## _wp0798

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### I. Introduction — scope and key magnitudes
- Definition: Quasi-fiscal activity (QFA) per Mackenzie and Stella (1996) — “an operation or measure carried out by a central bank or other public financial institution with an effect that can, in principle, be duplicated by budgetary measures in the form of an explicit tax, subsidy, or direct expenditure and that has or may have an impact on the financial operations of the central bank, other public financial institutions, or government.”
- Context and problem statement:
  - In many developing countries central banks have undertaken QFAs extraneous to typical central bank functions, significantly impacting their financial position and the economy.
  - Determinants of central bank profits and losses have not been a major literature focus; in industrial countries, central banks typically operate profitably with core earnings from seigniorage and access to zero cost financing (monetary base).
  - QFAs commonly include intermediation to favored sectors and administration of preferential exchange rates; sterilization/open market operations may also be treated as QFAs because of large losses that can affect the budget.
  - Measurement challenges: accounting inconsistencies, treatment of unrealized nominal losses on net foreign assets, and inflation-adjustment differences complicate measurement.
- Aim of the paper:
  - Identify and quantify main sources of RBZ QFAs since 2004.
  - Assess macroeconomic and financial impact.
  - Provide solutions on how to eliminate them and restore RBZ financial position.
- Key summary facts and magnitudes:
  - Central bank losses in most countries have not exceeded 10 percent of GDP; Zimbabwe’s realized central bank quasi-fiscal losses are estimated to have amounted to 75 percent of GDP in 2006.
  - Quasi-fiscal activities contributing to losses: monetary operations to mop up liquidity; subsidized credit; foreign exchange losses via subsidized exchange rates and multiple currency practices; financial sector restructuring.
  - Official inflation reached 1,594 percent as of January 2007.
  - Paper structure: Section II defines and quantifies RBZ quasi-fiscal losses; Section III quantifies an adjusted fiscal deficit including RBZ QFAs and discusses macroeconomic impact; Section IV analyses solutions; Section V concludes.

### II. Central bank quasi-fiscal losses — measurement and balance-sheet shifts
- Measurement caveats:
  - High inflation and regulated/distorted financial markets complicate quantification of economic value of RBZ quasi-fiscal losses.
  - Interest rate subsidies create negative “market” real interest rates.
  - Failure to apply inflation accounting standards, absence of fair value basis, and RBZ’s historic cost accounting limit financial statements to nominal values that misstate economic position.
  - The paper retains balance sheet data for quantification while recognizing it understates economic losses.
- Balance sheet shifts since 2004 (selected items in percent)
  - Liabilities (2003 2004 2005 2006 October):
    - Foreign liabilities: 32.5 24.0 42.9 12.8
    - Currency: 50.2 12.9 11.1 18.2
    - Gross required bank reserves: 10.9 23.8 13.8 23.0
    - RBZ Securities: 0.0 35.1 28.6 43.3
    - Government deposits: 0.0 2.7 3.0 0.7
    - Capital/Reserves: 0.0 0.0 0.0 0.0
  - Assets (2003 2004 2005 2006 October):
    - Foreign assets: 9.1 13.0 9.8 1.9
    - Loans to government: 0.2 0.7 0.5 0.7
    - Government securities: 24.3 7.4 0.8 0.1
    - Claims on public enterprises: 0.0 2.1 1.0 0.3
    - Claims on banks: 35.6 23.1 4.5 2.6
    - Nonearning assets: 22.0 46.5 70.3 83.3
  - Source: Reserve Bank of Zimbabwe; IMF staff estimates.
- Noteworthy balance sheet features:
  - Nonearning assets amounted to 83 percent of total assets as of October 31, 2006.
  - RBZ securities, introduced as a sterilization tool at the beginning of 2004, became the largest liability by the end of that year, overtaking currency in circulation.
  - Starting in 2004 sharp increases in statutory reserves to finance concessional credit to favored sectors led to a steep climb in required reserves, which are not remunerated.
  - Foreign liabilities have for some time been much larger than foreign assets; any currency depreciation produces losses.
  - Capital and reserves has been kept constant at a very low level (0.0 percent in table).
- Seigniorage dynamics:
  - Seigniorage for the RBZ fell from over 5 percent of GDP in 2001 to about 0.1 percent of GDP in 2005 due to drastic decline of real base money relative to nominal GDP and investment in assets with large negative real interest rates.
  - Only failure to apply a recognized accounting framework keeps RBZ capital and reserve from being negative.
- Main sources of RBZ quasi-fiscal losses (enumerated)
  1. Subsidies in terms of free foreign exchange to public enterprises; price supports to exporters to partially compensate them for an overvalued exchange rate; and subsidized credit to troubled banks, farmers, and public enterprises.
  2. Realized exchange losses stemming mainly from the purchase of foreign exchange from exporters and the public at higher prices than sales of foreign exchange to importers (mainly government and public enterprises); and recognition of previously unrealized exchange losses upon repayment of external debt, including to the Fund.
  3. Interest payments associated with open market operations to mop up liquidity.
- Operational expense:
  - RBZ’s operational expenses from January to October 2006 amounted to 4 percent of annual GDP.
- Accounting standard observation:
  - RBZ accounting does not conform to International Financial Reporting Standards; RBZ made moves to recognize impairment losses on some financial assets in its 2005 Annual Report, but absence of a recognized accounting framework resulted in a largely meaningless income statement; the paper therefore relies on estimates of flows from balance sheet data.

### III. Definitions and decomposition of RBZ quasi-fiscal losses
- Components:
  - Central bank current losses comprise: subsidies, realized exchange losses, and interest cost of open market operations.
  - Central bank capital losses comprise: unrealized exchange losses resulting from exchange rate movements on foreign currency assets and liabilities.
- Unrealized exchange losses:
  - Are part of RBZ’s quasi-fiscal losses but do not require immediate financing.
  - Are posted to a revaluation account as a noninterest-earning asset when periodic revaluations occur.
  - Represent a significant capital loss that would be reflected as a fiscal cost when the central bank is eventually recapitalized.
- RBZ practice:
  - RBZ excludes realized and unrealized valuation losses from its profit and loss accounts and accumulates them in separate asset accounts, overstating net annual profits and capital.

### IV. Subsidies — channels, programs, and magnitudes
- Channels of subsidy provision:
  - Direct free foreign exchange to parastatals for imports (fuel, grain, electricity) purchased by RBZ and accounted as a zero interest receivable from government under “other assets.”
  - Producer support/subsidies: Tobacco (fixed direct subsidy per kilogram), Gold (support price per gram increased several times since 2003), Cotton (per kilogram subsidy introduced on July 1, 2005).
- Support during banking crisis:
  - Troubled Bank Fund (TBF) provided short-term loans (periods not exceeding 3 months, often rolled over) to insolvent banks starting December 2003; TBF debt was supposed to be extinguished by March 31, 2004 but was extended.
- Subsidized lending programs:
  - Productive Sector Facility (PSF) and Agricultural Sector Enhancement Facility (ASPEF): subsidized rate of 20 percent per annum; PSF/ASPEF loans sometimes exceeded statutory reserves, leading RBZ to print money for the difference (January–July 2004 and September–December 2005).
  - Parastatals and Local Authorities Re-orientation Programme (PLARP): interest rates of 50 percent per annum but netted out from statutory reserves so no financing needed to date.
  - Loans to Grain Marketing Board (GMB) and additional loans to government with interest rates ranging from 0 to 50 percent per annum.
- Contributions to changes in reserve money (change since end of previous year; as a percent of annual GDP)
  - Reserve money: Dec-03 10.6; Dec-04 6.7; Dec-05 13.8; Oct-06 20.2
  - NFA: Dec-03 -4.1; Dec-04 -7.1; Dec-05 -43.2; Oct-06 -1.4
  - Claims on banks: Dec-03 4.2; Dec-04 2.3; Dec-05 0.6; Oct-06 1.8
  - Net claims on government: Dec-03 4.3; Dec-04 -0.1; Dec-05 -3.3; Oct-06 -0.2
  - RBZ securities: Dec-03 0.0; Dec-04 -21.5; Dec-05 -32.2; Oct-06 -32.4
  - Other items net: Dec-03 6.2; Dec-04 33.1; Dec-05 91.9; Oct-06 52.4
    - of which: Subsidies: Dec-03 4.0; Dec-04 13.9; Dec-05 20.3; Oct-06 15.4
      - of which: PSF and ASPEF: Dec-03 0.0; Dec-04 0.0; Dec-05 1.2; Oct-06 -0.1
    - TBF: Dec-03 2.4; Dec-04 7.7; Dec-05 0.3; Oct-06 0.1
    - Free forex to public enterprises: Dec-03 1.0; Dec-04 2.4; Dec-05 13.7; Oct-06 11.7
    - GMB: Dec-03 0.0; Dec-04 1.1; Dec-05 1.0; Oct-06 0.1
    - PLARP: Dec-03 0.0; Dec-04 0.0; Dec-05 0.0; Oct-06 0.0
    - Other loans to government: Dec-03 0.0; Dec-04 1.3; Dec-05 0.3; Oct-06 0.5
    - Private sector: Dec-03 0.6; Dec-04 1.4; Dec-05 3.9; Oct-06 3.1
  - Realized exchange losses: Dec-03 1.2; Dec-04 11.4; Dec-05 0.6; Oct-06 7.7
    - of which: Forex mobilization costs: Dec-03 0.0; Dec-04 0.0; Dec-05 0.0; Oct-06 5.7
  - Interest cost of RBZ bills: Dec-03 0.0; Dec-04 5.1; Dec-05 40.4; Oct-06 41.0

### V. Statutory reserve requirements — abrupt increases
- Statutory reserve requirements (percent)
  - Commercial banks — Demand deposits: Dec-03 30; Jan-04 50; Aug-04 60; Oct-05 45; Mar-06 60; Jul-06 40
  - Commercial banks — Time deposits: Dec-03 20; Jan-04 30; Aug-04 37.5; Oct-05 30; Mar-06 45; Jul-06 30
  - Commercial banks — Savings deposits: Dec-03 20; Jan-04 30; Aug-04 37.5; Oct-05 30; Mar-06 45; Jul-06 30
  - Merchant banks — Demand deposits: Dec-03 30; Jan-04 50; Aug-04 60; Oct-05 45; Mar-06 60; Jul-06 40
  - Merchant banks — Savings deposits: Dec-03 20; Jan-04 30; Aug-04 37.5; Oct-05 30; Mar-06 45; Jul-06 30
  - Finance houses — Time deposits: Dec-03 5; Jan-04 15; Aug-04 15; Oct-05 15; Mar-06 30; Jul-06 15
  - Building societies (savings + time deposits): Dec-03 0; Jan-04 30; Aug-04 30; Oct-05 30; Mar-06 45; Jul-06 30
  - Discount houses (call deposits): Dec-03 0; Jan-04 30; Aug-04 30; Oct-05 30; Mar-06 45; Jul-06 30

### VI. Realized exchange losses — mechanisms
- Foreign exchange operations and loss mechanics:
  - RBZ had a virtual monopoly on foreign exchange operations under exchange control regulations.
  - 2004 “auction” system and retention scheme required surrender of 25 percent of export proceeds at the official rate of Z$824/US$ for the public sector; the remainder provided to the auction at the managed auction rate.
  - Authorities maintained a secondary diaspora rate starting at Z$5,200/US$ for inward remittances.
  - Three zeros removed from banknotes on August 1, 2006; new currency equivalents: official rate Z$0.8/US$ and diaspora rate Z$5.2/US$.
  - Losses arose because RBZ bought foreign exchange from exporters at the auction or diaspora rate (whichever higher) and sold to importers at the auction rate and to public sector at the lower official rate; when diaspora rate exceeded auction rate, RBZ bought high and sold low.
  - October 2005: auction replaced by interbank market; inward remittances subject to interbank rate; official rate increased but RBZ continued selling to public sector at below-market official rate.
- RBZ practice:
  - RBZ excludes realized exchange losses from profit and loss and accumulates them separately — practice not recommended by IMF.

### VII. Interest cost of sterilization operations
- Instruments and chronology:
  - January 2004: Financial treasury bills at effective interest rates of over 900 percent per annum; later abandoned.
  - May 2004: Open Market Operation (OMO) bills introduced (same rates as government treasury bills but interest cost charged to RBZ).
  - June 2004: Special RBZ bills introduced (maturity two years; carried an interest rate sharply negative in real terms).
  - June 2006: 270-day nonnegotiable CD at zero interest rate replaced 2-year Special bills.
  - October 2006: RBZ introduced 5-year financial stabilization bonds.
- Magnitude of interest costs:
  - By 2005 the net interest cost of sterilization equaled 40 percent of GDP.
  - In 2006 interest cost grew further though liquidity impact was partly alleviated as authorities lengthened maturity of treasury bills.
- Feedback cycle:
  - Rising losses → rising remunerated liabilities → higher inflation → higher interest rates on bills → further interest cost acceleration.

### VIII. Unrealized valuation losses on foreign exchange holdings
- Unrealized losses:
  - Official devaluations when foreign liabilities exceeded foreign assets created unrealized losses on the RBZ’s net foreign asset position.
  - Unrealized valuation changes are posted to a revaluation account (noninterest-earning asset); no immediate monetary impact but significant capital loss.
  - The size of the loss is understated by the difference between the official exchange rate and the equilibrium economic exchange rate times the size of the RBZ’s net foreign currency liability position.

### IX. Macroeconomic impact of QFAs
- Transmission to the macroeconomy:
  - QFAs affect the economy directly through monetary expansion (money creation to finance losses) and indirectly by impairing monetary management effectiveness and central bank credibility.
  - Escalation of inflation in the last three years was fuelled by rapid money growth arising from RBZ’s QFAs.
  - Soaring inflation is attributed more to RBZ’s substantial quasi-fiscal activity than to conventional government budget deficits.
- Fiscal context:
  - Central government fiscal deficit for 2003–2005 averaged below 3 percent of GDP; primary balance in surplus in all years except 2004.
- Adjusted financing requirement:
  - Defined as financing requirement comprising: (i) central government’s primary balance; (ii) subsidies provided by RBZ; (iii) RBZ’s realized exchange losses; (iv) net interest payments of both central government and RBZ.
  - Quasi-fiscal losses are the major contributor to the adjusted financing requirement.
- Operational balance and real interest complications:
  - With highly negative real interest rates during various periods and lack of inflation accounting, an operational balance is not meaningfully interpretable for Zimbabwe.
  - Real ex-post interest rates are calculated as nominal 3-month treasury bill minus inflation actually prevailing over the 3 months after issuance; Zimbabwe’s real interest rates swung from positive to negative since 2003, making operational balance calculations meaningless.
- Monetary policy erosion:
  - RBZ forced to sterilize via open market operations and end-of-day mandatory investments in 2-year Special treasury bills (sharply negative real interest rates) and later zero-rate 270-day CDs.
  - Punitive overnight lending rate on access to RBZ facilities transferred costs to banks and complicated banks’ liquidity management but failed to reduce money growth effectively.

### X. Eliminating QFAs — recommended sequence and measures
- Overall objective:
  - Eliminate causes of losses, transfer quasi-fiscal losses to the budget, tighten fiscal policy, improve RBZ cash-flow, and restore RBZ financial position.
- Main measures (summary):
  - Eliminate quasi-fiscal activities.
  - Restructure central bank functions and activities; reduce operating expenses to avoid losses from increases in remunerated liabilities and nonearning assets.
  - Recapitalize central bank to move out accumulated losses or nonearning assets (and improperly priced off-balance-sheet items).
- Proposed government sequence (enumerated)
  1. Increase transparency and accountability:
     - Identify and properly recognize all quasi-fiscal losses and move them out from central bank books into government budget.
     - Include losses associated with former QFAs in projected deficit at budget preparation.
     - RBZ should disclose negative net worth publicly along with actions to restore net worth over time.
     - Accounting standards require disclosure of losses in income statement, charged against capital, and negative net worth shown in equity section.
  2. Take actual measures to reduce and eliminate QFAs:
     - Reforms include:
       - Full liberalization of the exchange rate regime for current account purposes.
       - Substantial fiscal tightening at the level of the adjusted primary balance.
       - Price deregulation and hard budget constraints on public enterprises.
       - Establishment of a strong nominal anchor by the RBZ.
  3. Ensure RBZ has resources to finance legitimate functions:
     - RBZ pricing should be consistent with functional objectives at market rates.
     - RBZ should have sufficient income via assets that generate income or transfers from budget to cover realized costs.
  4. Recapitalize RBZ after macro stabilization:
     - Recapitalization by issuance of marketable government securities through transparent budgetary appropriation would create central bank assets that bear market-related interest and duration.
     - Negotiable securities should be transferred directly to the central bank.
     - RBZ law would need amendment to permit government payment/recapitalization; current law does not allow payment by government to guarantee reduction in nonearning assets.
     - Central bank legislation should be revised to (i) limit QFAs, and (ii) recognize provisions for government support in case of major central bank losses.
     - Recapitalization should follow macro stabilization because transferring accumulated losses to the government has significant budgetary implications; the shift is a “zero-sum” game but increases transparency and strengthens central bank autonomy.
- Accounting and operational considerations for recapitalization:
  - Accounting standards require securities to be initially recognized at fair value; fair value equals face value only if securities have interest and duration matching similar market instruments.
  - Long-dated or undated securities with zero or submarket rates do not qualify for recapitalization at face value; interest payments on recapitalization securities must be recognized in income statement.
  - Stella (2005) argument: lump-sum transfer of required securities at reform outset provides credible commitment; phased recapitalization could be considered if scale exceeds budget resources.

### XI. Conclusions — causes, consequences, and remedy
- Causes and composition of losses:
  - RBZ losses arise from supporting government policy through quasi-fiscal activities and keeping the currency overvalued.
  - Current QFAs: subsidies, realized exchange losses, interest cost of open market operations.
  - Capital QFAs: unrealized exchange losses from exchange rate movements on foreign currency assets and liabilities.
- Consequences:
  - Escalating realized QFAs financed through money creation or issuance of central bank securities pushed inflation above 1,000 percent in 2006.
  - Developments created an unstable macroeconomic environment that risks hyperinflation and weakened RBZ credibility and independence.
- Remedy:
  - Eliminate QFAs, restructure RBZ operations, reduce operating expenses, restore cash-flow, and recapitalize RBZ once stabilization achieved.
  - Government should absorb QFAs into budgetary operations to improve transparency and accountability.
- Additional normative recommendations (Vaez-Zadeh (1991) rules reiterated):
  - Central bank should rely on government treasury bills for open market operations so monetary policy costs pass to government.
  - Central bank allocations should be at market prices and only within delegated functions; subsidies should be provided through the budget.
  - Central bank should borrow abroad only for short-term balance of payments needs; government should assume exchange rate risk of any foreign borrowing by central bank.
  - Central bank should set aside reserves against potential losses.
- Final assessment:
  - Central banks can function without positive equity, but positive equity enhances credibility and independence.
  - When balance sheets are seriously deteriorated, recapitalization is recommended after stabilization.
  - Required capital depends on foreign reserve policy and institutional relation with government; ability to meet monetary objectives depends on maintaining appropriate cash-flow and avoiding costly QFAs.

*Source: IMF Working Paper chapter "4. Unrealized exchange losses reflecting official devaluations because foreign liabilities exceeded foreign assets."*

### References..............................................................................................................

### _wp0798 - References

### I. INTRODUCTION
- Definition: Quasi-fiscal activity (QFA) per Mackenzie and Stella (1996) — “an operation or measure carried out by a central bank or other public financial institution with an effect that can, in principle, be duplicated by budgetary measures in the form of an explicit tax, subsidy, or direct expenditure and that has or may have an impact on the financial operations of the central bank, other public financial institutions, or government.”
- Context and problem statement:
  - In many developing countries central banks have undertaken QFAs extraneous to typical central bank functions, significantly impacting their financial position and the economy.
  - Determinants of central bank profits and losses have not been a major literature focus; in industrial countries, central banks typically operate profitably with core earnings from seigniorage and access to zero cost financing (monetary base).
  - QFAs commonly include intermediation to favored sectors and administration of preferential exchange rates; sterilization/open market operations may also be treated as QFAs because of large losses that can affect the budget.
  - Measurement challenges: Teijeiro (1989) and discussion highlight difficulties measuring quasi-fiscal losses because of accounting inconsistencies, treatment of unrealized nominal losses on net foreign assets, and inflation-adjustment differences.
- Aim of the paper:
  - Identify and quantify main sources of RBZ QFAs since 2004.
  - Assess macroeconomic and financial impact.
  - Provide solutions on how to eliminate them and restore RBZ financial position.
- Key summary facts and magnitudes:
  - Central bank losses in most countries have not exceeded 10 percent of GDP; Zimbabwe’s realized central bank quasi-fiscal losses are estimated to have amounted to 75 percent of GDP in 2006.
  - Quasi-fiscal activities contributing to losses: monetary operations to mop up liquidity; subsidized credit; foreign exchange losses via subsidized exchange rates and multiple currency practices; financial sector restructuring.
  - Official inflation reached 1,594 percent as of January 2007.
  - The paper structure: Section II defines and quantifies RBZ quasi-fiscal losses; Section III quantifies an adjusted fiscal deficit including RBZ QFAs and discusses macroeconomic impact; Section IV analyses solutions; Section V concludes.

### II. CENTRAL BANK QUASI-FISCAL LOSSES
- Measurement caveats:
  - High inflation and regulated/distorted financial markets complicate quantification of economic value of RBZ quasi-fiscal losses.
  - Interest rate subsidies create negative “market” real interest rates.
  - Failure to apply inflation accounting standards, absence of fair value basis, and RBZ’s historic cost accounting limit financial statements to nominal values that misstate economic position.
  - The paper retains balance sheet data for quantification while recognizing it understates economic losses.
- Balance sheet shifts since 2004:
  - Large and escalating quasi-fiscal losses shifted RBZ liabilities toward RBZ securities and required reserves.
  - QFAs demanded resources exceeding seigniorage; combined with high operating expenses they generated large losses.
  - Losses drove large movements in “other items net” and are classified as nonearning assets.
- Table 1 — Selected RBZ Balance Sheet Items (Percent)
  - Liabilities (2003 2004 2005 2006 October):
    - Foreign liabilities: 32.5 24.0 42.9 12.8
    - Currency: 50.2 12.9 11.1 18.2
    - Gross required bank reserves: 10.9 23.8 13.8 23.0
    - RBZ Securities: 0.0 35.1 28.6 43.3
    - Government deposits: 0.0 2.7 3.0 0.7
    - Capital/Reserves: 0.0 0.0 0.0 0.0
  - Assets (2003 2004 2005 2006 October):
    - Foreign assets: 9.1 13.0 9.8 1.9
    - Loans to government: 0.2 0.7 0.5 0.7
    - Government securities: 24.3 7.4 0.8 0.1
    - Claims on public enterprises: 0.0 2.1 1.0 0.3
    - Claims on banks: 35.6 23.1 4.5 2.6
    - Nonearning assets: 22.0 46.5 70.3 83.3
  - Source indicated in table: Reserve Bank of Zimbabwe; IMF staff estimates.
- Noteworthy balance sheet features (exact points preserved):
  - Nonearning assets are substantial; they amounted to 83 percent of total assets as of October 31, 2006.
  - RBZ securities, introduced as a sterilization tool at the beginning of 2004, became the largest liability by the end of that year, overtaking currency in circulation.
  - Starting in 2004 sharp increases in statutory reserves to finance concessional credit to favored sectors, such as agriculture, led to a steep climb in required reserves, which are not remunerated.
  - Foreign liabilities, largely credits from international financial institutions, have for some time been much larger than foreign assets; in this situation any currency depreciation produces losses.
  - The smallest liability is capital and reserves which has been kept constant at a very low level.
- Seigniorage dynamics:
  - Seigniorage for the RBZ fell from over 5 percent of GDP in 2001 to about 0.1 percent of GDP in 2005 due to drastic decline of real base money relative to nominal GDP and investment in assets with large negative real interest rates.
  - Only failure to apply a recognized accounting framework keeps RBZ capital and reserve from being negative.
- Main sources of RBZ quasi-fiscal losses (enumerated exactly as in source):
  1. Subsidies in terms of free foreign exchange to public enterprises; price supports to exporters to partially compensate them for an overvalued exchange rate; and subsidized credit to troubled banks, farmers, and public enterprises.
  2. Realized exchange losses stemming mainly from the purchase of foreign exchange from exporters and the public at higher prices than sales of foreign exchange to importers (mainly government and public enterprises); and recognition of previously unrealized exchange losses upon repayment of external debt, including to the Fund.
  3. Interest payments associated with open market operations to mop up liquidity.
- Operational expense note:
  - The RBZ’s operational expenses from January to October 2006 amounted to 4 percent of annual GDP.
- Accounting standard observation:
  - RBZ accounting does not conform to International Financial Reporting Standards which require losses from operations or diminution in financial asset values below cost to be recognized in the income statement; such standards generally do not allow losses to be capitalized as assets on the balance sheet.
  - While RBZ made moves to recognize impairment losses on some financial assets in its 2005 Annual Report, absence of a recognized accounting framework resulted in a largely meaningless income statement; the paper therefore relies on estimates of flows from balance sheet data.

*Source: Reserve Bank of Zimbabwe; IMF staff estimates.*

### 4.      Unrealized exchange losses reflecting official devaluations because foreign liabilities

### 4.      Unrealized exchange losses reflecting official devaluations because foreign liabilities exceeded foreign assets.

### Definitions and decomposition of RBZ quasi-fiscal losses
- Central bank current losses comprise: subsidies, realized exchange losses, and interest cost of open market operations.
- Central bank capital losses comprise: unrealized exchange losses resulting from exchange rate movements on foreign currency assets and liabilities.
- Unrealized exchange losses:
  - Are part of the RBZ’s quasi-fiscal losses but do not require immediate financing.
  - Are posted to a revaluation account as a noninterest-earning asset when periodic revaluations occur.
  - Represent a significant capital loss that would be reflected as a fiscal cost when the central bank is eventually recapitalized.
- The RBZ excludes realized and unrealized valuation losses from its profit and loss accounts and accumulates them in separate asset accounts, overstating net annual profits and capital.

### A. Subsidies — channels and magnitudes
- Direct free foreign exchange to parastatals for imports (fuel, grain, electricity) is purchased by RBZ and accounted on the RBZ balance sheet as a zero interest receivable from government under “other assets.”
- Producer support/subsidies:
  - Tobacco: fixed direct subsidy per kilogram regardless of auction prices.
  - Gold: support price per gram increased several times since 2003.
  - Cotton: per kilogram subsidy introduced on July 1, 2005.
- Support during banking crisis:
  - Troubled Bank Fund (TBF) provided short-term loans (periods not exceeding 3 months, often rolled over) to insolvent banks starting December 2003; TBF debt was supposed to be extinguished by March 31, 2004 but was extended.
- Subsidized lending programs:
  - Productive Sector Facility (PSF) and Agricultural Sector Enhancement Facility (ASPEF): subsidized rate of 20 percent per annum; PSF/ASPEF loans sometimes exceeded statutory reserves, leading RBZ to print money for the difference (January–July 2004 and September–December 2005).
  - Parastatals and Local Authorities Re-orientation Programme (PLARP): interest rates of 50 percent per annum but netted out from statutory reserves so no financing needed to date.
  - Loans to Grain Marketing Board (GMB) and additional loans to government with interest rates ranging from 0 to 50 percent per annum.
- Table 2 — Contributions to Changes in Reserve Money (Change since end of previous year; as a percent of annual GDP):
  - Reserve money: Dec-03 10.6; Dec-04 6.7; Dec-05 13.8; Oct-06 20.2
  - NFA: Dec-03 -4.1; Dec-04 -7.1; Dec-05 -43.2; Oct-06 -1.4
  - Claims on banks: Dec-03 4.2; Dec-04 2.3; Dec-05 0.6; Oct-06 1.8
  - Net claims on government: Dec-03 4.3; Dec-04 -0.1; Dec-05 -3.3; Oct-06 -0.2
  - RBZ securities: Dec-03 0.0; Dec-04 -21.5; Dec-05 -32.2; Oct-06 -32.4
  - Other items net: Dec-03 6.2; Dec-04 33.1; Dec-05 91.9; Oct-06 52.4
    - of which: Subsidies: Dec-03 4.0; Dec-04 13.9; Dec-05 20.3; Oct-06 15.4
      - of which: PSF and ASPEF: Dec-03 0.0; Dec-04 0.0; Dec-05 1.2; Oct-06 -0.1
    - TBF: Dec-03 2.4; Dec-04 7.7; Dec-05 0.3; Oct-06 0.1
    - Free forex to public enterprises: Dec-03 1.0; Dec-04 2.4; Dec-05 13.7; Oct-06 11.7
    - GMB: Dec-03 0.0; Dec-04 1.1; Dec-05 1.0; Oct-06 0.1
    - PLARP: Dec-03 0.0; Dec-04 0.0; Dec-05 0.0; Oct-06 0.0
    - Other loans to government: Dec-03 0.0; Dec-04 1.3; Dec-05 0.3; Oct-06 0.5
    - Private sector: Dec-03 0.6; Dec-04 1.4; Dec-05 3.9; Oct-06 3.1
  - Realized exchange losses: Dec-03 1.2; Dec-04 11.4; Dec-05 0.6; Oct-06 7.7
    - of which: Forex mobilization costs: Dec-03 0.0; Dec-04 0.0; Dec-05 0.0; Oct-06 5.7
  - Interest cost of RBZ bills: Dec-03 0.0; Dec-04 5.1; Dec-05 40.4; Oct-06 41.0

- Statutory reserve requirements (percent) — Table 3 highlights sharp changes:
  - Commercial banks:
    - Demand deposits: Dec-03 30; Jan-04 50; Aug-04 60; Oct-05 45; Mar-06 60; Jul-06 40
    - Time deposits: Dec-03 20; Jan-04 30; Aug-04 37.5; Oct-05 30; Mar-06 45; Jul-06 30
    - Savings deposits: Dec-03 20; Jan-04 30; Aug-04 37.5; Oct-05 30; Mar-06 45; Jul-06 30
  - Merchant banks:
    - Demand deposits: Dec-03 30; Jan-04 50; Aug-04 60; Oct-05 45; Mar-06 60; Jul-06 40
    - Savings deposits: Dec-03 20; Jan-04 30; Aug-04 37.5; Oct-05 30; Mar-06 45; Jul-06 30
  - Finance houses:
    - Time deposits: Dec-03 5; Jan-04 15; Aug-04 15; Oct-05 15; Mar-06 30; Jul-06 15
  - Building societies (savings + time deposits): Dec-03 0; Jan-04 30; Aug-04 30; Oct-05 30; Mar-06 45; Jul-06 30
  - Discount houses (call deposits): Dec-03 0; Jan-04 30; Aug-04 30; Oct-05 30; Mar-06 45; Jul-06 30

### B. Realized exchange losses — mechanisms and effects
- RBZ had a virtual monopoly on foreign exchange operations under exchange control regulations.
- In 2004 RBZ ran a heavily managed foreign exchange “auction”:
  - Retention scheme required surrender of 25 percent of export proceeds at the official rate of Z$824/US$ for the public sector; the remainder provided to the “auction” at the managed “auction” rate.
  - Authorities maintained a secondary diaspora rate starting at Z$5,200/US$ for inward remittances.
  - Note: Three zeros removed from banknotes on August 1, 2006; new currency equivalents: official rate Z$0.8/US$ and diaspora rate Z$5.2/US$.
- Losses arose because RBZ bought foreign exchange from exporters at the auction or diaspora rate (whichever higher) and sold to importers at the auction rate and to public sector at the lower official rate. When diaspora rate exceeded auction rate, RBZ bought high and sold low.
- October 2005 changes: auction system replaced by interbank market; inward remittances subject to interbank rate; official rate increased but RBZ continued selling to public sector at below-market official rate.
- RBZ excludes realized exchange losses from profit and loss and accumulates them separately — practice not recommended by IMF.

### C. Interest cost of sterilization operations
- RBZ sterilized liquidity injected by QFAs through issuance of interest-bearing liabilities:
  - January 2004: RBZ issued Financial treasury bills at effective interest rates of over 900 percent per annum; later abandoned.
  - May 2004: Open Market Operation (OMO) bills introduced (same rates as government treasury bills but interest cost charged to RBZ).
  - June 2004: Special RBZ bills introduced (maturity two years; carried an interest rate sharply negative in real terms).
  - June 2006: 270-day nonnegotiable CD at zero interest rate replaced 2-year Special bills.
  - October 2006: RBZ introduced 5-year financial stabilization bonds.
- The escalation of interest-bearing liabilities increased RBZ interest costs:
  - By 2005 the net interest cost of sterilization equaled 40 percent of GDP.
  - In 2006 interest cost grew further though liquidity impact was partly alleviated as authorities lengthened maturity of treasury bills.
- The cycle: rising losses → rising remunerated liabilities → higher inflation → higher interest rates on bills → further interest cost acceleration.

### D. Unrealized losses on foreign exchange holdings
- Official devaluations when foreign liabilities exceeded foreign assets created unrealized losses on the RBZ’s net foreign asset position.
- Unrealized valuation changes are posted to a revaluation account (noninterest-earning asset); no immediate monetary impact but significant capital loss.
- The size of the loss is understated by the difference between the official exchange rate and the equilibrium economic exchange rate times the size of the RBZ’s net foreign currency liability position.

### Macroeconomic impact of QFAs
- QFAs affect the economy:
  - Directly through monetary expansion (money creation to finance losses).
  - Indirectly by impairing monetary management effectiveness and central bank credibility.
- In Zimbabwe:
  - Escalation of inflation in the last three years was fuelled by rapid money growth arising from RBZ’s QFAs.
  - Soaring inflation is attributed more to RBZ’s substantial quasi-fiscal activity than to conventional government budget deficits.
  - Central government fiscal deficit for 2003–2005 averaged below 3 percent of GDP; primary balance in surplus in all years except 2004.
- Consolidation and adjusted financing requirement:
  - Adjusted central bank and government deficit defined as financing requirement comprising: (i) central government’s primary balance; (ii) subsidies provided by RBZ; (iii) RBZ’s realized exchange losses; (iv) net interest payments of both central government and RBZ.
  - Figure 4 shows quasi-fiscal losses are the major contributor to the adjusted financing requirement.
- Operational balance and real interest complications:
  - With highly negative real interest rates during various periods and lack of inflation accounting, an operational balance is not meaningfully interpretable for Zimbabwe.
  - Real ex-post interest rates are calculated as nominal 3-month treasury bill minus inflation actually prevailing over the 3 months after issuance; Zimbabwe’s real interest rates swung from positive to negative since 2003, making operational balance calculations meaningless.
- Monetary policy erosion:
  - RBZ forced to sterilize via open market operations and end-of-day mandatory investments in 2-year Special treasury bills (sharply negative real interest rates) and later zero-rate 270-day CDs.
  - Punitive overnight lending rate on access to RBZ facilities transferred costs to banks and complicated banks’ liquidity management but failed to reduce money growth effectively.

### Eliminating QFAs in a transparent and sustainable manner — recommended sequence and measures
- Overall objective: eliminate causes of losses, transfer quasi-fiscal losses to the budget, tighten fiscal policy, improve RBZ cash-flow, and restore RBZ financial position.
- Main measures:
  - Eliminate quasi-fiscal activities.
  - Restructure central bank functions and activities; reduce operating expenses to avoid losses from increases in remunerated liabilities and nonearning assets.
  - Recapitalize central bank to move out accumulated losses or nonearning assets (and improperly priced off-balance-sheet items).
- Proposed government sequence:
  1. Increase transparency and accountability:
     - Identify and properly recognize all quasi-fiscal losses and move them out from central bank books into government budget.
     - Include losses associated with former QFAs in projected deficit at budget preparation.
     - RBZ should disclose negative net worth publicly along with actions to restore net worth over time.
     - Accounting standards require disclosure of losses in income statement, charged against capital, and negative net worth shown in equity section.
  2. Take actual measures to reduce and eliminate QFAs:
     - Reforms include:
       - Full liberalization of the exchange rate regime for current account purposes.
       - Substantial fiscal tightening at the level of the adjusted primary balance.
       - Price deregulation and hard budget constraints on public enterprises.
       - Establishment of a strong nominal anchor by the RBZ.
  3. Ensure RBZ has resources to finance legitimate functions:
     - RBZ pricing should be consistent with functional objectives at market rates.
     - RBZ should have sufficient income via assets that generate income or transfers from budget to cover realized costs.
  4. Recapitalize RBZ after macro stabilization:
     - Recapitalization by issuance of marketable government securities through transparent budgetary appropriation would create central bank assets that bear market-related interest and duration.
     - Negotiable securities should be transferred directly to the central bank.
     - RBZ law would need amendment to permit government payment/recapitalization; current law does not allow payment by government to guarantee reduction in nonearning assets.
     - Central bank legislation should be revised to (i) limit QFAs, and (ii) recognize provisions for government support in case of major central bank losses.
     - Recapitalization should follow macro stabilization because transferring accumulated losses to the government has significant budgetary implications; the shift is a “zero-sum” game but increases transparency and strengthens central bank autonomy.
- Accounting and operational considerations for recapitalization:
  - Accounting standards require securities to be initially recognized at fair value; fair value equals face value only if securities have interest and duration matching similar market instruments.
  - Long-dated or undated securities with zero or submarket rates do not qualify for recapitalization at face value; interest payments on recapitalization securities must be recognized in income statement.
  - Stella (2005) argument: lump-sum transfer of required securities at reform outset provides credible commitment; phased recapitalization could be considered if scale exceeds budget resources.

### Conclusions
- Causes and composition of losses:
  - RBZ losses arise from supporting government policy through quasi-fiscal activities and keeping the currency overvalued.
  - Current QFAs: subsidies, realized exchange losses, interest cost of open market operations.
  - Capital QFAs: unrealized exchange losses from exchange rate movements on foreign currency assets and liabilities.
- Consequences:
  - Escalating realized QFAs financed through money creation or issuance of central bank securities pushed inflation above 1,000 percent in 2006.
  - Developments created an unstable macroeconomic environment that risks hyperinflation and weakened RBZ credibility and independence.
- Remedy:
  - Eliminate QFAs, restructure RBZ operations, reduce operating expenses, restore cash-flow, and recapitalize RBZ once stabilization achieved.
  - Government should absorb QFAs into budgetary operations to improve transparency and accountability.
- Additional normative recommendations (Vaez-Zadeh (1991) rules reiterated):
  - Central bank should rely on government treasury bills for open market operations so monetary policy costs pass to government.
  - Central bank allocations should be at market prices and only within delegated functions; subsidies should be provided through the budget.
  - Central bank should borrow abroad only for short-term balance of payments needs; government should assume exchange rate risk of any foreign borrowing by central bank.
  - Central bank should set aside reserves against potential losses.
- Final assessment:
  - Central banks can function without positive equity, but positive equity enhances credibility and independence.
  - When balance sheets are seriously deteriorated, recapitalization is recommended after stabilization.
  - Required capital depends on foreign reserve policy and institutional relation with government; ability to meet monetary objectives depends on maintaining appropriate cash-flow and avoiding costly QFAs.

*Source: IMF Working Paper chapter "4. Unrealized exchange losses reflecting official devaluations because foreign liabilities exceeded foreign assets."*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp0798.pdf_