ST168 billion. In Y4 government papers totaled ST1O2 billion, and in Y7, these were ST198 billion out of the total borrowings of ST486 billion. The bulk of these government papers were held by the CBT at any given time, that is, the CBT was the creditor. Only part of the government papers was held by commercial banks in T-bills, largely because, as discussed in Chapter VII, the T-bills could be tendered by commercial banks as 40 percent of their reserve requirements, and not 98 Macro-Financial Review: Policy and Program Formulation Chart 5-2 Shares of Instruments, Yj Commercial Credits, 15% Priority Credits, Govt Papers, DFIs 17% 44% Preferred Credits, CBT, 24% Shares of Instruments, Y7 Commercial Credits, 14% Govt Papers 41% Priority Credits, 19% Preferred Credits, CBT, 26% Financial Operations ofthe Public Sector: Government and SEs 99 because these papers offered a reasonable return. The average cost of these short- term maturity government papers was 6.0 percent during YI-Y3, 6.5 percent during Y4-Y5, and 7.5 percent in Y7, reflecting largely the re-discount rate of T-bills during these years. 5.14 Next in the line of borrowing instruments were preferred credits of the CBT. These were mostly advanced to the federal government in maturities of one-to-two years at a nominal charge of around 1.5 percent during the early years, and of 1.7 percent in the later years of the review period. The amounts borrowed annually were fairly sizable. In Y, preferred credits were ST41 billion, and held around that level until Y5. In Y6, the preferred credits were ST77 billion and ST126 billion in Y7. That is, much of the increase in this type of borrowing occurred during the crisis years, and it represented a sort of mandatory lending by the CBT to the government. 5.15 Both these instruments of borrowing did not entail a real amortization burden to the government because a good part of these obligations were rolled over into new obligations as they fell due. Hence, the financial cost for the government was mainly the interest charge, which was nominal for preferred credits at around half of the market interest rate for T-bills. Therefore, the financial cost of borrowing through T- bills and preferred credits was ST 5.1 billion in Y1, ST7.2 billion in Y4, and ST17.2 billion in Y7. This easy and almost cost-free access to credit was a major factor in the uncontrolled growth of credit, money supply, and hence, aggregate money demand. This led to financial pressures and inflation in later years as discussed in the next chapter. 5.16 Among the public sector's borrowing instruments, commercial credits represented the highest-cost source of borrowing to the public sector for short-term maturities. These credits were essentially similar to the loans extended by commercial banks to their prime borrowers at interest rates slightly below the market 100 Macro-Financial Review: Policy and Program Formulation Chart 5-3 Average cost (Rate, %) Average COSt Govt Papers, <6 months of Borrowing - Commercial Credits, <6 months Prime Rate 14 12 10 8 6 4 2 0 Y1 Y2 Y3 Y4 Y5 Y6 Y7 Financial Operations of the Public Sector: Government and SEs 101 rates. The cost of lending for these loans is lower than for other types of loans, and above all, the credit risk is minimal. Therefore, the interest rate on commercial credits to the public sector, although the highest cost it paid, was still slightly lower than the prime rate year after year. These rates ranged between 8.5-9.5 percent during YI-Y4, and then rose to 10-11.5 percent range during Y5-Y7. Borrowings by SEs 5.17 Most of these commercial credits to the public sector were in fact borrowings of the SEs, rather than the government. The instruments of borrowings for the SEs varied depending upon the creditor. The borrowings from the CBT were provided as a line of credit to the borrowing SE, with the authorization of the Ministry concerned as well as the MoF. But the CBT did not require the SE to submit supportive financial statements, nor was the CBT concerned with the repayment capacity of the SEs concerned. That is , the CBT did not carry out borrower evaluation in the strict sense of the term. The loan agreement, a fairly standardized document, only stipulated the repayment stream, and in the event of a default, the amount of default was simply added to the loan outstanding in the account of the SE concerned. Most of the CBT loans to SEs were priority credits running parallel to the directed credit system for the private sector discussed in Chapter VII. The typical maturity of CBT loans to SEs was 3 to 5 years - in some cases up to 7 years - at priority credit interest rates, well below market rates, thus harboring interest rate subsidies to the SEs. The financial cost of these subsidies was significant to the CBT. 5.18 SEs borrowing from the DFIs was more commercial in nature, in that interest rates were slightly higher than those of the CBT, yet DFI loans to SEs did not entail a strict repayment evaluation or an assessment of the financial status of the SE. It was not collateralized lending, nor did the credit mechanism involve any financial penalties or losses to the SE in case of non-performance. Since most of the borrowings from the DFIs was to finance SEs investment, the bulk of the DFI credit 102 Macro-Financial Review: Policy and Program Formulation to SEs was of 5 to 6 years maturity, though SEs also borrowed short-term for their operations. The SEs turned to commercial loans on market terms only after they had exhausted their credit line with the CBT and the DFIs, because the banking system charged not only market rates, but required realizable collateral and stringent reporting, thus imposing some financial discipline. For a few financially viable SEs, commercial loans were a source of extra liquidity to manage their cash positions on a temporary basis. Some SEs also obtained suppliers' credit with bank guarantees extended generally by the DFI concerned. Overseas borrowing of SEs, which were small and always involved a guarantee of the Tusanian government both for the credit risk and foreign exchange risk, were practically sovereign borrowings. Given the absence of penalties and of a meaningful collateral system underlying SE borrowings. there was-no recovery management in case of default. Although there were defaults. these were not reported because the CBT or the DFI simply rolled over the credit. That is, financial failure for the SE did not imply bankruptcy or foreclosure for the enterprise concerned. Only the commercial credit entailed penalties, and their financial obligations were met through transfers if not through their own cash flows. 5.19 The borrowings of the SEs as priority credits from the DFIs were ST2.1 billion in YI, rising to ST4.2 billion in Y4, and doubling again to ST8.5 billion in Y7. The average interest on DFI credit was 7.5 percent during YI-Y3, rising to 8/0-9.5 percent during Y4-Y5, and finally to 9.0 percent during Y6-Y7. For government guaranteed borrowings, these rates represented reasonable costs to the SEs, and were free of any risk premium to be paid to the lending institutions. 5.20 On this basis, the average cost of the annual borrowings to the public sector were 5.5 percent in YI, rising to 6.6 percent in Y4, to around 6.9 percent during Y5 and Y6, and to 6.8 percent during Y7. These were the average costs on the annual borrowing operations of the government, and should not be confused with the average costs of the public domestic debt outstanding discussed below. Further, the cost of borrowings of the public sector were similar to the pattern observed in other Financial Operations ofthe Public Sector: Government and SEs 103 countries. These were well below market costs because the borrowings are sovereign liabilities with no credit risk or repayment risk. In economic terms, the real cost of borrowings were substantially negative as discussed in the next chapter, and thus represented a net transfer of resources to the public sector from the rest of the economy. We will return to this issue later on. Domestic Debt and Debt Servicing Costs 5.21 The domestic debt outstanding in Yj was ST553 billion, increasing to ST878 billion by Y4, and finally to ST1398 billion in Y7. This phenomenal increase in the domestic debt outstanding occurred because of the new borrowings needed to finance the deficit together with rollovers of existing obligations, mainly in preferred credits advanced by the CBT to the government. The preferred credits outstanding were ST368 billion in Y1, nearly two-thirds of the total debt outstanding; while government papers were ST73 billion, or 13.7 percent of the total debt in the same year. In other words, the CBT was the main holder of the public sector debt, amounting to about 80 percent of the domestic debt. This pattern prevailed throughout this period. 5.22 The average cost structure of the debt outstanding was, however, similar to those discussed earlier, that is, preferred credits of the CBT were the least-cost borrowing instrument of the government. Because of the dominance of preferred credits, the average interest cost of the debt outstanding for government borrowings was 2.2 percent in Y1, which marginally increased to 2.8 percent by Y7. In comparison, the average interest cost of the debt outstanding for the SEs, mainly DFI credits and commercial loans, was much higher, around 7.7 percent in Y1, rising to 9.6 percent by Y7. Since the government was able to obtain such low cost credit, it could afford a substantial increase in the domestic debt burden over these years. 104 Macro-Financial Review: Policy and Program Formulation Table 5.3 Domestic Debt Public Sector: Government, State Enterprises Annual Indicators Y, Y2 Y3 Y4 Y5 Y6 Y7 (ST billions, end ofperiod) Domestic Debt Outstanding 533 624 754 878 1044 1203 1398 Government Papers, <6 months 73 82 89 102 131 174 198 Preferred Credits,CBT,1-2 yrs 368 432 528 610 721 814 938 Priority Credits, DFIs,1-5 yrs 72 89 107 125 144 161 184 Commercial Credits, <6 mos 20 21 30 41 48 54 78 Domestic Debt Servicing costs 16.6 19.9 24.0 30.3 37.1 46.2 56.9 Government Papers, <6 months 4.4 4.9 5.3 6.6 8.5 12.2 14.9 Preferred Credits,CBT,1-2 yrs 5.2 6.5 7.9 9.8 11.5 13.8 16.9 Priority Credits, DFIs,1-5 yrs 5.4 6.7 8.0 10.0 12.2 14.5 16.6 Commercial Credits, <6 mos 1.7 1.8 2.7 3.9 4.8 5.7 8.6 Domestic Debt Servicing costs as per cent of revenue 7.8 9.1 10.6 12.9 15.1 17.8 20.6 as per cent of expenditures 6.5 7.5 8.7 10.3 11.2 11.8 12.6 Foreign Debt Service M<, 21.8 25.1 29.4 34.9 42.3 49.6 61.0 of this: 68% federal 14.9 17.0 20.0 23.7 28.8 33.7 41.5 Total Debt Servicing costs 31.5 36.9 44.0 54.0 65.9 79.9 98.4 Domestic Debt Servicing costs 16.6 19.9 24.0 30.3 37.1 46.2 56.9 Foreign Debt Servicing costs 14.9 17.0 20.0 23.7 28.8 33.7 41.5 as per cent of revenue 14.9 16.8 19.5 23.0 26.8 30.7 35.7 as per cent of expenditures 12.4 14.0 16.0 18.3 19.8 20.5 21.7 Average cost (Rate, %) 3.1 3.2 3.2 3.4 3.6 3.8 4.1 for Government 2.2 2.2 2.1 2.3 2.4 2.6 2.8 for SEs, and Others 7.7 7.7 7.8 8.4 8.9 9.4 9.6 Government Papers, <6 months 6.0 6.0 6.0 6.5 6.5 7.0 7.5 Preferred Credits,CBT,1-2 yrs 1.4 1.5 1.5 1.6 1.6 1.7 1.8 Priority Credits, DFIs,1-5 yrs 7.5 7.5 7.5 8.0 8.5 9.0 9.0 Commercial Credits, <6 mos 8.5 8.5 9.0 9.5 10.0 10.5 11.0 Domestic Debt; Shares (%) 100 100 100 100 100 100 100 Government Papers, <6 mos 13.7 13.1 11.8 11.6 12.5 14.5 14.2 Preferred Credits,CBT,1-2 yrs 69.0 69.2 70.0 69.5 69.1 67.7 67.1 Priority Credits, DFIs,1-5 yrs 13.5 14.3 14.2 14.2 13.8 13.4 13.2 Commercial Credits. <6 mos 3.8 3.4 4.0 4.7 4.6 4.5 5.6 For details see Annex V, Table 5-3 Financial Operations of the Public Sector: Government and SEs 105 5.23 The total interest charge on the domestic public debt was STI6.6 billion in Y, and increased to ST30.3 billion in Y4. Such a steep rise in the interest cost of the domestic debt was still manageable, considering that these interest charges amounted to a small proportion, only 6.5 percent of total federal expenditures in Y1, 10.3 percent in Y4, and 12.6 percent in Y7. This is the main reason why the government was not too concerned about incurring deficits, borrowings, and debt servicing costs. The interest cost as a proportion of federal revenue, however, was higher. It was 7.8 percent in Y1, increased to 12.9 percent in Y4, and to 20.6 percent in Y7. That is, for each Siwat of revenue, the government paid about 21 percent in interest obligations of domestic debt in Y7, though much lower than it had in preceding years. 5.24 This picture changes considerably when the Siwat counterpart of external debt servicing obligations are added. Since the government was the main borrower of the foreign M< loans, about 68 percent of the amortization and interest charge is appropriated to the government's fiscal accounts, while the remaining 32 percent is ascribed to SEs, since a good part of these external M< loans financed the SEs investment program. On that basis, the cost of servicing foreign M< obligations to the federal government was an estimated STI4.9 billion, rose to 23.7 billion in Y4, and then increased to ST41.5 billion in Y7. Thus, there was a nearly threefold increase in the foreign debt servicing cost. While this increase occurred in part because of an increase in the external M< debt, the major cause of the increase was the devaluation of the Siwat and a consequent increase in the counterpart liabilities. 5.25 When these debt servicing costs on the external debt are combined with the costs of the domestic debt, the total debt servicing cost to the federal government increases significantly. In Y1, these total costs were ST31.5 billion amounting to 14.9 percent of federal revenues. In Y4, these costs increased to 54.0 billion, amounting to 23.0 percent of revenues. By Y7, total debt service charges rose to ST98.4 billion, 35 percent of total revenues. Therefore, on the revenue side, there was a significant 106 Macro-Financial Review: Policy and Program Formulation impact, as the amount of total debt service increased by more than three times, and the proportion of these costs in total revenues more than doubled over the review period. On the expenditure side, however, the total cost of debt servicing was still not a deterrent in financial terms. These costs were 12.4 percent of total expenditures in Yj; thereafter increased to 18.3 percent in Y4, and finally to about 21.7 percent of total expenditures in Y7. On the revenue side, the burden was not negligible, since for each Siwat of revenue the government had to pay about one-fourth to one-third in service charges during the Y5-Y7 years. If the arrears are also included, together with a slowdown in the roll-over of domestic liabilities, the implicit burden of debt servicing could have amounted to about 45 percent of revenues. But as matters stood, the debt servicing burdens of both the domestic and foreign liabilities were not an insurmountable constraint for the federal government in local currency, as long as the CBT was willing to charge these debts, especially the preferred credits, as an 'extra- ordinary' item on its balance sheet. Therein lies another reason why the government and the CBT perceived the Y6-Y7 crisis as mainly a financial phenomenon, originating from external illiquidity, rather than a structural macro-financial imbalance. Yet these imbalances existed. 5.26 The demand for domestic financial resources by the public sector during the Y5-Y7 years, arose at a time when the private sector needed as much financial resources as it could get to tide over increased operating costs, loss of sales, and operating revenues owing to severe austerity measures and restructuring needs caused by a revamped incentive regime and major shifts in relative prices. Since the mid-years of the review period, this pattern has been very much in evidence. For a full measure of this shift of both the financial and real resources from the private sector to public sector, the analysis of financial system credit flows at the aggregate level, and detailed discussion of the mechanism and the policy regime governing the operations of the financial systems which facilitated this transfer, see Chapter VI. Financial Operations ofthe Public Sector, Government and SEs 107 Fiscal Operations of the Government 5.27 To evaluate the fiscal operations of the federal government we need to look at three items in some detail: revenues, expenditures and transfers to DFIs and SEs. Apart from the transfers, the destabilizing trend came from the expenditure side, while revenue levels held fairly steady throughout the period. During YI-Y7, revenues increased at an average annual rate of 4.5 percent, but the growth in expenditures was twice as fast at 10.1 percent per year. In the early part of the review period, YI-Y4, growth in revenues was 3.5 percent per year while expenditure growth was 5 percent per year. In contrast, during Y5-Y7, while growth in revenues was 5.9 percent, expenditures grew nearly three times faster at 16.8 percent per year (see Table 5.1, and Annex V Table 5-1). Alarmed by this, the government began to apply the brakes in Y7 and partially succeeded in restraining the expenditure growth, yet expenditures still grew by 16.2 percent in Y7 Likewise, transfers to DFIs increased fairly rapidly from 11.1 percent per year during Y1-Y4, and by 15.1 percent in Y5-Y7- The reason that the transfer to DFIs increased so rapidly was the pressure on the government to maintain the operations investment program of the SEs in spite of rapidly deteriorating federal finances. These transfers to the SEs were ST42 billion in Y1, increased to ST58 billion in Y4, finally rising to ST74 billion in Y7. Taken together, transfers to DFIs and the SEs were one-third of total revenues of the federal government in Y1, rising to 38.7 percent in Y4, and then steeply rising to 46.0 percent in Y7. 5.28 A detailed review of the underlying causes of these fiscal trends, which is not attempted here, would require an in-depth analysis of the revenue base and major expenditure categories: entitlements and defense. This would divert the focus of this case study from macro-financial aspects to fiscal aspects. Therefore, for the purposes of this exercise, the fiscal outcome is taken as given. It is linked to the credit operations of the CBT and the banking system to finance the resulting deficit and its implications for the private sector and the Tusanian economy. But to provide a flavor 108 Macro-Financial Review: Policy and Program Formulation Chart 5-4 Federal Deficit Fiscal Trends, Federal .....Revenues Expenditures 30 25 20 15 0 Y1 Y2 Y3 Y4 Y5 Y6 Y7 Financial Operations of the Public Sector: Government and SEs 109 of understanding, let us have a closer look at the Y7 federal budget and the underlying trends, followed by a summary of how the Tusanian government could possibly improve its fiscal operations. 5.29 The Tusanian government proposed a record budget for Y7. Revenues were projected to grow by 7.5 percent from ST260 billion in Y6 to ST280 billion as compared to average increases of 5.2 percent in the previous two years. This was to be accomplished essentially without change in tax rates or introduction of new taxes. The only change of the tax base was for the property tax following a new assessment in Y6. Apart from the effects of real GNP growth and inflation, continuing improvements in tax administration were expected to account for the remaining increase in revenues. On the expenditure side, alarmed by a 17.5 increase in Y6, the government proposed a 12.0 increase in Y7. This increase was still faster than the target rate of revenues but zero, if not negative, in real terms. The government nearly succeeded in its efforts, but by mid-Y7, the parliament got into action and increased the federal budget, added extra expenditures and stipulated a higher level of transfers to DFIs and SEs. This forced the government to borrow more from the CBT and to approve the DFI and SE operations, as though there were no financial crisis. Eventually the growth of expenditures declined slightly to 16.2 percent, still higher than the targeted budget rate of 12.0 percent. 5.30 The Tusanian annual programming exercise has a built-in lag of one year. That is, fiscal projections for Y7 were done in mid-Y6, using Y5 as a base year. As a result, total expenditures and transfers programmed for Y7 appeared fairly reasonable to those engaged in program formulation. That Y6 would turn out to be worse than Y5 could be anticipated, but not officially, as no government would admit in advance to a worsening financial situation. In a way, therefore, Y7 projections of expenditures were ceiling figures, a cap on growth of the government's outlays and investment program. Apart from the deliberate scaling down of expenditure plans, a reduction in 110 Macro-Financial Review: Policy and Program Formulation the investment program, and the hardest one politically, could not materialize. Rapid inflation in Y6 and Y7 did not help matters either. 5.31 The real failure in fiscal performance was on the revenue side, because for successful demand management a good deal of improvement on the fiscal side had to be anchored in raising revenues. In the economic situation of Y5-Y7, this was a challenge given the low tax base, the hardships already being experienced by the general public, and poor tax administration -the reasons put forth as hampering revenue-raising efforts. Yet, the argument can be made that Tusania's tax effort had been reasonable, since economic and fiscal studies have shown that Tusania had performed above the levels expected for a country of its size and economic structure. Revenues averaged around 16 percent of the GDP in the early years, though falling to 11.4 percent in Y5. However, in view of both the immediate needs for more public saving and Tusania's ambitious long-term investment plans, an increase in this ratio was needed. But the current level of fiscal deficit was the result of a tax system whose elasticity with respect to income was still relatively low. Even with recent improvements in tax administration, important tax revenue potential has not been touched or fully exploited. Tax collection rose in Y5 and Y6, though not so rapidly. This happened for several reasons: 1) a growing economy and price increases, 2) some of the monopoly revenues and taxes on imported goods deferred earlier were collected; and 3) an effort was made to improve tax collections involving: the expansion of offices and staff, provision of mobile tax collecting units, simplification of appeal procedures and tightening of collection procedures. This increase in tax revenue did not come from new levies or changes in the tax structure and no new tax charges were envisaged in the annual programs of Y6 and Y7. 5.32 Given that major gains in raising tax revenue were achieved through piecemeal efforts, tax specialists advocated that improvement in tax revenues would require the government to: Financial Operations ofthe Public Sector: Government and SEs Ill i. enlarge the coverage of the agricultural income tax and bring more of the larger units into the tax system. The target for Y6 was to cover 3 percent of larger units covering 20 percent of the cultivated areas, and the proposal for Y7 was to extend this to at least 7 percent of the units. ii. enlarge the coverage of the personal income tax (other than for agricultural income). iii. tighten up on exemptions to businesses for corporate taxes, have a quick one-shot increase, and to tighten up on reporting requirements for tax on income from corporate bonds. iv. increase the rates on property taxes and make independent checks of a sample of self-assessments. v. broaden the base of the production tax by applying it to more commodities, pending the introduction of indirect tax reform, possibly including the introduction of a value-added tax. vi. reduce exemptions on tariffs on imported capital goods, and consider increased tariffs on imported consumer goods and components for them. vii. to improve municipal government incomes and to pass a new law substantially increasing rates to cover inflation 5.33 These tax proposals could not be implemented in their entirety, though the government did take some actions concerning the property tax, deferrals, and exemptions. These efforts were inadequate, however, and resulted in federal deficits of the magnitude discussed earlier. Financial Operations of State Enterprises (SEs) 5.34 Preparing a consolidated financial position of SEs is a daunting challenge because even the federal government does not prepare these cQnsolidated accounts. The SE finances are subsumed under Ministerial or Departmental budgets, depending on their sector of operations, and thus are captured in federal fiscal accounts through 112 Macro-Financial Review: Policy and Program Formulation these Ministerial budgets. Besides, SEs do not follow uniform standards of accounting and reporting, therefore, simply adding up line items of the SE's financial statements may lead to meaningless aggregation. For example, the transfers that the SEs receive from the federal budget are not a direct transfer, rather an 'extra-budget' item and may be routed through a Special Fund at the Ministry or the sectoral DFI. There are several of these funds. Worse yet, the transfer may be subsumed under "Residual Funding," a line item in the Ministerial budget; or it may even be lumped under a "lending fund" maintained at the CBT or the DFIs. Likewise, since the SEs investment program is part of the Ministry or the Department's investment program, it may appear under sectoral investment as capital budget expenditures, participation, operating finance, or depreciation items. An evaluation of the SE's accounting procedures is not intended here. Rather, the point is that it will be very difficult to prepare a meaningful consolidated position of SEs finances, especially as a guide to pricing policies and macro-financial programming, until the MoF itself prepares a consolidated SE account by requiring the SEs to submit their financial statements directly to the MoF. 5.35 Given these imponderables, the SEs consolidated financial position is reported here on the basis of the aggregation of Ministerial or Departmental accounts. The overall size of the SE's deficit has already been discussed, inclusive of operational losses and investment, as a first approximation, and then including the federal transfers. That the SEs operational losses had been running high was widely known, but the size of it had always been in dispute. For example, total revenue of SEs in Y6 is estimated at ST87 billion, but the only breakdown available lists four of Financial Operations ofthe Public Sector: Government and SEs 113 Chart 5-5 Quasi Deficit; SEs Quasi Deficit, Trends Operational Losses SEs Revenue SEs Expenditure 40 35 30 25 20 15 10 5 0 Y1 Y2 Y3 Y4 Y5 Y6 Y7 114 Macro-Financial Review: Policy and Program Formulation the largest SEs covering railways, coal, electricity, and the Agricultural Production Office, which is not an SE, but a conglomeration of SEs engaged in the agricultural sector. Likewise, no direct estimate of SEs costs of operation is available, since a good part of the cost is covered by contribution in kind via allocation of materials and services, which may have been paid for by a different agency of the government. The expenditure estimates have been cobbled together on the basis of various financial reports of the SEs and ministries. These estimates show that the expansion of SEs expenditures started in Y3 and peaked in Y6 at 22.2 percent, followed by another 21.2 percent increase in Y7 after the government put restraints on these expenditures. The main reason for the increase in expenditures, besides the routine increase owing to the growth of operations, was inflation. As inflation gathered momentum, SEs lost control on the cost side, as wages and salaries and prices of raw materials and inputs kept rising, though not as fast as inflation. While the wages and salaries structure of the SEs and the public sector is not contractually indexed to inflation, the labor unions were able to command substantial increases in wages, together with employee benefits, to prevent erosion of their real income. 5.36 Given the major increases in operational losses, in Y6 the government announced a package of SE price increases ranging between 7.0 percent to 18.0 percent for Y7. At the time of preparation of the Y7 Annual Program, the MoF was not in a position to quantify the sum total of the impact on revenues. It was expected that the growth of revenues would nearly double to about 12.0 percent, as compared to about 5 or 6 percent per year in the previous couple years. As it turned out, revenue growth in Y7 was 8.0 percent, higher than 6.1 percent the previous year. Clearly, if the government is to impose financial discipline on the SEs, the implementation machinery has to be strengthened, otherwise price increases by themselves are no guarantee to reduce operational losses, as was the case in Y7. 5.37 The most difficult category of expenditures to assess concerns investment by SEs. The enterprises need investment finance to cover increases in stocks and in Financial Operations ofthe Public Sector: Government and SEs 115 working capital and participations, as well as for fixed investment. Sources of financing include the surplus on government operations, transfers from the general budget, DFI's regular loans, special funds, foreign project credits and other loans, e.g. suppliers' credits, and credit from the banking system. Since total permitted credit from the banking system is fixed by the macro-financial program to maintain real growth and price increases are set as part of the MoF fiscal program, SE's fixed investment is the residual item which must adjust to the available financing. While this is the case on the financing side, the government sets targets for investment, based on an assessment of production capacity sector-by-sector in quantitative terms. These are later used by the Ministry of Industry in granting approvals and license both to the SEs and the private sector for establishing manufacturing units. Clearly, there was significant growth in SEs investment as estimated here from ST42 billion in Y] to ST102 billion in Y7, increasing around 16 percent per year during Y1-Y7. This provided for real increases despite inflation, at least in the early period. But the largest increase in investment appears to have occurred during Y5-Y7 when the SEs investment increased by 25.3 percent in spite of financial difficulties all around. 5.38 If the government were to keep SEs finances within reasonable limits, then SE's investment needs had to be brought in line as part of the macro-financial program, and SEs access to credit needed to be curtailed and closely monitored. The SEs extensively borrowed domestically from the banking system as well as overseas with the federal government's guarantee. These eventually became the government's liability, both on external and domestic accounts, as the SEs were unable to service these obligations from their own sources,. The SEs had also accumulated substantial arrears, both on their routine operations and on loans, as only a small portion of the amount due was paid during the years Y6 and Y7. Part of the arrears were rolled over by the banking system, but these liabilities added to the burden of the public sector finances and pre-empted private sector access to the financial system, with disastrous consequences for productive sectors, as discussed in Chapter VII. 116 Macro-Financial Review: Policy and Program Formulation ANNEX V - Exhibit 1 The analysis of government finances requires the aggregation of data on financial operations as shown in Exhibit 1. But this refers to the fiscal operations of the federal government only, which is the largest part of the total public sector finances. Using a similar approach, fiscal operations of the provincial and local governments can also be prepared and merged together under the category of government fiscal accounts to arrive at the Federal Deficit. Next step is to determine the net financed balances of the SEs and other agencies who depend on government finances, federal and local, to arrive at the quasi-fiscal deficit. The sum of government's fiscal deficit and the quasi-fiscal deficit, mainly on SEs accounts, provides the total public sector deficit. The analysis of the size and composition of the public sector deficit is critical to the formulation of macro-financial program. FINANCIAL OPERATIONS OF THE GOVERNMENT REVENUE EXPENDITURES Tax Revenues Current Expenditures Direct Taxes Defense Income tax Administrative Wealth/Capital gain tax Social Services and Entitlements Other direct taxes Interest Expenses on Borrowed Funds - Indirect Taxes Capital Expenditure Sales tax, VAT Investments by Sector Custom duties Other indirect taxes Non-Tax Revenues DEFICIT/SURPLUS.....(-/+) FINANCING (of deficit through) Foreign Borrowing (net, drawing less repayments) From Official Sources (bilateral, multilateral) From Private Sources (foreign banks...) Domestic borrowing (net) Central Bank (Currency issues, Credits, Cash Balances) Banking System (bills, certificates, credits) Non-Bank Public (bills, certificates) Other Funds RATIOS Revenue/GDP Ratio Deficit/GDP Ratio Expenditure/GDP Ratio Financial Operations of the Public Sector: Government and SEs 117 ANNEX V Table 5-1 Financing Public Sector Deficits: (1 of2) Government, State Enterprises (SEs) Y, Y2 Y3 Y4 YS Y6 Y7 (,SJ billions, end of period) Public Sector Deficit 185 206 232 269 328 427 552 Federal Deficit 112 123 134 151 183 236 304 Revenues 212 219 226 235 246 260 276 Expenditures 255 264 275 295 332 390 453 Transfers to DFIs (net) 27 31 34 37 40 44 53 Transfers to SEs, Other (net) 42 47 51 54 57 62 74 Quasi Deficit; SEs 73 83 98 118 145 191 248 Investment 42 47 52 58 65 80 102 Operational Losses,SEs 31 36 46 60 80 111 146 SEs Revenue 67 70 74 78 82 87 94 SEs Expenditure 98 106 120 138 162 198 240 Financed by: Domestic Borrowings 168 185 209 239 281 383 486 Foreign Borrowings 5 6 6 7 10 11 15 Arrears and Others 12 15 17 23 37 33 51 Total Financing 185 206 232 269 328 427 552 Total Financing 185 206 232 269 328 427 552 Memo Items Domestic Borrowings 168 185 209 239 281 383 486 Government borrowings: from 108f 110 113 12 1T 3 T 23 7242 Central Bank 90 91 90 96 112 182 224 ComBanks 18 19 23 24 27 21 18 Qausi-govt borrowings:from 160 -75 96 19 147 1 244 ComBanks 8 12 16 20 23 39 50 Central Bank 12 17 22 25 34 54 72 DFIs 28 37 44 53 60 72 94 Others 12 9 14 21 25 15 28 Annual Growth Rates(% Public Sector Deficit 9.5 11.4 12.6 15.9 21.9 30.2 29.3 Federal Deficit 8.3 9.8 8.9 12.7 21.2 29.0 28.8 Revenues 3.0 3.3 3.2 4.0 4.7 5.7 6.2 Expenditures 3.2 3.5 4.2 7.3 12.5 17.5 16.2 Quasi Deficit; SEs 9.6 13.7 18.1 20.4 22.9 31.7 29.8 Investment 10.4 11.9 10.6 11.5 12.1 23.1 27.5 Operational Losses 12.1 16.1 27.8 30.4 33.3 38.8 31.5 SEs Revenue 4.1 4.5 5.7 5.4 5.1 6.1 8.0 SEs Expenditure 7.2 8.2 13.2 15.0 17.4 22.2 21.2 Shares, Ratios (%) Federal Deficit/Total Deficit 60.5 59.7 57.8 56.1 55.8 55.3 55.1 Quasi Deficit/Total Deficit 39.5 40.3 42.2 43.9 44.2 44.7 44.9 Transfers/Revenues 32.5 35.6 37.6 38.7 39.4 40.8 46.0 Transfers/Total Deficit 37.3 37.9 36.6 33.8 29.6 24.8 23.0 1 J~ Macro-Financial Review: Policy and Program Formulation ANNEX V Table 5-1 Financing Public Sector Deficits: (2 of 2) Government, State Enterprises (SEs) Y, Y2 Y3 1 Y4 Y5 Y6 Y7 (S7 bdhlions, en of period) Ratios of GDP Public Sector Deficit /GDP 14.5 14.6 14.7 14.9 15.3 16.4 18.3 Federal Deficit 8 8-7 8. 8.4 8. 9.1 10.1 Revenues 16.6 15.5 14.3 13.0 11.4 10.0 9.2 Expenditures 19.9 18.7 17.5 16.3 15.4 15.0 15.0 Quasi Deficit, SEs 5.7 5.9 62 6. 7 7.3 8.2 Investment 3.3 3.3 3.3 3.2 3.0 3.1 3.4 Operational Losses 2.4 2.5 2.9 3.3 3.7 4.3 4.9 SEs Revenue 5.2 5.0 4.7 4.3 3.8 3.3 3.1 SEs Expenditure 7.7 7.5 7.6 7.6 7.5 7.6 8.0 GDP (current) 1280 143 1575 186 2149 2604 3T1 Average Annual Growth Rates YI-Y7 YI-Y4 Y4-Y7 Y5-Y7 Public Sector Deficit 20o 13.3% 27.1% 29.7% Federal Deficit 181% 03% 2-6.3 28n9% Revenues 4.5% 3.5% 5.5% 5.9% Expenditures 10.1% 5.0% 15.4% 16.8% Transfers to DFIs (net) 11.9% 11.1% 12.7% 15.1% Transfers to SEs, Other (net) 9.9% 8.7% 11.1%_ 3.9T% Quasi Deficit, SEs 22.6% 17.4% 28.1 0.8Fo% Investment 15.9% 11.4% 20.7% 25.3% Operational Losses 729.5 24.6% 34.5% 35.1% SEs Revenue 5.8% 5.2% 6.4% 7.1% SEs Expenditure 16.1% 12.1% 20.3% 21.7% Financed by: Domestic Borrowings 19.4% 12.5% 26.7% 31.5% Foreign Borrowings 20.1% 11.9% 28.9% 22.5% Arrears and Others 27.3% 24.2% 30.4% 17.4% Total Financing 20./% 13TT 27.T 297% Government borrowings: from 14.4% |3.6% 26.3% 31.9% Central Bank 16.4% 22% 3.6o 41.4% ComBanks 0.0% 10.1% -9.1% -18.4% Quasi-govt borrowings: from 26.3% 25.6% _27.0 n1.T%- ComBanks 35.7% 35.7% 35.7% 47.4% Central Bank 34.8% 27.7% 42.3% 45.5% DFIs 22.4% 23.7% 21.0% 25.2% Others 15.2% 20.5% 10.1% 5.8%__ Financial Operations ofthe Public Sector: Government and SEs 119 ANNEX V Table 5-2 Domestic Borrowing Operations: (1 of2) Government, State Enterprises (SEs) Y, Y 2 1Y3 1Y, Ys Y, Y, (ST7 bd7ons, end of period) Total Deficit 185 206 232 269 328 427 552 Federal Deficit 112 94 183 236 304 Quasi Deficit; SEs 73 83 98 118 145 191 2 Financed by: Domestic Borrowings 168 185 209 239 281 383 486 Foreign Borrowings 5 6 6 7 10 11 15 Arrears and Others 72 15- 17 723 37 -33 -51 Domestic Borrowings 168 185 209 239 281 383 486 Government borrowings 108 110 113 120 139 203 242 SEs and Others' borrowings 60- 7 96 T9 742 180 244 Lending to Public Sector 168 185 209 239 281 383 486 by: Central Bank 102 10 1 121 146 236 296 by: Commercial Banks 26 31 39 44 50 60 68 by: DFIs 28 37 44 53 60 72 94 by: Others 12 9 14 21 25 15 28 Borrowing Instruments 168 185, 209 239 281 383 486 Govt Papers, <6 months 73 82 89 102 131 174 198 Preferred Credits, CBT, 1-2 years 41 35 37 40 40 77 126 Priority Credits, DFIs,1-5 years 28 37 44 53 60 72 94 Commercial Credits, <6 months 26 31 39 44 50 60 68 Borrowing Costs (amounts) 9.3 10.9 12.7 15.7 19.3 26.3 33.1 for Government 4.9 5.3 5.7 6.9 8.6 12.7 15.6 for SEs, and Others 4.4 5.6 7 8.8 10.7 13.6 17.5 Govt Papers, <6 months 4.4 4.9 5.3 6.6 8.5 12.2 14.9 Preferred Credits, CBT, 1-2 years 0.6 0.5 0.6 0.6 0.6 1.3 2.3 Priority Credits, DFIs,1-5 years 2.1 2.8 3.3 4.2 5.1 6.5 8.5 Commercial Credits, <6 months 2.2 2.6 3.5 4.2 5 6.3 7.5 Average cost (Rate, %) 5.5 5.9 6.1 6.6 6.9 6.9 6.8 for Government 4.5 4.8 5 5.8 6.2 6.3 6.4 for SEs, and Others 7.3 7.4 7.3 7.4 7.5 7.5 7.2 Govt Papers, <6 months 6 6 6 6.5 6.5 7 7.5 Preferred Credits, CBT, 1-2 years 1.4 1.5 1.5 1.6 1.6 1.7 1.8 Priority Credits, DFIs,1-5 years 7.5 7.5 7.51 8 8.5 9 9 Commercial Credits, <6 months 8.5 8.5 9 9.5 10 10.5 11 Prime Rate 9.0 9.0 9.5 10.0 10.7 11.7 12.2 120 Macro-Financial Review: Policy and Program Formulation ANNEX V Table 5-2 Domestic Borrowing Operations: (2 of 2) Government, State Enterprises (SEs) Memo Items YI Y2 3Y I , Y Y (23 btions, end o period) Instruments; Share(%) 100 100 100 100 100 100 100 Government Papers, <6 months 43.45 44.32 -42.58 42.68 46.62 45.43 40.74 Preferred Credits, CBT, 1-2 years 24.4 1892 -77 1674 T4.23 -20.1 2. Priority Credits, DFIs,1-5 years 16.67 20 21.05 22.18 21.35 18.8 19.34 Commercial Credits, <6 months 15.48 16.76 18.66 18.41 17.79 15.67 13.99 Average Annual Growth Rates Total Public Deficit 20.0% 13.3% 27.1% 29.7%1 Federal Deficit 18.1% 10.5% 26.3% 28.9% Quasi Deficit; SEs 22.6% 17.4% 28.1% 30.8% Financed by: Domestic Borrowmgs . 194% 12.% 26.7% 1 Foreign Borrowings 20.W 11.9% 28.% 22.o Domestic Borrowings Governmentborrowings 14.4% 3.6% 26.3% 31.9% SEs borrowings 26.3% 25.6% 27.0% 31.1% Borrowing Instruments 19.4% 12.5% 26.7% 31.5% Government Papers 18.1% 11.8% 24.7% 22.9% Preferred Credits, CBT 20.6% -0.8% 46.6% 77.5% Priority Credits, DFIs 22.4% 23.7% 21.0% 25.2% Commercial Credits 17.4% 19.2% 15.6% 16.6% Costs of Borrowings 23.6% 19.2% 28.2% 31.0%_ Government Papers 22.6% 14.8% 30.8% 32.1% Preferred Credits, CBT 25.7% 3.7% 52.5% 88.2% Priority Credits, DFIs 26.1% 26.4% 25.9% 28.8% Commercial Credits 22.5% 23.7% 21.4% 22.3% for Government 21.3% 12.1% 31.2% 34.7% for SEs, and Others 26.0% 26.3% 25.7% 28.0% Financial Operations of the Public Sector: Government and SEs 121 ANNEX V Table 5-3 Domestic Debt Public Sector: Government, State Enterprises (SEs) Y, Y Y Ys Y 6 Y1 (S7 bions, end of period) Domestic Debt Outstanding 533 624 754 878 1044 1203 1398 Government Papers, <6 months 7 82 9 102 131 174 198 Preferred Credits, CBT, 1-2 years 368 43T -528 610 721 814 93V Priority Credits, DFIs,1-5 years 72 89 107 125 144 161 184 Commercial Credits, <6 months 20 21 30 41 48 54 78 Domestic Debt Servicing costs 16.63 19.86 299 30.29 37.09 4618 56.7 Government Papers, <6 months 4.4 4.9 5.3 6.6 8.5 12.2 14.9 Preferred Credits, CBT, 1-2 years 5.2 6.5 7.9 9.8 11.5 13.8 16.9 Priority Credits, DFIs,1-5 years 5.4 6.7 8.0 10.0 12.2 14.5 16.6 Commercial Credits, <6 months . T 1.V -7./ -.9 4. 3.7 8.6 Domestic Debt Servicing costs as per cent ot revenue 7.8 9.1 10.6 12.9 15.1 17.8 20.6 as per cent of expenditures . 1.5 8. 10.3 112 11.8 12.6 Revenues, ST billions 212 219 226 235 246 260 276 Expenditures, ST billions 255 264 275 295 332-2 390 453 External debt serivce M<,$ 273 302 338 371 415 451 484 Official Exchange Rate 80 83 87 94 102 110 126 External debt serivce M<,ST 21.8 25.1 29.4 34.9 42.3 49.6 61.0 of this: 68% federal 14.9 17.0 20.0 23.7 28.8 33.7 41.5 Total Debt Servicing costs 31.5 36.9 44 54 65.9 79.9 98.4 Domestic Debt Servicing costs 16.6 19.9 24 30.3 37.1 46.2 56.9 Foreign Debt Servicing costs 14.9 17 20 23.7 28.8 33.7 41.5 as per cent of revenue 14.9 16.8 19.5 23.0 26.8 30.7 35.7 as per cent of expenditures 12.4 14.0 16.0 18.3 19.8 20.5 21.7 Average cost (Rate, %) 3.1 3.2 3.2 3.4 3.6 3.8 4.1 for Government 2.2 2.2 2.1 2.3 2.4 2.6 2.8 for SEs, and Others 7.7 7.7 7.8 8.4 8.9 9.4 9.6 Government Papers, <6 months 6.0 6.0 6.0 6.5 6.5 7.0 7.5 Preferred Credits, CBT, 1-2 years 1.4 1.5 1.5 1.6 1.6 1.7 1.8 Priority Credits, DFIs,1-5 years 7.5 7.5 7.5 8.0 8.5 9.0 9.0 Commercial Credits, <6 months 8.5 8.5 9.0 9.5 10.0 10.5 11.0 Domestic Debt; Shares (%) 100 100 100 100 100 100 100 Government Papers, <6 months 13.7 13.14 11.8 11.62 12.55T 14.46 14.16 Preferred Credits, CBT, 1-2 years 69.0 69.2 70.0 69.5 69.1 67.7 67.1 Priority Credits, DFIs,1-5 years 13.5 14.3 14.2 14.2 13.8 13.4 13.2 Commercial Credits, <6 months 3.8 3.4 4.0 4.7 4.6 4.5 5.6 CHAPTER VI MACRO- FINANCIAL MANAGEMENT 6.1 In the absence of a well functioning money market, the government and the CBT normally have relied on direct instruments of monetary control to contain aggregate demand, which remains the cardinal feature of the Tusanian demand management to this today. ' There were some belated attempts to use indirect instruments of monetary control, but these attempts were not effective. Further, whatever indirect controls were operative, they simply could not cope with the recurring monetary instability, the dimensions of financial imbalances, and the pressures on the exchange rate and price levels. Given the size of public sector deficits and domestic borrowings, the government preempted the market mechanism to ensure that financial resources be available to the public sector both in the required magnitudes and at costs well below market level. Additionally, the system of direct controls discussed in Chapter VII, together with a system of interventions led to significant financial repression and segmentation over the years, and the financial system was heavily taxed. The CBT, in most cases, for macro-financial management purposes, had no choice except to resort to direct controls on monetary magnitudes during the crisis years. These mechanisms of control worked chiefly through the financial operations of the banking system, stipulated by the CBT, and mainly affected the commercial banks. The DFIs played an increasing role, but mainly on the lending side and credit supply to the SEs and priority sectors, and not so much on the containment of monetary expansion. 123 124 Macro-Financial Review: Policy and Program Formulation 6.2 Historically, the routine controls on monetary growth have not been particularly effective for Tusania. In formulating short-run monetary policy as a demand management policy tool, the Tusanian monetary authorities regard money supply, broad money and domestic credit as the most relevant intermediate target variables in order to achieve a set of predetermined macroeconomic objectives. At the beginning of each year, monetary authorities determine target rates of growth of these aggregates on the basis of expected developments of the economy in the coming year. They choose a rate of expansion of the money supply consistent with a desirable rate of inflation and a rate of GDP growth set by the government in its annual program. Once the target rate of the expansion of money supply is set, then authorities determine the rate of growth of bank credit to ensure an optimum increase in the money supply on the basis of expected changes in foreign reserve holdings and government borrowing from the financial system. 6.3 This approach, however, does not allow for any casual linkage between money and real output on the one hand, and for money and the balance payments on the other. Money may be neutral in the long-run, but it certainly affects real income, the balance of payments, and the price level through a variety of channels in the short run. Disregarding these casual linkages in formulating monetary policy leads to unrealistic estimates of the target rates of expansion of the monetary variables and produces destabilizing effects. Above all, the degrees of freedom available to the CBT in the conduct of monetary policy are limited because the government's fiscal policy, especially expenditure policy, overrides monetary policy except during the crisis years when the adherence to an economic program became imperative. Then, fiscal controls simply could not provide the leverage to contain the aggregate demand. 6.4 Since domestic credit expansion is pivotal to monetary growth, the CBT sets credit ceilings to control the rate of domestic credit growth for the banking system, both at the aggregate and institution level. This ceiling is expressed in terms of a Macro Financial Management 125 percentage increase in bank credit over the preceding year's level. The CBT enforces the credit expansion by requiring the banks to submit a monthly report on their loan activities and by imposing penalties when they fail to observe the ceiling (for details, see Chapter VII). Enforcement of these ceilings has been difficult, and even when the CBT succeeds in enforcing them, direct credit control does not necessarily enable CBT to meet the target rates of growth of the money and the broad money supply. For example, unexpected changes in the balance of payments or the government's budgetary operations could easily frustrate the CBTs efforts to control the money supply. While this happened in the crisis years of Y5-Y7, such changes may not affect the credit ceiling management. If the money supply is the relevant intermediate variable as a gauge of the direction of monetary policy, the direct credit control has not been as effective an instrument of control as it has appeared. 6.5 In view of these limitations, the CBT is left with the alternative of controlling the money supply by regulating liquidity levels, the reserve base, and other direct measures. Since the liquidity and cash reserve ratios are less effective as policy instruments, the CBT cannot easily control either the money multiplier or the reserve base. The reserve base in Tusania has been generated by the monetization of government debt and foreign exchange holdings during the fixed exchange rate regime and even after partial deregulation in late years. Until then, monetary authorities had no way of preventing the monetary consequences of balance of payments deficits unless they resorted to direct controls over the foreign trade regime, which is what happened in the early review period. Subsequently, during the late review period, with the devaluation of the Siwat, the managed foreign exchange auction system, and a liberalized foreign trade regime, the CBT still found it difficult to control monetary magnitudes as it had no control over the government's fiscal operations and was obliged to accommodate fiscal deficits. Under these circumstances, the CBT could not easily control the growth of mdhetary magnitudes. 126 Macro-Financial Review: Policy and Program Formulation 6.6 There is sufficient evidence that financial deepening in Tusania is close to the average levels observed in most developing countries with a per capita GNP of $870, and it has remained stable. The indicator of financial depth - the ratio of M, and M2 to GNP - was around 19 percent of GDP throughout the review period. In an economy such as Tusania's, financial deepening hinges more upon the speed and level of monetization of economic activities. An improved financial system can foster greater mobilization of resources and monetary authorities can help the process by 1) removing segmentation of financial markets and, by 2) promoting diversification of financial instruments, thus enhancing financial deepening. But this would only occur provided that positive real interest rates and monetary stability are maintained for sufficiently long periods. This did not happen in Tusania. When real interest rates did turn positive, it happened in an environment of monetary instability and speculative behavior as witnessed during the YS-Y7 period. 6.7 In Tusania, owing to the low and rather rigid interest rate structure, which per force leads to credit rationing, the cost of borrowing remained an inoperative monetary policy tool. Instead, direct measures at banking credit and liquidity control were the most frequently used instruments of monetary management, as discussed later in this Chapter. Banking institutions in Tusania seldom advance consumer loans. They basically finance trade, working capital, and, to some extent, fixed investments. This pattern of lending implies that liquidity constraints of the banking system have little impact on consumer spending. For that matter, monetary policy instruments cannot regulate consumer outlays. But monetary instruments do affect trade financing, working capital and fixed investment outlays, and liquidity controls affect private investment and borrowing from the banking system. They thus have a greater impact on production and employment. The government, however, as a major investor in Tusania, unlike the private sector, is not subject to the liquidity constraint as it has access to borrowings from CBT. It readily exercises this privilege, while the SEs have monopoly access to DFIs and also to the CBT. This pattern of access to credit, combined with the government's command over real resources owing to its Macro Financial Management 127 monopoly power to create money - seigniorage - almost guarantees the passivity of monetary controls to government's fiscal operations. Further, since the money market is rudimentary and is dominated by short-term government papers with below market rates and yields, interest rates are not much of a constraint to government borrowings from the financial system, either. The indirect instruments of monetary control, therefore, are neutral with respect to a large part of aggregate money demand, and the burden of adjustment is disproportionately borne by market-based components affecting the private sector. Interest Rate and Price Trends 6.8 Interest rates in Tusania have been regulated throughout, but attempts were made at partial deregulation during Y5-Y7. At the same time, there was a segmentation in the rate structure as applicable to the private and public sectors. For a long period, interest rates were kept fairly low both on the deposits and loans of the banking system. In particular, lending rates were subsidized for the public sector and on SE borrowings from the DFIs and CBT. The rate structure was intended more as a mechanism for allocating banking credit between private and public sector borrowers and among various uses of credit within each category of borrower. In general, both the deposit and lending rates for the financial operations of the public sector were generally lower than prevailing market rates effective for the private sector. Lending rates to the priority sector borrowers were clearly subsidized, regardless of whether the loans originated from the CBT, the DFIs, or the commercial banks. This overlapping system of segmentation in the interest rate structure contributed to financial repression, and the resulting distortions reinforced distortions of the incentive regime in the real sectors. Even after deregulation, the government tried, though unsuccessfully, to control interest rates. It stipulated that the spread between the deposit rate and the prime rate would not be more than 5.0 percent, and that the difference between the prime rate and the maximum lending rate would not be more than 2.5 percent. In practice, these guidelines could not be adhered to. 128 Macro-Financial Review: Policy and Program Formulation Table 6.1 Price and Interest Rates Annual Indicators Average Annual Growth Rates YJ Y4 Y6 Y7 Y1 -Y7 Y1 -Y4 Y5-Y7 (per cent) (per cent) Prices, Annual Increase Cost of Living 9.1 15.6 24.5 22.4 17.7 12.9 23.4 Food Prices 6.0 11.7 18.1 16.1 13.0 9.5 17.1 Wholesale Prices 7.3 12.9 19.3 18.2 14.4 10.6 18.7 GDP deflator 6.0 11.6 19.7 15.3 12.9 8.9 17.5 Interest Rates (per cent) CBT Lending Rates T-Bills Rediscount 6.0 6.5 7.0 7.5 Medium-Term Credits 8.0 8.5 9.5 9.5 Priority Credits 7.5 8.0 9.0 9.0 Banking System Lending Rates General Rate - Overdrafts 9.5 10.5 12.5 13.0 Short-term credits 11.0 12.5 14.5 15.0 Medium-term Credits 12.0 13.0 16.0 16.5 Inter-bank call money 14.0 16.5 18.5 19.0 Prime Rate 9.0 10.0 11.7 12.2 Banking System Deposit Rates Savings Accounts 0 - 3 months 2.5 3.0 3.5 3.5 3 - 6 months 3.0 3.5 4.5 4.5 6-12 months 4.0 4.5 5.5 5.5 For details see Annex VI, Table 6-1 The banking system found ways to circumvent restrictions through an elaborate system of fees and charges, which effectively raised the cost of borrowing to the private sector beyond the posted rates. The public sector was insulated from these practices and hence enjoyed not only preferential access to credit but also a lower cost of borrowing due to this segmentation in the rate structure. Macro Financial Management 129 6.9 Interest rates remained fairly stable in the early part of the review period. Toward the end of Y4 it was clear that the CBT would have to allow the peg rate - the rate of rediscount on treasury bills - to increase, given the monetary expansion and intensifying inflation. The CBT rediscount rate ranged between 6-6.5 percent during Y1-Y5, was raised to 7 percent in Y,, and to 7.5 percent in Y7. Thus, there was a substantial increase in the rediscount rate during Y6-Y7 and, as a result, the entire rate structure both on the lending and deposit side shifted upwards. The CBT raised its lending rates on priority credits from 7.5 percent during YJ-Y3 to 8 percent in Y4, to 8.5 percent in Y5 and to 9 percent during Y6-Y7. These rates were applicable on the bulk of CBT credit to public-sector borrowers. Likewise, the CBT raised the interest rates on medium term credits, keeping the same differential between the rediscount rate and its lending rates to the public sector. The lending rates of the banking system increased even faster, from the range of 9.5-12.5 percent prevailing during YJ-Y4, and to 12.5-16.5 percent during Y6-Y7. Since the bulk of the banking system's lending is in overdrafts of 3 months, the interest rate on overdrafts is regarded as a peg rate for commercial loans. It increased from 9.5 percent during YJ-Y2 to 10.5 percent in Y4, gradually increasing to 13 percent in Y7. In contrast, the inter-bank call money rate increased from 14 percent during YI-Y2, to 16.5 percent in Y4, jumped to 18.5 percent by Y6, and to 19 percent by Y7. This is because inter-bank' borrowing in Tusania is used mostly to shore up liquidity and to avoid CBT penalties. It is the most expensive type of borrowing and is normally done as a last resort. The prime rate of the banking system is the lowest-cost borrowing since it is applicable to well-established corporate borrowers and ranged from 9.0 percent during Y-Y3 to about 12.0 percent during Y6-Y7. 6.10 This shift in the rate structure on the lending side was not matched by a similar shift in the rate structure on the deposit side. Short-term deposit rates increased from around 2.5-3.0 percent during Yi -Y4, to 3.5-4.5 percent during Y5- Y7, with a noticeable increase in the rate on money market CDs. The bulk of the deposits of the banking system, however, were not affected by the shift in the interest 130 Macro-Financial Review: Policy and Program Formulation rates. Demand deposits rarely carry any interest and short-term savings deposits have the lowest interest rate in the entire banking system. The savings deposits of the banking system are a small proportion of total deposits and deposits of a maturity longer than a year or fixed maturity deposits are even smaller. Therefore, the general shift in the interest rate structure that occurred during Y5-Y7, especially on the lending side, did not have much impact on the deposit side. The maximum range of deposit rates was 3.5-5.5 percent during Y6-Y7, at a time when lending rates were significantly higher, and it was well below the rate of rediscount on T-bills. The general increase in interest rates on the lending side was not accompanied by a strong inducement to savers. In fact, when these interest rate trends were juxtaposed with price trends, as shown in Chart 6-1, the resulting negative real rates on deposits may have intensified preferences for current expenditures over savings. This further added to aggregate demand pressures and compounded the difficulties in the task of monetary control. 6.11 The price level came under pressure during Y4-Y5 - the mid years. Until then, inflation as measured by cost of living increase, the consumer price index (CPI), was tolerable. The CPI increased at the average annual rate of 12.9 percent during Y1-Y4, but this average rate does not adequately convey the pressures on the price level. These pressures began to emerge in Y4 when inflation was 15.6 percent. During the first half of Y2, inflation gathered momentum. By Y5, the CPI had jumped to 21.3 percent, nearly double the rate prevailing in early years. In Y6 the CPI rose by 24.5 percent, and in Y7 when some brakes were applied, the CPI still managed to rise by 22.4 percent. Food prices also increased substantially during Y5- Y7, but through an elaborate system of controls and subsidies on strategic consumer items and food staples, the rate of food price increases was kept to around 17 percent per annum during Y,-Y7, still double the rate of early years. These price increases were accompanied by substantial upward pressures on wages and salaries but despite labor union actions and widespread unrest, the fixed income groups - mainly the salary and wage earners and pensioners - saw a significant erosion of their real Macro Financial Management 131 Chart 6-1 Cost of Living Prices and T-Bills Rediscount Interest Rates General Rate - Overdrafts Prime Rate 25 20 15 10 5 0 YI Y2 Y3 Y4 Y5 Y6 Y7 132 Macro-Financial Review: Policy and Program Formulation incomes and purchasing power. The lower wage earning groups were hit specially hard, and in the absence of a social safety net, except for subsidies on food items, their relative position worsened. This caused widespread unrest and opposition to the belt-tightening measures being advocated by the government in Y7. 6.12 The swift rise in the general price level during Y4-Y7 cannot be explained in terms of growth of money supply and banking credit alone. The root cause of inflation was continued public sector spending without a parallel increase in revenues, either through taxes or the SE's pricing structure. The growth of monetary magnitudes, especially credit to public sector on the financing side, was the major source of this excess demand. Likewise, depreciation of the Siwat, both in the parallel and official markets, was widely perceived as a destabilizing factor "causing" price increases as each devaluation was immediately translated into a rise in the price of imported items. This was invariably followed by a rise in the general price level. To begin with, however, devaluation occurred because Tusanian inflation was much higher than that of its major trading partners. The partial devaluations generated a self-sustaining speculative cycle that fed on the slide of the Siwat, first in the parallel market, and then in the formal market. This led to a massive turnover of funds both in the official and parallel markets, thus siphoning off banking credit to finance speculation and starving the real sectors of liquidity and credit. It was only in the late part of the crisis years that these inter-links became more vivid as speculative activities intensified. 6.13 Given these price trends, if one compares the interest rates of the banking system on the lending side and the general price level, real lending rates were positive, though barely, during the early years. As inflation gathered momentum, the rigidities of the system did not allow for adjustments and real interest rates turned negative. In general, adjustments in interest rates during inflationary periods lag behind unless the authorities take firm actions to bring the peg rate - the rediscount rate of the Central bank - at par, or in exceptional circumstances, ahead of the rate of Mfacro Financial Management 133 inflation. But when price increases are substantial, as they were in Tusania during the crisis years, it is almost impossible for authorities to bring about a big jump in interest rates within a short period. Therefore, real interest rates almost invariably turn negative. Besides, in times of rapid inflation like this, it is far from clear why the authorities must always attempt to maintain positive interest rates. As a long- term policy, positive real interest rates are desired, but it is not possible to have the entire interest rate structure shift or move in tandem with inflation, albeit with a lag. In this sense, Tusania's situation was no exception. Worse yet, the lending rates of the CBT were raised but not by enough of a margin, and therefore the real cost of borrowing to its customers in the public sector declined with inflation. This encouraged a perverse behavior in the public sector, i.e. to increase outlays at a time when the exigencies of demand management and control of inflation required just the opposite - a reduction in public sector outlays. The CBT's lending rates for priority sectors were 7.5 percent during YI-Y3, reasonably close to the rate of inflation. As inflation accelerated to above 20 percent during Y5-Y7, these CBT lending rates were raised to 8.5-9.0 percent, far below the rates of inflation. Thus, CBT lending rates in real terms became negative by a wide margin. 6.14 In contrast, the lending rates of the banking system were higher than, or on a par with, the rate of inflation during Y1-Y3, especially for commercial banks, both for short- and medium-term credits. During the mid-review years, however, these lending rates also began to fall behind the rate of inflation. During Y5-Y7, the rates were lower by about 8 percent, leading to negative real rates during the crisis year, and thus compounding the difficulties of monetary controls on credit expansion. For example, the interest rate on overdrafts was below the rate of inflation during Y1-Y3, but reasonably close. Later on, it increased to 11.5-13 percent during Y5-Y7, but the inflation rate outstripped this gradual increase by a wide margin. The lending rates of commercial banks for short- and medium-term credit were slightly higher than the overdraft rates, but followed the same pattern. The lending rate to prime borrowers of the banks was 9.3 percent during Y1-Y3, increased to 10.3 percent during Y4-Y5, 134 Macro-Financial Review: Policy and Program Formulation and then to 11.5 percent to 12.0 percent in Y6-Y7, well below the rate of inflation throughout the period. This is not to suggest that negativity of the real rate of interest must always immediately be compensated for, and in full. Besides, this is an almost impossible task for monetary authorities and not necessarily a prudent course of action. If the negativity coincides with speculative behavior, however, and banking credit is diverted to finance speculative activities, especially in the foreign exchange market, the pressures on exchange rate and price level are intensified, as happened in Tusania. Further, routine business borrowings of a short-term nature have more to do with a comfortable cash-flow and good business outlook. If they coincide with lower or negative real costs, all the better from a purely business point of view, but this also induces spending and intensifies inflation. 6.15 More or less similar trends prevailed on the deposit side with substantially negative real rates during the Y5-Y7 period. Although the deposit rates rose to 3.5-4.5 percent on short-term deposits and 5.5 percent on longer term deposits during Y5-Y7, deposit rates in real terms remained substantially negative throughout these years, adversely affecting deposit growth. It is true that several factors besides the real interest rate affect financial savings such as real income, attitudes towards thrift, and expectations. In an economy like Tusania, rapid inflation did exert a downward pressure on the private propensity to save through creating a relative price effect, making current consumption favorable over future consumption. Further, as happened in Tusania, having reached a plateau, consumption may not decline commensurably to the loss of real income, in spite of efforts to control spending through a whole range of direct controls. When these factors are combined with the inadequacy of policy measures, price and interest rate trends do adversely affect financial savings. 6.16 Clearly then, the interest rate policy of the government failed a§ a major anti- inflationary tool during the crisis years. The authorities felt that since there had been a substantial rise in interest rates and that the interest rate structure both on deposits Macro Financial Management 135 and lending had shifted upwards, that there was no room for a further increase in interest rates without choking-off economic activity thereby causing a deeper recession. No government could afford this in the midst of what was perceived essentially as a foreign liquidity crisis, rather than a deeper financial and economic malaise with roots extending well beyond the crisis years. The only recourse left to the Tusanian authorities was to impose strict price controls to stem rising inflation and to resist price increases of the SEs. Price controls were imposed on strategic food items, pharmaceuticals, oil and petroleum products, and essential consumer items. This led to a thriving curb-market for these items. State-owned stores were soon emptied, long lines formed, and protests erupted, while the media displayed the hardships suffered by veterans and the elderly. This public display of the government's failure, made it even more difficult to adhere to fiscal discipline, impose financial accountability on the SEs, and control monetary growth in face of rising inflation. Monetary growth 6.17 Monetary growth during the early part of the review period YI-Y4 was high but stable. Growth, however, quickly gathered momentum during Y5 and became volatile during Y6-Y7. The CBT had little success in controlling the rate of expansion of monetary aggregates. Reserve money, the source of money supply and liquidity expansion, increased by 10.6 percent per year during YI-Y4 During Y5-Y7 the average annual growth was 21.6 percent, nearly double the rate of growth during the first half of the review period. This pattern was common to all monetary aggregates. The money supply growth rates were similar to those of reserve money, though there were some differences in the pattern of growth of the components. During YI-Y4, the growth of currency was 10.1 percent per year, but during Y5-Y7, the rate of currency expansion was 21.1 percent per year. Consequently, the rate of growth of MI during Y5 -Y7 was nearly double the rate of the early part of the review period. There was a 136 Macro-Financial Review: Policy and Program Formulation Table 6.2 Monetary Survey Annual Indicators Average Annual Growth Rates YI Y4 Y6 Y7 Y1-Y7 Y1-Y4 Yr-7 (ST billions) (per cent) Money supply (MI) 251 338 490 587 15.2 10.4 21.0 Currency 116 155 221 267 14.9 10.1 21.1 Demand deposits 135 183 269 320 15.5 10.7 20.9 Quasi Money 64 97 129 145 .14.6 14.9 13.8 M2=MI+QuasiMoney 315 435 619 732 15.1 11.4 19.5 Total Deposits: FinSystem 199 280 398 465 15.2 12.1 18.5 Total BankSys Deposits 191 269 384 439 14.9 12.1 17.3 ComBanks Deposits 184 255 365 417 14.6 11.5 16.9 Annual Growth Rates (%) M, 6.8 13.4 22.2 19.8 Money Supply (M2) 8.9 13.9 20.7 18.3 Currency 8.2 12.3 21.4 20.8 Demand Deposits 7.1 14.4 22.8 19.0 Quasi Money 11.4 15.5 15.2 12.4 Reserve Money 8.4 14.6 21.1 22.2 15.5 10.6 21.6 BanSys Deposits 4 20.0 20.0 14.8 16.3 12.9 17.4 Deposits of FinSystem 8.7 14.8 20.2 16.8 BankSys Deposits 9.3 14.5 20.4 14.3 ComBanks Deposits 9.1 13.8 19.7 14.2 Shares, Ratios (%1) Mi / GDP 19.6 18.7 18.8 19.5 M2 / GDP 24.6 24.1 23.8 24.3 Currency / GDP 9.1 8.6 8.5 8.9 For details see Annex VI, Table 6-2 substantial expansion in quasi-money, but its growth during Yi-Y4 was 14.9 percent per year, much higher than that of MI, and during Y5-Y7 the growth was 13.8 percent per year, lower than that of Mi growth. This is attributed to a shift in deposit patterns from interest-bearing deposit instruments to more liquid deposits, owing to accelerating inflation and the higher liquidity requirements of both businesses and Macro Financial Management 137 Chart 6-2 Money supply (M I) Growth of Currency Monetary Aggregates Demand Deposits Quasi Money SReserve Money 25 20 I1.5 10 5 0 _ YI Y2 Y3 Y4 Y5 Y6 '7 138 Macro-Financial Review: Policy and Program Formulation households. As a result, the rate of growth of M2 increased from 11.4 percent in Y 1. Y4 to 19.5 percent during Y5-Y7. 6.18 There were several reasons for large monetary growth during Y5-Y7 The main factors included substantial growth in public sector deficits financed by the borrowing from CBT and the banking system, short-term inflows of CDs, and other foreign funds treated as net additions to foreign assets in so far as these represented foreign currency deposits of the CBT with overseas banks. In fact, these were short- term foreign external debt liabilities of Tusania lodged with the CBT. To analyze both of these items, we need to have a closer look at the CBT's financial operations. The major item on the asset side of the balance sheet is the net domestic credit extended by the CBT. It had substantial growth during Y5-Y7 at 34.6 percent per year as compared to 9.1 percent growth per year during Yi-Y4. This was the major factor in monetary expansion. The net foreign assets as reported by the CBT showed a major increase from ST9 billion in Y, to ST23 billion in Y4 and then to ST54 billion in Y7. This is already discussed in Chapter IV concerning the pattern of inflows of foreign currency deposits (fCDs) which continued to increase in the early years, and subsequently reversed the trend. CBT accounts do not fully capture these trends because they exclude foreign arrears that began to build up, first slowly, and then substantially during the crisis years. The uncovered counterpart of these short-term foreign liabilities began to appear in Y4 estimated at STI3 billion, increased to ST43 billion in Y5, then further increased to ST99 billion in Y6 and to STI 10 billion in Y7. The sheer size of these liabilities, as reported by foreign creditors, have a serious implication for the CBT's balance sheet. If fully accounted for, the CBT's net foreign assets as reported should be substantially negative. These liabilities have to be covered in some fashion through flows of financial resources to the CBT, either domestically from the rest of the financial system, or from abroad. That the CBT engaged in these transfers is clear, representing the reverse of sterilization of foreign fund inflows, since these uncovered foreign arrears were not Macro Financial Management 139 Table 6.3 Summary Accounts, CBT Annual Indicators Average Annual Growth Rates Y, Y4 Y6 Y, Y1 -Y7 Y1 -Y4 Y5-Y7 (ST billions) (per cent) Total Assets 1M 220 349 432 18.1 11.4 29.1 Foreign Assets (Net) 9 23 43 54 34.8 36.7 29.9 CBTDomestic Credit (Net) 114 148 255 319 18.7 9.1 34.6 Public Sector 102 121 236 296 19.4 5.9 42.4 Government 90 96 182 224 16.4 2.2 41.4 SEs and Others 12 25 54 72 34.8 27.7 45.5 Others 12 27 19 23 11.5 31.0 -12.4 Total Liabilities 159 220 349 432 18.1 11.4 29.1 Currency 116 155 221 267 14.9 10.1 21.1 Reserves of ComBanks 25 36 54 62 16.3 12.9 17.4 Other Reserves 7 11 17 19 Other Liabilities 11 18 57 84 40.3 17.8 110.3 Reserve Money 139 188 270 330 BanSys Deposits 25 36 54 62 Currency, non-bank public .107 141 199 249 Reserves of other FinIns 7 11 17 19 Arrears and Reschedulings 0.0 18.8 154.8 177.6 Arrears Due (-) 0.0 13.0 99.0 110.0 Balance (new liabilities) 0.0 5.8 55.8 67.6 Annual Growth Rates (%) TotalAssets 9.2 14.6 34.7 23.8 Domestic Credit 6.1 10.4 44.9 25.1 To: Public Sector 3.6 8.0 61.6 25.4 Government 1 6.7 62.5 23.1 SEs and Others 28.3 13.6 58.8 33.3 Total Liabilities 9.2 14.6 34.7 23.8 Currency 8.5 12.3 21.4 20.8 Reserves of ComBanks 6 20.0 20.0 14.8 For details see Annex VI, Table 6-3 and Annex VII, Table 7-3 included in the government's accounts either. These arrears were mainly for balance of payments financing, though a small part of the short-term foreign borrowings 140 Macro-Financial Review: Policy and Program Formulation ended up financing public sector deficit, thereby contributing to domestic monetary expansion. 6.19 These foreign arrears, the foreign liabilities of CBT, have two parts. One is the counterpart of the fCDs mentioned above. The other consists of trade and external debt arrears, both in the public and private sectors. The Siwat value of fCD liabilities was around 44 billion in Y3. In Y4 nearly half of it was rolled over, but an additional ST21.9 billion was re-deposited in CBT accounts overseas. By mid-Y5, it was quite clear to the creditors that these fCDs could not be repatriated and ended up as the bulk of arrears of ST43 billion. In Y6 as the foreign exchange shortage turned into a liquidity crisis, trade financing credits and other external debt obligations also ended up as part of the arrears, even though they originated partly in the private sector. Eventually, Tusania had to request massive rescheduling to cover these arrears, and all these obligations ended up being sovereign obligations of the government. But the CBT did not report these obligations as liabilities on its accounts because a good portion were not CBT obligations, in the strict sense, and in any case had serious consequences for the CBT's own financial operations. 6.20 In purely economic terms, the flow of financial resources through the CBT to the public sector, whether of domestic or foreign origin, were provided at below- market cost and their costs are not fully captured. For example, on the liability side of the CBT, currency in circulation is nearly a zero-cost item. It increased from STI 16 billion in Yi to ST267 billion in Y7 at the average rate of 14.9 percent per year, much of it occurring during Y5-Y7. The reserves and deposits of the banking system with CBT likewise increased from ST25 billion in Yj to ST62 billion in Y7, and again much of the deposits carry zero-interest cost to the CBT. Banks are allowed to keep 40 percent of their reserves in treasury bills. Because the treasury bill rate had been substantially below the market interest rate, the go'vemment was able to obtain financing at a rate well below market cost from the banking system. Later on, the government issued stabilization securities, and the CBT made it Macro Financial Management ]41 mandatory for commercial banks to hold these securities as part of the liquidity requirement, over and above the reserve requirements. Since these stabilization securities carried a rate closer to T-bills, again, the amount held in the represented securities forced lending by the banking system to the government through the CBT. Since these short-term instruments are the liability of the government, and not of the CBT, the reserves and other deposits of the banking system with CBT, offered below market-cost resources to the public sector, and led to a substantial monetary expansion. Monetary Control Mechanism 6.21 In the normal course of events, the CBT, like any other monetary authority, does have an array of policy instruments at its disposal. These are: open market operations, interest rates, liquidity and cash reserve ratios, stabilization directives, and a roster of direct controls over banking system credit. Among these instruments, the CBT almost exclusively relies on direct credit and liquidity controls to influence the rate of growth of money and other monetary variables instead of indirect instruments operating through money and capital market mechanisms. Direct measures to control liquidity expansion in times of swift inflation are, however, an exception rather than the rule. They are inadequate to provide the brakes needed on monetary expansion, and worse yet, lead to an adverse impact on those segments of the economy unable to pay the premia to secure sufficient credit for their operations. Open Market Operations (OMO) 6.22 In Tusania, open market operations (OMO) are not important and have not been important in controlling monetary aggregates for several reasons - principally the absence of a well-functioning money market. The CBT, however, buys and sells government securities to raise funds for the government and to service government debt. But given the limited size of the market, and since the government controls the 142 Macro-Financial Review: Policy and Program Formulation return on government securities of various types, the investors - households or institutions - are reluctant to hold them. In many cases, potential investors do not have access to some of these markets. The buying and selling of all government papers is done by the CBT through designated banks only, for amounts as stipulated by the government, and at discount rates determined by the government and the CBT. Thus, the CBT finds itself in the unenviable position of stipulating quantity, price, timing, and buying and selling terms of government securities. A large part of the government securities, such as treasury bills and certificates, is held by the financial institutions for liquidity reasons, maintaining the required reserve ratio, or because holding of the securities is declared mandatory by the CBT on behalf of the government, amounting to forced lending. As far as the financial institutions are concerned, such an operation is equivalent to an increase in liquidity, cash, or reserve ratios because the banking institutions have no choice but to hold these securities. Since these securities are fully backed by the government and are practically risk-free assets, financial institutions hold them partly for portfolio reasons even though the return is below market levels. This asset preference, however, is diluted in times of tight liquidity. For those financial institutions who would like to sell their holding of these securities, their only recourse is the rediscount window of CBT. Therefore, the CBT in effect acts as the last-resort buyer and has to accommodate secondary transactions originating from the financial institutions. The CBT, rather than the market, has the initiative in the purchase or sale of securities through sales contracts or repurchase agreements, since there is hardly any active secondary market. 6.23 The CBT does change, though rather infrequently, the rediscount rate. Since the interest rate structure was kept at unrealistically low levels, a change in the treasury bill rate alone had no noticeable effect on the supply of money and bank credit, except as indicating the intention of authorities in their future monetary policy operations. In view of these factors, open market operations in government securities in Tusania are neither open nor market-based. To label the sale and purchase of the securities by the CBT as OMOs is a misnomer. The size of the market for T-bills and Macro Financial Management 143 other government papers has remained fairly small and secondary markets could not be developed. Therefore, OMOs are unlikely to be an important factor. Likewise, the legal and institutional settings embedded in the structure of the Tusanian financial system do not facilitate open market operations. Reserve Requirements 6.24 In Tusania, reserve requirements are mainly applicable to commercial banks, though the banking law stipulates that all the financial institutions, including DFIs, engaged in the lending business, should be subjected to compliance. The DFIs, since they are not deposit-money banks and mainly serve the public sector, are exempt from this obligation, as are non-bank financial institutions. The reason for this segmentation is that the CBT regards reserve requirements mainly as a monetary policy tool rather than as a part of a safety-net mechanism to ensure the solvency of financial institutions. The CBT operates a fractional reserve requirement computed for a 30-day accounting period on liquid and near-liquid liabilities of the commercial banks - mostly demand deposits, time deposits, and savings deposits lodged with the banking system. This amounts to about 85 percent of the total deposit liabilities of the commercial bank, and is called the reserve requirements (RR) base. The required reserves are classified into primary reserves, consisting of deposits with the central bank, and secondary reserves, consisting of eligible assets such as T-bills - up to 40 percent of the required reserves. The banks, however, maintain excess reserves to ensure that their inter-bank and inter-branch accounts are covered for clearance and settlement purposes, and to avoid penalties. The banks do not normally keep free reserves, nor do they maintain borrowed reserves. Thus, most of the reserves are held in compliance with reserve requirements, along with some excess reserves in sufficient amounts for settlement and clearance through the Tusanian payment system for inter-bank accounts. 144 Macro-Financial Review: Policy and Program Formulation 6.25 The impact of the reserve requirements on Tusanian commercial banks is to increase their financial intermediation costs, since reserve deposits with CBT do not earn any interest. Commercial banks would prefer to hold reserves in interest-bearing instruments. The banks also argue that these requirements should be imposed on the DFIs as well as on those financial institutions who compete with the banks in lending business, since the lack of these requirements confers upon these institutions an edge in the credit market. In periods of rising interest rates, the costs of the reserves becomes more binding. That is, the main reason for the CBT to use them is as an instrument to limit monetary expansion. 6.26 For a considerable time, throughout the early years of the review period, the CBT maintained a reserve requirement of 20 percent for the deposit-money banks, mainly the commercial banks, and some DFIs, such as the Savings Bank and the Tusanian National Bank. The commercial banks as a group, however, maintained about 4 percent more as excess reserves, thus the actual reserve ratio during Yi-Y3 was around 24 percent. In Y4 the reserve requirements were raised to 22 percent, and in Y5 to 23 percent, a level that prevailed through Y6. In Y7 , the required reserve ratio was again raised to 24 percent. Each time the ratio was raised, the actual reserve ratio increased by about another 4 percent to account for the excess reserves. Thus during Y5-Y7, the actual reserve ratio was around 27 percent of the liquid and near-liquid liabilities of the commercial banks, amounting to about 85 percent of all the deposit liabilities in a given year. 6.27 On this basis, the total reserves maintained by the banking system were ST37 billion in Y1, rose to ST55 billion in Y4, further increased to ST82 billion in Y6, and to ST96 billion in Y7. Since 40 percent of the required reserve amount could be kept in T-bills, the actual reserves deposited with CBT in non-interest bearing accounts were ST25 billion in Y1, rising to ST36 billion in Y4, with a sharp increase to ST54 billion in Y6 and ST62 billion in Y7. Since the increase in the reserve requirements coincided with an increase in the T-bill rediscount rate, followed by an upward shift Macro Financial Management 145 Table 6.4 Reserve Requirements Annual Indicators Yz Y2 Y3 Y4 Y5 Y6 Y7 (per cent) Required Reserve Ratio (RR) 20.0 20.0 20.0 22.0 23.0 23.0 24.0 Actual Reserve Ratio of 23.7 23.7 23.9 25.8 26.9 26.9 27.3 ComBanks (ST billions) Deposit Liabilities of 184 202 224 255 305 365 417 ComBanks RR Base -85% 156 169 188 213 253 305 348 Required Reserves (amounts) 31 34 38 47 58 70 84 of which 40% T-Bills 12 14 15 19 23 28 33 R-Deposit with CBT 19 20 23 28 35 42 50 Excess Reserve Deposit with 6 6 7 8 10 12 12 CBT Actual Reserves of 37 40 45 55 68 82 96 Commercial Banks of which: Deposited with CBT 25 26 30 36 45 54 62 Reserve of Other Banks 7 9 10 11 13 17 19 Total Reserves of BankSys 44 49 55 66 81 99 115 For details see Annex VI, Table 6-4 in the structure of lending rates, the banking system cost of loanable funds increased by the amount of the interest differential on the reserves deposited with CBT. These cost increases coincided with the tightening liquidity position of the commercial banks during late Y6, and by Y7 there was a noticeable impact on the growth of commercial bank credit to the private sector. 146 Macro-Financial Review: Policy and Program Formulation Liquidity Control 6.28 Direct controls of liquidity levels are an important feature of the monetary control system in Tusania. Traditionally the liquidity ratio in Tusania is more of a prudential instrument than an instrument for monetary control because it is not a statutory requirement and does not carry a penalty for non-compliance as does the reserve requirement. The liquidity ratio is defined as the ratio of short-term liquid and near-liquid assets to total deposit liabilities. This differs from the more standard type of liquidity ratio stipulated to compare assets and liabilities of roughly the same maturities. Besides, banks have to maintain sufficient levels of liquidity, anyway, to support their lending operations. Otherwise, the financial costs of being non-liquid are severe, starting with the very high costs of inter-bank borrowings - the call money rates discussed earlier. Therefore, Tusanian banks have typically maintained fairly high liquidity ratios, defined as the ratio of liquid and near liquid assets to total deposit liabilities. These assets consist of vault cash, T-bills held both in lieu of reserve requirements and as portfolio balances, the net inter-bank call money position, reserve deposits with CBT, and other short-term near liquid assets like Treasury Certificates and commercial bills of exchange of less than 30 days. In this sense, the liquidity ratio in Tusania is a composite of the cash ratio, the reserve ratio, and some additional liquidity to safeguard against unexpected increases in cash obligations emerging from the payments system or unforeseen losses to the banks. The ratio of cash to demand deposits for Tusanian banks remained fairly comfortable through the review period, ranging between 7-8 percent, depending on the size of the bank, with higher ratios for larger banks. This range of cash ratio is close to the cash ratios observed in the banking systems of countries similar to Tusania. However, since this ratio is based on the vault cash of commercial banks and demand deposits, rather than total liquid and near-liquid liabilities of the banks, it does not fully capture system-wide needs of hard liquidity. Nonetheless, even with these exclusions, changes in the cash ratio affect credit creation in broadly the same manner as changes in a standard reserve requirement, even though it is not part of the required reserves. Macro Financial Management 147 Table 6.5 Liquidity of Commercial Banks Annual Indicators YJ Y2 3 4 5 6 7 (ST billions) Total Assets of ComBanks 237 272 311 347 403 461 527 Total Liquid Assets 66 73 84 101 120 146 143 Cash in Vault 9 10 12 14 17 22 18 Total T-bills 18 21 22 28 31 37 37 Balances with CBT 25 26 30 36 45 54 62 Others 14 16 20 23 27 33 26 ComBank Deposit Liabilities 184 202 224 255 305 365 417 (per cent) Liquidity and other Ratios Liquidity Ratio (LR) 35.9 36.1 37.5 39.6 39.3 40.0 34.3 Cash R on all Deposits 4.9 5.0 5.4 5.5 5.6 6.0 4.3 Cash R on DDs only 7.3 7.5 8.2 8.5 8.5 8.8 6.3 Liquidity net of RR 15.8 16.3 17.4 18.0 17.0 17.5 11.3 Liquid Assets/Total Assets 27.8 26.8 27.0 29.1 29.8 31.7 27.1 Annual Growth Rates Cash in Vault 11.1 20.0 16.7 21.4 29.4 -18.2 Total T-bills 16.7 4.8 27.3 10.7 19.4 0.0 Balances with CBT 4.0 15.4 20.0 25.0 20.0 14.8 For details see Annex VI, Table 6-5 6.29 The liquidity ratio is estimated by Tusanian banks in two different ways. As a composite ratio of all liquid and near-liquid assets - including cash and reserves with the CBT - to total deposit liabilities. This liquidity ratio ranged from 36 percent in Yi to a high of 39.6 percent in Y4, rising to 40 percent in Y6, and then decreasing to 34.3 percent in Y7. But in effect, the banks separate the reserve component, and calculate their liquidity net of reserve deposits with CBT and T-bills on the asset side. On the liability side, 85 percent of all the deposit liabilities are taken as the required liquidity base. This liquidity ratio, net of reserve requirements, provides the bank 148 Macro-Financial Review: Policy and Program Formulation with a better gauge of their liquidity position. This "net" liquidity ratio ranged between 16-17 percent through YI-Y6, and then dropped 11.3 percent in Y-,. 6.30 Given this system, the impact of changes in the liquidity ratio by itself was not significant. Banks have always maintained higher liquidity levels than needed, on top of cash and required reserves. Therefore, raising the composite liquidity ratio indirectly through reserve requirements did not serve the purpose of controlling inflation or reducing the pressure on exchange rates during the crisis years. The CBT, therefore, resorted to direct liquidity controls. In the first round, in late Y6, the CBT ordered the banking system to recall all loans secured through foreign currency collateral in overseas accounts. These loans were the major source of round-tripping in the parallel market by speculators who made large profits as the Siwat depreciated in the parallel market. However, this did not stop speculation and round-tripping. Therefore, in early Y7, the government froze all deposits of the public sector with the banking system, which traditionally were about 23 percent of the total deposits of the banking system. Such a large and sudden freeze created a liquidity squeeze and the inter-bank rate shot-up to 19 percent in Y7. This decision was aimed to stop the banks from using public-sector deposits to finance the speculative private sector borrowings, trade financing, and foreign exchange transactions. This was to induce the banks to reduce overdrafts and increase their efforts to mobilize deposits, or to cut back on their overall credit levels. 6.31 -In view of the experience of the early years and given the premia on being liquid on a routine basis in a financial system like Tusania, the banking system had built up substantial liquidity levels by Y5. In Y6 the CBT ordered banks to hold stabilization securities and proceeded forthwith to debit the accounts of banks holding large liquid funds. The rate offered on the stabilization securities was tied to Treasury Bills rate at around 7 percent. The CBT declared that the holdings of stabilization securities was mandatory. They were non-negotiable and non- transferable for a 90-day maturity period. In effect, it amounted to a forced transfer Macro Financial Management 149 of financial resources from the banking system to the public sector at below-market cost. The objectives of the policy were plausible, however, the implementation was not undertaken in an orderly manner; rather, in an abrupt fashion. The result was that a good number of banks, including some major ones, were caught in a liquidity crisis in late Y6 through early Y7. The CBT had no choice but to extend the required liquidity to those banks severely affected by these controls to prevent their collapse. During mid-Y7, the CBT extended credit facilities to these banks in difficult liquidity positions totaling ST40 billion, as lender of the last resort. Of these banks, two state commercial banks were not only illiquid but were also technically insolvent. 6.32 These direct liquidity control measures did have a noticeable impact during the early part of Y7 Commercial banks began to apply brakes on banking credit and intensified their loan recall on overdraft accounts. At the same time, commercial banks began pulling away from medium-term investment types of loans and started selling T-bills and other government papers in excess of their reserve requirements. As a result, bank's holdings of T-bills decreased from ST47 billion in Y6 to ST40 billion at the end of Y7. 6.33 These measures succeeded in dampening speculation, inflationary and exchange rate pressures. However, this was achieved at the great cost of starving the productive sector - the economically efficient borrowers - of banking credit. It allowed the less efficient borrowers, traders, speculators and the public sector, to ride out the crisis. With one hand, the government pulled out banking liquidity and credit from the system, and with the other hand, the government was forced to re-inject liquidity into the banking system. In the process, it further distorted credit allocation to the real sectors. The interest-rate increase prevented the productive sectors from sustaining their operations, as they could no longer afford new banking credit. Only the high turn-over businesses could afford access to banking credits. These trends did not help to revive an already sagging economy, and the entire burden of adjustment fell upon direct controls on credit, discussed in the next chapter. 150 Macro-Financial Review: Policy and Program Formulation ANNEX VI - Exhibit 1 MONETARY AGGREGATES MONEY SUPPLY (M) Currency in Circulation Demand Deposits QUASI MONEY (Time Deposits) MONEY SUPPLY (M2)=(M1 + QUASI MONEY) M3 =M2 + Other Liabilities of Deposit Banks RESERVE MONEY Currency in Circulation Reserve of Deposit Money Banks CREDIT TO DOMESTIC ECONOMY (Net) Private Sector Public Sector NET FOREIGN ASSETS Foreign Liabilities Foreign Assets RATIOS Mj/GDP M2/GDP M3/GDP (financial deepening) Currency/GDP Private Sector/Total Credit Public Sector/Total Credit TARGET RATES Money Supply (MI) Credit To Domestic Economy (Net) Private Sector Public Sector Macro Financial Management 151 ANNEX VI - Exhibit 2 ASSETS AND LIABILITIES OF THE CENTRAL BANK TOTAL ASSETS 1. Foreign Assets Gold Foreign exchange Holdings of SDR Contribution to IMF: Gold Foreign exchange SDR 2. Local Currency Contribution to IMF 3. Claims on Central Government Balance at provincial treasuries Treasury bills Government bonds Loans and rediscounts for OFCIs Coins in issue department 4. Claims on Private Financial Institutions Rediscounts Government bonds 5. Other assets TOTAL LIABILITIES 1. Notes in circulation 2. Deposits Central government Counterpart funds Private sector Commercial banks Government savings bank Others 3. Allocations of SDRs (IMF) 4. Liabilities to IMF 5. Bilateral swap arrangement (CB guarantees) 6. Capital accounts 7. Other liabilities 152 Macro-Financial Review: Policy and Program Formulation ANNEX V - Exhibit 3 LIQUIDITY OF COMMERCIAL BANKS TOTAL LIQUID ASSETS Vault cash Balances with Central Bank Inter-bank balances and call money (net) Treasury bills Treasury certificates Other liquid assets TOTAL DEPOSIT LIABILITIES LIQUID ASSETS (as percent of total deposit liabilities) Vault cash Balances with Central Bank Inter-bank balances and call money (net) Treasury bills Treasury certificates Other liquid assets Macro Financial Management 153 ANNEX VI Table 6-1 Prices and Interest Rates Y Y2 Y3 Y4 Y Y