## apdfea

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---

### Executive Summary — Overview and evidence
- Many central banks in emerging market and developing economies (EMDEs) used asset purchases to reduce financial stresses during the COVID-19 crisis; some used them to provide macroeconomic stimulus.
- EMDE asset purchase programs have been generally modest in size and implemented in the early months of the COVID crisis; data referenced cover March 2020–March 2021.
- Regression analysis based on event studies using high frequency data indicates these actions lowered bond yields significantly without exerting downward pressure on exchange rates (October 2020 GFSR; Fratto and others 2021; Arena and others 2021).

### Executive Summary — Key risks and motivations
- Asset purchase programs may raise concerns about heightened risks of fiscal dominance and debt monetization.
- Large government financing needs can catalyze pressure on central banks to expand balance sheets, which may lead to high inflation when deficits rise to high levels and the inflation–deficit relationship becomes highly nonlinear.
- Direct financing (primary market purchases, subsidized credit, or overdrafts) is distinct from secondary market purchases and poses greater risk of undermining central bank balance sheets, independence, and price stability.
- Even secondary market asset purchases can be monetized if central banks lack latitude to sterilize reserves by adjusting policy rates (e.g., by paying interest on reserves) or by selling assets.

### Executive Summary — Principles for designing asset purchase programs
- Central bank operational independence and latitude to adjust its policy rate; strong governance framework required.
- Purchases only on central bank’s own initiative and to help achieve mandated policy objectives.
- Scale of purchases (and, upon exit, sales) should be appropriate for achieving objectives; purchases should be at market prices with strong preference for secondary market operations.
- Central bank should ensure fiscal support to cover any losses associated with asset purchase programs to preserve financial autonomy and reduce risks to monetary independence.
- Distinguish between small-scale asset purchases (SSAPs) and large-scale asset purchases (LSAPs).

### Executive Summary — Small-Scale Asset Purchases (SSAPs)
- SSAPs: smaller scale, address dysfunction in specific markets in near-crisis or crisis situations.
- Temporary and small-scale purchases can improve market functioning — instrumental during COVID-19 crisis.
- Limited duration and modest scale reduce risks to central bank balance sheets and price stability.
- Experience with SSAPs in EMDEs remains limited; exit may pose challenges.

### Executive Summary — Large-Scale Asset Purchases (LSAPs)
- LSAPs: used for monetary policy accommodation; longer-term commitment to a large balance sheet; often target longer-maturity government bonds.
- Expose central banks to considerable maturity risk and possibly credit risk; appropriate only for central banks with high operational independence and credibility.
- A strong and sustainable fiscal position is a key prerequisite.
- Deploying LSAPs with weak public finances could:
  - Fuel investor concerns about fiscal dominance,
  - Increase vulnerability to capital outflow and exchange rate pressures,
  - Risk being counterproductive if coupled with poorly anchored inflation expectations, large unhedged foreign currency debt, or high external debt.

### Executive Summary — Direct financing: when justified and safeguards
- Preference for secondary market purchases remains, but limited direct financing may be justified if secondary market is poorly developed or market dysfunction is severe.
- Direct financing should be time-bound, very modest, disclosed transparently, pay at a minimum the central bank policy rate, and involve marketable securities.
- Overdraft facilities and subsidized primary financing can be consistent with price stability only if central bank retains latitude and balance sheet strength to implement policy rate decisions consistent with its mandate.
- Central banks must avoid signals that they will be prevented from raising policy rates or selling assets later, as that can lead to exchange rate collapse and high inflation.

### Executive Summary — Implementation and exit
- Purchases should normally occur in the secondary market to reduce balance sheet risks and avoid perceptions of fiscal dominance.
- Exit from SSAPs and LSAPs requires ability to adjust policy rates and to sell assets; lack of fiscal backing or political commitments to allow policy normalization can make exit difficult.
- Central banks should ensure clarity between short-term purchases and longer-term commitments to avoid conflating crisis support with monetary accommodation.

### Executive Summary — Conclusions and policy recommendations
- Asset purchases can be beneficial for EMDEs under some conditions:
  - To restore market functioning during stress (SSAPs) or, in very specific circumstances, to provide monetary accommodation (LSAPs).
- Core prerequisites:
  - Operational independence and policy credibility,
  - Purchases on central bank initiative at market prices,
  - Appropriately scaled purchases with clear exit plans,
  - Fiscal support for potential losses,
  - Strong preference for secondary market operations; any direct financing must be limited, transparent, and remuneration aligned with the policy rate.
- Given limited EMDE experience and substantial risks, considerable caution is required before deploying LSAPs; SSAPs are generally the lower-risk, first-best option for addressing market dysfunction.

---

### Introduction — Fiscal dominance: definitions and channels
- Fiscal dominance can materialize when:
  - Fiscal authority pushes central bank to keep policy rate below level consistent with price stability to reduce government borrowing costs.
  - Government forces central bank to provide direct credit at below-market interest rates and specifies amount to borrow.
  - Government confiscates central bank capital (transfer of FX reserves or distribution of unrealized profits).
- Governance weaknesses increasing fiscal dominance risk include political involvement in monetary policy decision-making, removing protections for central bank officials, or adding conflicting goals to the central bank remit.
- Historical note: Sweden’s Riksbank pressured to finance wartime expenditures in mid-18th century, leading to rapid price runups.

### Introduction — Limiting adjustment of policy rates
- Governments sometimes preclude central banks from raising interest rates needed for price stability because of budgetary/macro implications.
- Such constraints have led to large runups in inflation and unanchored expectations even in credible central banks (example: Johnson Administration pressure on US Fed in mid-1960s helped launch the Great Inflation).
- Constraining policy rate adjustment can create substantial inflationary pressure even with lean central bank balance sheets.
- Implication: strong institutional safeguards ensuring central bank independence are crucial.

### Introduction — Direct financing: forms, risks, and mitigants
- Forms: government overdraft, primary market purchases of government securities.
- Most emerging market central banks allow some direct financing for short-term borrowing; some use it extensively as a cash management tool.
- Risks depend on whether central bank initiates financing and on government dictates about amount and price.
- Contrast: secondary market purchases are central bank-initiated, at market prices, do not provide new funds to government.
- Conditions where direct financing may not cause monetary financing:
  - Central bank retains latitude to adjust policy rate and sterilize excess reserves (paying interest on excess reserves or adjusting liquidity operations).
- Why direct financing tends to undermine central bank performance:
  - Persistent direct financing weakens balance sheet, especially if large, long maturity, and concessional rates.
  - Weakened balance sheet reduces willingness/ability to raise rates needed for price stability.
  - Prolonged periods of lower return on assets than liabilities intensify risks to operational independence.
- Severe examples: Sudan, South Sudan, Venezuela, Zimbabwe—central bank credit to government resulted in triple-digit inflation and exchange rate collapse; Germany (early 1920s) and Hungary (post–World War II) cited for hyperinflation.
- Legal mitigants: treaties and constitutional prohibitions (example: EU Maastricht Treaty clause 104) act as a “speed bump”.

### Introduction — Forced remittances and government arrears
- Governments may force central banks to pay unrealized profits or sell FX at concessional rates, deteriorating central bank balance sheets.
- Government arrears can be perceived as contingent liabilities of central banks, creating expectations of eventual printing of money.
- Arrears are often ad hoc and non-transparent, complicating estimation and clearance.

### Introduction — Core principles linking asset purchases and monetary policy independence
- Central bank balance sheet actions can alleviate financial stress and provide stimulus, but require a strong institutional framework to minimize risks to independence and price stability.
- Core principles:
  - Central bank must retain ability to set and adjust effective policy rate.
  - Asset purchases should be voluntary, aligned with price and financial stability objectives, and reversible (central bank must be free to sell assets later).
  - Purchases should be at market prices; secondary market preferred.
  - Government financial position must be on a stable footing so central bank can hike rates if needed without jeopardizing government solvency.

### Introduction — Objectives of asset purchases and COVID evidence
- Primary objectives: improve market functioning during stress; support orderly market conditions and financial stability.
- SSAPs: targeted, limited in duration and scale; during COVID EMDE SSAPs were smaller and focused on government securities.
- Evidence: SSAPs successful in bringing down spiked longer-term bond yields (IMF October 2020 GFSR; Fratto and others 2021).
- Cautions: purchases must be in domestic bond market; longer-term risks include moral hazard and impeding market development.
- Note: central bank purchases of private sector securities not explored; these entail additional credit risk and political economy pressures.

---

### 1. Mar.–Aug. 2020 and 2. Sep. 2020–Mar. 2021 — Asset purchases and market functioning during COVID
- Initial emergency interventions restored market functioning; success likely facilitated by massive policy easing of AE central banks.
- EMDE asset purchase programs were mostly relatively small and often partly offset by other operations, so central bank balance sheets "have not expanded significantly."
- Offsetting operations included FX reserve sales and "operation twist" strategies (Brazil, India, Mexico).
- Primary market interventions can be justified where secondary market lacks depth and liquidity even in normal times; they can improve monetary transmission, support primary market functioning, and ease government funding pressures.
- Significant risks associated with funding government in primary market; further consideration signaled for Chapter 6.

### 1./2. — Monetary easing through LSAPs
- LSAPs (QE): ongoing purchases of government bonds (and often private assets) to lower yields on longer-term government bonds and risky assets; purchases in secondary markets at market prices.
- Literature shows asset purchases depress yields on longer-term government bonds and risky assets, and boost output and inflation via reducing term premiums and signaling prolonged accommodation.
- Conditions where attractive for EMDEs:
  - Low equilibrium real interest rate and low inflationary pressure, or exhausted conventional policy space.
  - Benefits: reduce interest costs for private/public borrowers; free government funding for temporary expenditures (vaccination programs, support to low-income households and SMEs).
- Limitations for EMDEs:
  - Benefits probably diminished relative to AEs; aggregate demand less sensitive to longer-term yields; forward guidance less effective due to limited credibility.
  - Passthrough to household and corporate borrowing costs likely lower.
  - LSAPs can weaken market functioning and entail substantial risks; should be used only with:
    - Very solid fiscal fundamentals,
    - Strong governance and entrenched central bank independence,
    - Inflation expectations anchored at or below target.
- Key risk: LSAPs shorten effective maturity of consolidated public debt, increasing central bank maturity risk; purchasing long-term bonds at low yields can later cause substantial deterioration in central bank earnings if rates rise, potentially impeding timely tightening and anchoring of inflation expectations.

### 1./2. — Governance, transparency, and prudential stance
- Program design features that improve viability:
  - Strong initial fiscal position.
  - High degree of central bank independence and perceived latitude to raise interest rates even if this worsens central bank and government finances.
  - Conducting purchases in the secondary market to allay perceptions of fiscal dominance and reduce balance sheet hits.
- Transparency: clear communication about design and exit conditions—conditioned on achieving monetary policy objectives—can mitigate perceptions of fiscal dominance.
- Typical prudential stance:
  - EMDEs with policy rates well above zero should not use LSAPs for macroeconomic stimulus; conventional tools should be used until policy rates approach zero.
  - LSAPs are less agile and may require large and persistent balance sheet expansions to match a modest policy rate cut; exit is more difficult and costs/risks significant.
- Integrated toolkit: combining conventional monetary policy with tools (foreign exchange intervention, capital flow management in some circumstances) can improve monetary autonomy.

### 1./2. — Minimizing risks to price stability
- AE experience shows LSAPs do not necessarily lead to high inflation, but AEs have long-standing credibility and reserve-currency issuer status, reducing vulnerability to capital outflows and exchange rate pressures.
- EMDEs face greater risks of capital outflows, exchange rate pressures, and inflationary responses requiring tightening, diminishing prospective stimulus from LSAPs.
- Recommended program scale and structure for EMDEs:
  - Adopt smaller scale than AEs to limit maturity and balance sheet risks.
  - Prefer "quantity-based" programs over "price-based" programs (yield curve caps) because price-based programs can compel unlimited purchases and undermine balance-sheet control.
  - Strong public finances are important prerequisite for larger-size programs.
- Need for further analysis of transmission channels, benefits, risks, and multilateral implications (exchange rates, capital flows, global asset prices), especially for larger EMDEs or groups of EMDEs.

### 1./2. — Primary purchases and overdrafts: design and mitigation
- Primary market purchases:
  - May be infeasible in sizeable amounts if secondary markets are underdeveloped; limited short-period primary purchases may be warranted in severe stress.
  - Central bank should purchase only marketable government debt; keep maturities short (example: "3–12 months") to be self-liquidating and facilitate exit.
- Overdraft finance:
  - Day-to-day use at government's discretion provides a more direct path to fiscal dominance than primary purchases unless strong limits exist.
  - Complementary steps to minimize risks:
    - Remuneration should be "at or above the central bank’s monetary policy rate."
    - Any overdraft should be modest in size; many central bank laws set maximum overdraft amounts often specified as a percentage of government revenue.

---

### Annex 2 — Central Bank Overdraft Facilities (examples of limits)
- Purpose: overdraft should be a short-term cash management buffer rather than long-term financing.
- Appropriate rate: standing credit facility rate somewhat above monetary policy rate; in practice deposit rate or policy rate often used.
- Key legal and operational limits commonly applied:
  - Limit financing to a proportion of estimated revenue for the fiscal year or average revenue for the three immediately preceding fiscal years; limit usually between 5 and 12 percent of the revenue base.
  - Repayment within a short time frame; legislation often mandates drawings must be repaid by end of current fiscal year (or specified short maximum repayment period).
  - Repayment in reserve money from current revenues or by selling securities at market-determined rates; avoid repayment by placing long-term low-yield securities that de-capitalize the central bank.
  - Transparency: publish information on overdraft use and rate of remuneration promptly.
- Context matters: where history of fiscal dominance exists, formal legal limits may be insufficient; central banks may refuse to provide overdraft finance even if legally permissible.

### Annex 2 — Specific provisions and examples
- Limits on central bank financing often set between 5 and 12 percent of the revenue base; examples of central banks applying such limits include Banco de México, Bank of Canada, Bank of Malaysia, Central Bank of Kenya, Central Bank of Morocco, Bank of Albania, Bank of Botswana, Bank of Japan.
- Fixed nominal amount example: Bank of Israel.
- Securities purchased in primary issues may be included in overall CB financing limit (Bank of Malaysia, Bank of Albania).
- Maximum allowable tenor examples: 91 days, 120 days, 150 days, 6 months (Banco de México, Central Bank of Morocco, Bank of Israel, Bank of Canada).
- Maximum repayment period and interest provisions:
  - Loans must be repaid before end of first quarter in fiscal year after loan contracted (Bank of Canada, Bank of Brazil, Bank of Malaysia).
  - Loans collateralized by debt securities with maximum maturity and bearing interest at market rates (Bank of Albania, Bank of Canada, Central Bank of Kenya).
  - Interest rates set by monetary policy committee or applicable refinancing rate (Bank of Korea, Central Bank of Morocco).
- Context, approvals, currency, and disclosure:
  - Emergency declaration (war or natural disaster) required for central bank financing in some jurisdictions (Central Bank of Dominican Republic, Central Bank of Chile).
  - Loans may require central bank board approval, written loan agreements, or Parliamentary approval (Bank of Albania, Central Bank of Brazil, Banco de México, Bank of Korea).
  - Breach of legal limits often requires reporting to Parliament and published remedies (Bank of Albania, Bank of Botswana).
  - Central bank publishes information on investments in government securities in monthly balance sheet (Bank of Canada).
  - Loans typically made only in domestic currency (Bank of Albania).

### Annex 2 — Operational practice and risks
- UK example (April 2020): Treasury and Bank of England announced potential use of government’s overdraft (Ways & Means) account; government pledged weekly publication of usage data and clarity on remuneration rate; no change to remit of Debt Management Office.
- Risks:
  - Repayment via long-term low-yield securities can de-capitalize central bank and impair mandate achievement.
  - Absent strict limits and transparency, overdrafts can open door to uncontrolled direct credit (example referenced: Egypt in 2011).

### Annex 2 — Conclusions and guidance
- Overdrafts should be constrained by clear legal limits on amount, tenor, interest rate, and approval procedures.
- Require prompt transparency and disclosure on usage and remuneration rates to reduce market concerns and abuse.
- Ensure repayment is in reserve money from current revenues or market-rate securities to avoid weakening central bank balance sheets.
- Maintain central bank independence in the decision to initiate overdraft use; legal permissibility alone may not justify use where credibility and history of fiscal dominance are concerns.

*apdfea — Asset Purchases and Direct Financing (IMF).*

### Executive Summary ������������������������������������������������������������������������������������������������������

### Executive Summary

### Overview
- Many central banks in emerging market and developing economies (EMDEs) have used asset purchases to reduce financial stresses during the COVID-19 crisis, and some are using them to provide macroeconomic stimulus.
- EMDE asset purchase programs have been generally modest in size and implemented in the early months of the COVID crisis; data referenced cover March 2020–March 2021.
- Regression analysis based on event studies using high frequency data indicates these actions lowered bond yields significantly without exerting downward pressure on exchange rates (October 2020 GFSR; Fratto and others 2021; Arena and others 2021).

### Key risks and motivations
- Asset purchase programs may raise concerns about heightened risks of fiscal dominance and debt monetization.
- Historical experience shows large government financing needs can catalyze pressure on central banks to expand balance sheets, which may lead to high inflation when deficits rise to high levels and the inflation–deficit relationship becomes highly nonlinear.
- Direct financing (primary market purchases, subsidized credit, or overdrafts) is distinct from secondary market purchases and poses greater risk of undermining central bank balance sheets, independence, and price stability.
- Even secondary market asset purchases can be monetized if central banks lack latitude to sterilize reserves by adjusting policy rates (e.g., by paying interest on reserves) or by selling assets.

### Principles for designing asset purchase programs
- The central bank must have operational independence and latitude to adjust its policy rate as needed to achieve its objectives; a strong governance framework is required.
- Asset purchases should be made only on the central bank’s own initiative and to help achieve its mandated policy objectives.
- The scale of purchases (and, upon exit, sales) should be appropriate for achieving those objectives and purchases should be at market prices; there should be a strong preference toward purchases in the secondary market.
- The central bank should aim to ensure it has fiscal support to cover any losses associated with its asset purchase programs to preserve its financial autonomy and reduce risks to monetary independence.
- Distinguish clearly between short-term, smaller operations (small-scale asset purchases, or SSAPs) and longer-term, larger operations (large-scale asset purchases, or LSAPs).

### Small-Scale Asset Purchases (SSAPs)
- SSAPs are typically deployed on a smaller scale to address dysfunction in specific markets in near-crisis or crisis situations.
- EMDEs may benefit from temporary and small-scale asset purchases to improve market functioning — these were instrumental during the COVID-19 crisis.
- Keeping duration limited and scale modest reduces risks to central bank balance sheets and price stability.
- Experience with SSAPs in EMDEs remains limited, and exit from these programs may pose challenges.

### Large-Scale Asset Purchases (LSAPs)
- LSAPs are used as a tool for monetary policy accommodation, typically involve a longer-term commitment to a large balance sheet, and often target longer-maturity government bonds.
- LSAPs expose central banks to considerable maturity risk and possibly credit risk; they should be undertaken only by central banks with a high degree of operational independence and policy credibility.
- A strong and sustainable fiscal position is a key prerequisite for LSAPs to be an effective tool.
- Deploying LSAPs against the backdrop of weak public finances could:
  - Fuel investor concerns about fiscal dominance,
  - Increase vulnerability to capital outflow and exchange rate pressures,
  - Risk being counterproductive if coupled with poorly anchored inflation expectations, large unhedged foreign currency debt, or high external debt.

### When direct financing may be justified and required safeguards
- A strong preference remains for secondary market purchases, but limited direct financing may be justified if the secondary market is poorly developed or market dysfunction is severe.
- Direct financing should be time-bound, very modest in size, disclosed in a transparent way, pay at a minimum the central bank policy rate, and involve securities that are marketable.
- Overdraft facilities and other forms of subsidized primary financing can be consistent with price stability only if the central bank retains latitude and balance sheet strength to implement policy rate decisions consistent with its mandate.
- Central banks must avoid allowing direct financing to be interpreted as a signal that they will be prevented from raising policy rates or selling assets later, as that can lead to exchange rate collapse and high inflation.

### Implementation and exit considerations
- Purchases should normally occur in the secondary market to reduce balance sheet risks and avoid raising market concerns about fiscal dominance.
- Exit from both SSAPs and LSAPs requires the ability to adjust policy rates and to sell assets; lack of fiscal backing or political commitments to allow policy normalization can make exit difficult.
- Central banks should ensure clarity between short-term purchases and longer-term commitments to avoid conflating crisis support with monetary accommodation.

### Conclusions and policy recommendations
- Asset purchases can be beneficial for EMDEs under some conditions, notably to restore market functioning during stress (SSAPs) or, in very specific circumstances, to provide monetary accommodation (LSAPs).
- Core prerequisites for asset purchase programs:
  - Operational independence and policy credibility of the central bank,
  - Purchases on the central bank’s initiative at market prices,
  - Appropriately scaled purchases with clear exit plans,
  - Fiscal support for potential losses to preserve central bank financial autonomy,
  - Strong preference for secondary market operations; any direct financing must be limited, transparent, and remuneration aligned with the policy rate.
- Given limited EMDE experience and the substantial risks outlined, considerable caution is required before deploying LSAPs; SSAPs are generally the lower-risk, first-best option for addressing market dysfunction.

*Source: Executive Summary, "Asset Purchases and Direct Financing" (IMF discussion paper, March 2020–March 2021 data).*

### Introduction

### Introduction

### Fiscal dominance — definitions and channels
- Fiscal dominance may materialize in several ways:
  - The fiscal authority may push the central bank to keep the policy rate below the level consistent with price stability to reduce the cost of government borrowing.
  - The government may force the central bank to provide it with direct credit at below-market interest rates, and also specify the amount it wishes to borrow.
  - The government may in effect confiscate some of the central bank’s capital, including by forcing it to transfer foreign exchange reserves or to distribute unrealized profits.
- Governance weaknesses that increase fiscal dominance risk include involving politicians or government officials in monetary policy decision-making; removing protections provided to the central bank governor and other officials; or adding goals to the central bank’s remit that detract from its monetary and financial stability priorities.
- Historical note: Sweden’s Riksbank came under pressure to finance large wartime expenditures by printing money in the mid-18th century, leading to rapid price runups (Bordo and Levy (2020) referenced).

### Limiting adjustment of policy rates (and other instruments)
- Key findings:
  - Governments sometimes preclude central banks from raising interest rates needed to ensure price stability because of budgetary or macroeconomic implications.
  - Such constraints have led to large runups in inflation and unanchored inflation expectations even in countries with long track records of price stability and high central bank credibility (example: pressure by the Johnson Administration on the US Federal Reserve in the mid-1960s helped launch the Great Inflation).
  - Constraining policy rate adjustment can create substantial inflationary pressure even if central bank balance sheets are quite lean.
- Implication:
  - Strong institutional safeguards ensuring central bank independence are crucial for price stability, especially when central bank objectives conflict with fiscal authorities’.
- Context:
  - Low inflation after the COVID shock made low interest rates desirable to both fiscal authorities and central banks, but tensions can nevertheless emerge if markets perceive governments are tying central bank hands.

### Direct financing
- Forms of direct financing:
  - Government overdraft facility at the central bank.
  - Purchases of government securities by the central bank in the primary market (a loan to the government and corresponding credit to the government’s account at the central bank).
- Historical and cross-country context:
  - The Bank of England has had an overdraft facility since its founding in 1694.
  - Most emerging market central banks allow direct financing in some form, especially for short-term borrowing (Jacome and others 2012); some use it extensively as a cash management tool.
  - Direct financing has been used to reduce volatility in government borrowing costs during episodes of market stress (including COVID), especially by EMDEs.
- Risks and mechanics:
  - The risk of direct financing depends on:
    - Whether the central bank initiates the claim on the government at its discretion and in pursuit of its own mandate.
    - Whether the motivation for direct financing is the government’s desire to reduce the cost of its borrowing by dictating the amount and price of credit.
  - Contrast with secondary market asset purchases: central bank-initiated, at market prices, central bank decides how much to buy and when; the government does not receive new funds in this case.
- Conditions where direct financing may not cause monetary financing:
  - If the central bank retains latitude to adjust its policy rate, it could sterilize excess reserve creation (for example, by paying interest on excess reserves or adjusting rates on liquidity-draining operations) and achieve mandated objectives.
  - Several economies, including some EMDEs, have provided limited direct financing while maintaining low inflation.
- Why direct financing tends to undermine central bank performance:
  - Persistent direct financing weakens the central bank balance sheet, especially if financing is large in scale, long maturity, and at concessional interest rates.
  - A weaker balance sheet can make the central bank less willing or able to take actions (such as sharply raising interest rates) needed to ensure price stability.
  - Prolonged periods in which the central bank receives a lower return on assets than it pays on liabilities intensify risks to operational independence.
- Severe examples and outcomes:
  - When direct financing is combined with restrictions on policy rate adjustment, balance sheet expansion financed by non-interest bearing money can yield very adverse effects for price and macroeconomic stability.
  - Examples cited: Sudan, South Sudan, Venezuela, and Zimbabwe—central bank credit to the government resulted in triple-digit inflation and exchange rate collapse; Germany (early 1920s) and Hungary (post–World War II) cited for hyperinflation in AEs after major wars.
- Legal and institutional mitigants:
  - Many governments have ratified treaties or passed constitutional prohibitions against providing direct central bank credit to the government (example: the European Union’s Maastricht Treaty, clause 104).
  - Legal limits act as a “speed bump” reducing the risks of abuse, though some governments seek to circumvent or undo them.

### Forced remittances and related pressures
- Forms and effects:
  - Governments may force central banks to pay out unrealized profits (beyond legally agreed profit-sharing), or to sell foreign exchange to government at concessional rates.
  - Forced remittances deteriorate the central bank’s balance sheet, creating agency problems similar to direct non-market financing and undermining focus on mandated objectives.
- Government arrears:
  - Government arrears may be viewed as a contingent liability of central banks, creating expectations that central banks will ultimately clear them (potentially by printing money).
  - Arrears are often ad hoc and non-transparent, making the scale difficult to estimate and cumbersome to clear because they are incurred across different government departments without centralized accounting.
- Note: Annex 1 provides additional illustrations of fiscal dominance over central bank balance sheet policies (for example, directed lending and guarantees) that tend to weaken both the financial position and independence of central banks.

### Asset purchases and monetary policy independence — core principles
- Overarching point:
  - Central bank balance sheet actions can alleviate financial stress and provide monetary stimulus, but a strong, carefully designed institutional framework is essential to minimize risks to central bank independence and price stability.
- Core principles the authors identify for asset purchase programs:
  - First: The central bank must retain the ability to set and adjust its effective policy rate as required to achieve its mandated objectives. Any provision of credit to government—whether direct or indirect—should not interfere with this ability.
  - Second: Asset purchases should be made voluntarily at the initiative of the central bank, and clearly aligned with the central bank’s price and financial stability objectives. Central bank communication about how the purchases serve central bank objectives—and will only continue if this is the case—is crucial. The central bank must be free later to sell the purchased assets if required to achieve its objectives. Asset purchases should be well-aligned with overall policy implementation and stance.
  - Third: Asset purchases should be at market prices. This avoids costly subsidies to the government that would hurt the balance sheet and mitigate perceptions of fiscal dominance. The second and third considerations together favor central bank purchases in the secondary market rather than direct lending to the government.
  - Fourth: The government’s own financial position must be on a stable footing, even if temporarily stressed. The central bank must retain latitude to hike interest rates as needed without jeopardizing government solvency. A strong fiscal position is needed to backstop potential losses from asset purchase programs; if government debt is viewed as unsustainable, the risks of central bank financing are likely to outweigh benefits.
- Clarifications:
  - An “effective policy rate” means a policy rate that the central bank is willing and able to implement in its monetary operations. A rate labeled as the “policy rate” but not used to impact the market is not an effective rate.
  - In dysfunctional or thin markets, observable market prices may be absent or unusually low; the central bank may need to determine an appropriate price taking into account its policy rate and recent yields in stable periods.

### Objectives of asset purchases and evidence from COVID crisis responses
- Primary objectives for central bank purchases of government securities include:
  - Improving market functioning during periods of stress where investor flight to liquid assets and limited intermediary capacity raise pressures on longer-maturity government bonds and private assets.
  - Supporting orderly market conditions and mitigating risks to financial stability.
- Characteristics of small-scale asset purchase programs (SSAPs):
  - Targeted to support critical markets and limited in duration and scale to reduce risks to central bank balance sheets and communicate that interventions address short-term market dysfunction.
  - EMDE SSAPs during the COVID crisis were generally smaller-scale and more narrowly focused on market functioning than AE interventions, concentrating mainly on purchases of government securities rather than private sector assets.
- Evidence:
  - SSAPs were successful in a range of markets (IMF October 2020 GFSR, Fratto and others 2021). Notably, longer-term bond yields that had spiked were brought down following interventions.
- Cautionary notes:
  - Central bank purchases must be made in the domestic bond market to address domestic market dysfunction; supporting international bond markets could risk significant losses of limited FX reserves.
  - While purchases can improve market functioning, longer-term risks include moral hazard and impeding market development (e.g., hedging markets).
  - The paper does not explore central bank purchases of private sector securities; such purchases entail additional credit risk and heightened political economy pressures.

*apdfea - Introduction (IMF PDF chapter excerpt)*

### 1. Mar.–Aug. 20202. Sep. 2020–Mar. 2021

### 1. Mar.–Aug. 20202. Sep. 2020–Mar. 2021

### Asset purchases and market-functioning during COVID
- Initial emergency interventions "in response to COVID" helped restore market functioning; however, "experience with these programs remains limited, and the success during the COVID crisis was likely facilitated by the massive policy easing of AE central banks."
- EMDEs’ asset purchase programs have mostly been relatively small and often partly offset by other operations, so central bank balance sheets "have not expanded significantly."
- Examples of operations that offset purchases:
  - Some EMDEs sold FX reserves or engaged in "operation twist" strategies (Brazil, India, Mexico).
  - Operation twist involves buying longer-term government securities and selling short-term securities to take duration risk from the market without increasing central bank liabilities.
- While EMDEs mainly focused on secondary market purchases during COVID, primary market interventions can be justified where the secondary market lacks depth and liquidity even in normal times; these interventions can:
  - Improve monetary transmission.
  - Support continued functioning of the primary market.
  - Ease government funding pressures.
- Significant risks are associated with funding the government in the primary market; the chapter signals further consideration of ways to limit these risks in Chapter 6.

### Monetary easing through LSAPs (large-scale asset purchases)
- Definition and mechanisms:
  - LSAPs (sometimes called QE) commit the central bank to ongoing purchases of government bonds (and often private assets) to lower yields on longer-term government bonds and risky assets.
  - Purchases are undertaken in secondary markets at market prices.
- Evidence and channels:
  - A large literature shows asset purchases depress yields on longer-term government bonds and risky assets, and boost output and inflation.
  - LSAPs operate through reducing term premiums and signaling prolonged accommodative policy; portfolio rebalancing can lower borrowing costs for firms and generate spillovers to other asset classes.
- Conditions and potential benefits for EMDEs:
  - Attractive where EMDEs face a low equilibrium real interest rate and low inflationary pressure, or where conventional policy space is exhausted.
  - Benefits may include reducing interest costs for private and public borrowers, freeing government funding for temporary expenditures (e.g., vaccination programs, support to low-income households and SMEs).
- Limitations and cautions:
  - "Benefits of LSAPs in providing stimulus are probably diminished in many EMDEs relative to AEs."
  - Aggregate demand in EMDEs is likely less sensitive to longer-term yields; forward guidance may be less effective due to limited credibility to keep policy rates low.
  - Passthrough to household and corporate borrowing costs is likely lower.
  - LSAPs can weaken market functioning and entail substantial risks; should only be considered in countries with:
    - Very solid fiscal fundamentals.
    - Strong governance with deeply entrenched central bank independence.
    - Inflation expectations anchored at or below target levels.
- Key risk highlighted:
  - LSAPs shorten the effective maturity structure of consolidated public debt, with the central bank bearing increased maturity risk.
  - If long-term bonds are purchased at low yields and interest rates later need to rise sharply, the central bank can experience a substantial deterioration in earnings.
  - Concerns over central bank balance sheet deterioration may impede timely tightening needed to keep inflation expectations anchored.
  - Government resistance to monetary tightening is more likely if fiscal position remains weak.

### Objectives of asset purchases and governance/transparency
- Program design features that improve viability:
  - Strong initial fiscal position in government.
  - High degree of central bank independence and perceived latitude to raise interest rates sufficiently to achieve price stability even if this worsens central bank and government finances.
  - Conducting purchases in the secondary market helps allay perceptions of fiscal dominance and reduces potential large hits to central bank balance sheets.
- Transparency:
  - Clear communication about the design and exit conditions—conditioned on achieving monetary policy objectives—can mitigate perceptions of fiscal dominance.
  - A growing number of EMDE central banks have provided regular and detailed communications targeted at financial markets and broader economic agents.
- Typical prudential stance:
  - EMDEs with policy rates well above zero should not use LSAPs for macroeconomic stimulus; conventional tools should be used until policy rates approach zero.
  - LSAPs are less agile and may require large and persistent balance sheet expansions to match the stimulus of a modest policy rate cut; exit is more difficult and costs/risks can be significant.
- Integrated policy toolkit:
  - For EMDEs with policy rates well above zero, combining conventional monetary policy with additional tools (e.g., foreign exchange intervention, capital flow management in some circumstances) can improve monetary autonomy—referenced as discussed in the October 2020 IMF Policy Paper.

### Minimizing risks to price stability from asset purchase programs
- Differences between AEs and EMDEs:
  - AE experience has allayed concerns that LSAPs necessarily lead to high inflation, but AE central banks benefit from long-standing credibility and reserve-currency issuer status.
  - Reserve currency status reduces vulnerability to capital outflow and exchange rate pressures; EMDEs face greater risks of capital outflows, exchange rate pressures, and inflationary responses requiring tightening.
  - A greater likelihood that policy will have to be tightened diminishes prospective stimulus from LSAPs.
- Recommended program scale and structure for EMDEs:
  - Adopt a smaller scale for asset purchase programs than AEs to limit maturity and balance sheet risks.
  - Prefer "quantity-based" programs (targeting quantity to move interest rates) over "price-based" programs (yield curve caps), because price-based programs can compel unlimited purchases and undermine control of balance-sheet size and macroeconomic stability.
  - Strong public finances are an important prerequisite for larger-size asset purchase programs.
- Need for further analysis:
  - More analytical work and country experience are required to understand transmission channels, benefits, risks, and multilateral implications (exchange rates, capital flows, global asset prices).
  - Be attentive to multilateral implications of asset purchases by larger EMDEs or groups of EMDEs in addition to AEs.

### Primary purchases and overdrafts: design features and risk mitigation
- Primary market purchases:
  - May be infeasible in sizeable amounts if secondary markets are underdeveloped; in periods of severe stress, limited primary purchases for a short period may be warranted.
  - Where yield curves are short and markets shallow, determining appropriate secondary market prices for long-dated securities is difficult.
  - Well-targeted primary market participation can address dysfunction and keep the door open for predominantly market financing of government deficits.
  - Central bank should purchase only marketable government debt to minimize balance sheet risks.
  - If maturity of primary purchases is kept short (for example, "3–12 months"), the central bank’s policy rate may provide a reasonable basis for discounting in the absence of a robust market rate.
  - Short-maturity purchases are "self-liquidating" in principle and facilitate exit, though exit may still be complicated if market financing remains impaired.
- Overdraft finance (direct credit via central bank overdraft):
  - Day-to-day use would be at the government's discretion, providing a more direct path to fiscal dominance than primary market purchases unless strong limits exist.
  - Complementary steps to minimize macroeconomic stability risks associated with overdraft facilities include:
    - Remuneration should be "at or above the central bank’s monetary policy rate."
    - Any overdraft should be modest in size; many central bank laws set maximum overdraft amounts, often specified as a percentage of government revenue over a recent window (example format: "10 percent of the aver-...").

*Italicized source attribution: apdfea - 1. Mar.–Aug. 20202. Sep. 2020–Mar. 2021 (source PDF: apdfea - 1. Mar.–Aug. 20202. Sep. 2020–Mar. 2021).*

### Annex 2 provides examples of how a range of central banks limit the use of overdraft facilities.

### Annex 2 — Central Bank Overdraft Facilities (examples of limits)

### Design features and limitations to mitigate fiscal dominance
- Purpose: overdraft should be a short-term cash management buffer rather than long-term financing.
- Appropriate rate: in principle, the standing credit facility rate—somewhat above the monetary policy rate. In practice, the deposit rate, or policy rate, is more often used.
- Key legal and operational limits commonly applied:
  - Limit financing to a proportion of estimated revenue for the fiscal year or average revenue for the three immediately preceding fiscal years; the limit is usually between 5 and 12 percent of the revenue base.
  - Repayment should be made within a short time frame; legislation often mandates drawings must be repaid by the end of the current fiscal year (or subject to a specified short maximum repayment period).
  - Repayment should be in reserve money obtained from current revenues or raised by selling securities to the market at market-determined rates; avoid “repayment” by placing long-term low-yield securities with the central bank that de-capitalize the central bank.
  - Transparency: information on use of the overdraft and on the rate of remuneration should be published promptly to limit abuse.
- Context matters: where there is a history of fiscal dominance, formal legal limits may be insufficient to reassure markets; central banks may refuse to provide overdraft finance even if legally permissible.

### Specific provisions and examples from selected central banks (as summarized)
- Setting the limit on central bank (CB) financing:
  - Financing limited to a proportion of estimated revenue for the fiscal year / average revenue for three immediately preceding fiscal years; limit usually between 5 and 12 percent of the revenue base.
    - Examples: Banco de México, Bank of Canada, Bank of Malaysia, Central Bank of Kenya, Central Bank of Morocco, Bank of Albania, Bank of Botswana, Bank of Japan
  - Fixed nominal amount:
    - Example: Bank of Israel
  - Securities purchased in primary issues are included as part of the overall limit set for CB financing:
    - Examples: Bank of Malaysia, Bank of Albania (includes securities purchased through open market operations)
- Maximum allowable tenor for loans/advances:
  - 91 days, 120 days, 150 days, 6 months
    - Examples: Banco de México, Central Bank of Morocco, Bank of Israel, Bank of Canada
- Maximum repayment period and interest rate:
  - Loans must be repaid before the end of the first quarter in the fiscal year after the loan/advance is contracted.
    - Examples: Bank of Canada, Bank of Brazil, Bank of Malaysia
  - Loans are collateralized by debt securities that have a maximum maturity and bear interest at market rates.
    - Examples: Bank of Albania, Bank of Canada, Central Bank of Kenya
  - Interest rate on loans are set by the monetary policy committee/or interest rate applicable is the rate for banks’ refinancing.
    - Examples: Bank of Korea, Central Bank of Morocco
- Provisions on context, approvals, currency, and disclosure requirements:
  - Government must declare an emergency situation based on security (war or threat of war) or natural disasters for the central bank to finance budgetary expenditures.
    - Examples: Central Bank of Dominican Republic, Central Bank of Chile
  - Loans require approval of the central bank board / loans carry a written loan agreement executed between the central bank and the government / loans require Parliamentary approval.
    - Examples: Bank of Albania, Central Bank of Brazil, Banco de México, Bank of Korea
  - Granting of loans (or waivers for amounts above the legal limit) should not conflict with monetary policy objectives; the central bank endeavors in periods of monetary expansion to restrict credit to government and to contract the outstanding amount, as warranted.
    - Examples: Bank of Albania, Bank of Korea
  - Where the legal limit is breached the central bank submits to the Parliament a report outlining the causes and remedies / any use of CB financing above the legal limit is subject to agreement between central bank and Minister of Finance, and such agreement is published in gazette within 15 days of the agreement.
    - Examples: Bank of Albania, Bank of Botswana
  - The central bank publishes information on investments in securities issued or guaranteed by the government in its monthly balance sheet.
    - Example: Bank of Canada
  - Loans are made only in domestic currency.
    - Example: Bank of Albania

### Operational practice and recent experience
- UK example during COVID-19 market dysfunction (April 2020):
  - The UK Treasury and Bank of England announced that use might be made of the government’s overdraft (Ways & Means) account at the Bank of England.
  - The government pledged transparency about use of the facility—weekly publication of data on any usage, and clarity on remuneration rate—and no change to the remit of the Treasury’s Debt Management Office, which is still expected to meet all the government’s financing needs by market-based issuance.
- Risks highlighted:
  - Repayment via long-term low-yield securities can reduce a central bank’s net present value and de-capitalize the central bank, impairing its ability to achieve mandated objectives.
  - Absent strict limits and transparency, overdrafts can open the door to more substantial and uncontrolled direct credit (example referenced: Egypt in 2011).

### Conclusions and policy guidance (implicit from examples)
- Overdrafts should be constrained by clear legal limits on amount, tenor, interest rate, and approval procedures.
- Require prompt transparency and disclosure on usage and remuneration rates to reduce market concerns and potential abuse.
- Ensure repayment is in reserve money from current revenues or market-rate securities to avoid weakening central bank balance sheets.
- Maintain central bank independence in decision to initiate overdraft use; legal permissibility alone may not justify use where credibility and history of fiscal dominance are concerns.

*Source: Annex 2, “Central Bank Overdraft Facilities,” apdfea — Asset Purchases and Direct Financing (IMF).*

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_Source: https://www.imf.org/-/media/files/publications/dp/2021/english/apdfea.pdf_