From the beginning of the second stage of Economic and Monetary Union (EMU) on 1 January 1994, the institutional framework of macro-economic policy-making in the European Union has changed significantly. Most rules which constitute economic union in the final stage already apply from this date onwards: the co-ordination of economic policy is based on the "broad guidelines", the "multilateral surveillance" is in place, the "excessive deficit procedure" is put into practice, the "no bail-out principle" is in force, the provisions for the freedom of cross-border capital movements are the same as in Stage Three of EMU, and, last but not least, Member States must respect certain rules in the financing of public expenditure. In fact, legal provisions still to be implemented at the beginning of the third stage are limited to those which relate to excessive deficits: in the third stage, Member States must avoid such deficits, while in the second stage they "endeavour" to avoid them; furthermore, sanctions against Member States which are running excessive deficits can only be taken in the third stage. The present article describes the constraints imposed on Member States in the financing of public expenditure.
The new legal framework for economic and fiscal policy-making in the European Union reinforces the irreversibility of the process towards EMU. The new rules for budgetary financing have necessitated important modifications to legislation and arrange-ments in virtually all Member States. In a number of cases, national practices which had a long tradition in the financing of the budget have been abandoned or modified in order to comply with the new law of the Union. Indeed, EMU is no longer just a programme. Essential parts of it have already been put into practice.
In the past, all governments in one form or another resorted to credits from their central banks in order to finance public expenditure. In some countries, this was used as a permanent contribution to the coverage of the deficit; the outstanding amounts have reached more than 10% of GDP in a few cases. In other countries, limited credit lines at the central bank mainly served to bridge liquidity shortages of the government during the financial year. There was no government in the European Union which did not use in some way or another liquidity from the central bank for the financial management of its budget.
A different practice of avoiding the competition for funds on the markets was also used extensively by some governments in the past. This consisted of obliging banks, insurance companies, pension funds and other financial intermediaries to invest a part of their funds in government bonds or to grant credit to the public sector in some other form, usually at artificially low interest rates. The "privileged access" to financial institutions which was established in this way could take various forms, from straightforward restrictions on the portfolio management of the banking sector to subtle institutional arrangements for the privileged financing of a specific type of public expenditure.
From the beginning of 1994, these practices are prohibited.
Central banks of the Member States may no longer grant directly any credit
to the public sector. Likewise, the authorities of the Member States, but
also those of the European Union, are no longer allowed to impose rules
on financial institutions which constitute privileged access to the funds
of these institutions. The purpose is to submit the public sector in its
borrowing behaviour to the same constraints as those of the private sector.
This is an essential element of the Treaty of Maastricht and will help
to ensure financial discipline in the run-up to monetary union and later
in the third stage, when the same rules will apply in the framework of
a single monetary policy. The
prohibition on direct central bank financing of the public sector is also
an important element of central bank independence: central banks' monetary
policy operations shall not be influenced by public financing needs.
1. Prohibition of central bank credit to the public sector
The principle that central banks must not finance the government or other bodies of the public sector is laid down in Article 104 of the Treaty establishing the European Community, which reads as follows:
1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as "national central banks") in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.
2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the ECB as private credit institutions.
The legislator, anticipating that the implementation of this principle would raise a number of questions, has envisaged secondary legislation in order to clarify its meaning. According to Article 104 b.2, the Council ... may specify definitions for the application of the prohibition referred to in Article 104 a.
The Commission, in accordance with the Committee of Governors of the Central Banks, deemed secondary legislation highly desirable and made a formal proposal for a respective Council Regulation as soon as the Treaty entered into force (1 November 1993). Informal preparatory work, including work for the prohibition of privileged access to financial institutions and for other pieces of secondary legislation needed for Stage Two, had already started earlier in 1993. Thanks to the determination of all institutions involved in the legislation to accomplish the task before the end of the year - European Parliament, Council, Committee of Governors, Commission - it was possible to have the Regulations on central bank credits and on privileged access adopted by the Council on 13 December 1993 and published in the Official Journal on 31 December 1993 . Despite the belated entry into force of the new Treaty, the complete set of secondary legislation (in all, seven Council Acts) was in place when the second stage of EMU started on 1 January 1994.
In preparing secondary legislation based on Article 104, two types of
questions had to be addressed. First, a few questions relating to the general
nature of credits which would or would not fall under the prohibition had
to be clarified. Second, a number of specific practices had to be scrutinized
which in a strict sense imply central bank credit, but which one might
not want to prohibit because they relate to the fiscal agent function of
a central bank and because they are limited in size.
(a). General questions
- Existing stocks of debt
Overdraft facilities or any other type of credit facility with a national central bank (and later with the European Central Bank) in favour of the public sector are prohibited. This follows directly from Article 104. The question was whether this prohibition should be considered as including only new credits granted after 1 January 1994 or whether existing stocks of government debt held by central banks on 31 December 1994 should also fall under the ban. For two reasons, it was considered that existing stocks should be allowed to be carried over under certain conditions. First, the reimbursement or refinancing of existing stocks of debt within the short period of time between the entry into force of the Treaty and the start of Stage Two would in a number of cases have risked disrupting financial markets. Second, funds provided by central banks may have weakened fiscal discipline and may have caused problems for monetary policy when they were granted, but no longer exert such negative influences at present or in the future. What is important is that no further credits from central banks are available to governments. Therefore, the prohibition laid down in Article 104 should be interpreted as applying to new credits, but not to existing stocks of debt.
However, it was not thought admissible that existing stocks of government debt should remain as assets in the balance sheets of central banks indefinitely. Large amounts of such assets might hamper the flexibility of monetary policy; this should in particular be seen in the perspective of Stage Three when the balance sheets of all central banks will be consolidated for the purpose of the single monetary policy. Therefore, Council Regulation No. 3603/93 stipulates that only stocks of debt with a fixed maturity may be carried over. In compliance with this provision, Member States have, if necessary, converted existing debt into fixed maturity debt or are in the process of doing so. The maturity is not specified in the Regulation. Hence, Member States are free to choose according to their particular considerations. Some maturities chosen stretch well into the first quarter of the next century. Neither is the remuneration of the debt prescribed. It ranges from zero interest rate to close-to-market rates in the arrangements made so far between governments and their central banks.
- Purchases of debt instruments on the secondary market
Article 104 leaves central banks in principle free to purchase government debt instruments on the secondary market. The reasons are:
(i) in most countries the large and liquid market in government paper
is vital for the conduct of open market operations;
(ii) debt purchased on the secondary market has previously been submitted to the market pricing mechanism;
(iii) secondary market purchases entail no direct financial relationship between the public sector and central banks.
The recitals to the Council Regulation make clear that purchases made on the secondary market must not be used to circumvent the prohibition of Article 104.
- Cross-border purchases
Another question is whether Article 104 should be read as prohibiting direct purchases by the central bank of country A of debt instruments issued by the government of country A or whether the central bank of country A should also be prohibited from purchasing debt instruments of governments from other Member States. The solution found is that "cross-border" purchases by a Member State's national central bank of another Member State's marketable debt instruments are permitted in Stage Two, if conducted for the purpose of managing foreign exchange reserves. In Stage Three, similar provisions apply to transactions between the countries participating in the single monetary policy and those still outside.
- Definition of the public sector
It should be noted that the prohibition of Article 104, and the prohibition
of privileged access to financial institutions of Article 104 a (see below)
not only refer to the central government, but to a rather comprehensive
list of entities which together constitute the public sector. Two specifications
in secondary legislation were necessary. The first concerns "public undertakings",
for which the substance of the definition given in Commission Directive
80/723/EEC on the financial transparency of such undertakings was used.
Furthermore, it is made clear in the Council Regulation that central banks
do not belong to the public sector.
(b). Specific questions
Article 104 not only forbids 'large-scale', long-term financing of government deficits but excludes as well the bridging of liquidity shortages in the execution of the budget. A government can no longer draw upon the central bank but must have recourse to commercial banks or other financing sources for short-term funds. However, central banks may continue to act as fiscal agents for public sector entities to the extent that no granting of credits is involved in the related operations. There are various practices in Member States that are related to the fiscal agent function and which may give rise to central bank credit. While the ban on Article 104 must not be violated in the conduct of fiscal agent functions, it should on the other hand not hinder the efficient conduct of such functions by the central banks of Member States. Therefore, the Council Regulation under certain strict conditions provides limited exemptions for certain practices implying central bank financing.
- Intra-day credit
In many countries, central banks hold all the major accounts of the central government, and all the central government receipts and payments flow directly, or are channelled indirectly, through these accounts. Intra-day credit to the government arises when payments are executed by the central bank on behalf of the government on a real time basis and net debtor positions arise during the day. In a strict sense, such intra-day credit is a form of very short term central bank financing of the public sector.
In the development of modern payments systems there is a trend towards real time gross settlement systems. Article 104 should not hinder an efficient execution of payments transactions by central banks. Furthermore, due to its very short term and technical nature, there are no implications for the conduct of an independent monetary policy to be expected. Finally, the existence of intra-day credit does not diminish the working of the market mechanism on government borrowing. To avoid circumvention of Article 104, however, intra-day credit is explicitly defined so as to exclude an extension into overnight credit.
- Collection of cheques
The collection of cheques by central banks on behalf of their governments may imply (interest-free) short-term central bank financing ("float") if cheques written by the private sector in favour of the Treasury are credited by the central bank to the Treasury account immediately upon, or very soon after, receipt while the corresponding debits to the accounts of the banks of the issuers of the cheques are made a few days later.
In principle, a positive float from the collection of cheques is a kind of short-term credit and therefore inconsistent with Article 104. The direct effects of a positive float are relatively minor; the short-term liquidity management may, however, be affected. Therefore, in principle cheques should not be credited to the Treasury account before the drawee is debited; however, this is difficult to ensure in every individual case. For cost and efficiency reasons, under certain conditions a more pragmatic approach is acceptable. The solution chosen is to determine fixed lags between the reception of the cheque by the central bank and the crediting of the public sector account. These lags should correspond to the practices in each Member State and should be such that the operations on average ensure neutrality with respect to credit effects.
- Holding of coins
In most Member States, coins are issued by the Treasury and put into circulation by the central bank. In some cases, the government account is credited by the central bank before coins are put into circulation and is not debited when reflows to the central bank occur.
Such transactions in principle constitute a form of (non-interest bearing) credit. However, in some countries, it would be rather impractical, or even impossible, to apply this principle in a strict sense whereby a central bank would only be allowed to credit the account of the issuer of coins once the coins have been put into circulation and, conversely, would be obliged to debit on the government account immediately the counter-value of any reflows of coins. Instead, the national central banks should be allowed (albeit not be obliged) to hold coins issued by the Treasury up to a certain ceiling. For practical reasons, a ceiling equivalent to 10% of coins in circulation has been fixed. Given the particular situation in Germany after reunification, the ceiling has been fixed at 15% for this country.
- Credits in the fulfilment of international monetary obligations
The IMF being an intergovernmental organization, commitments under IMF for balance-of-payments support are to be fulfilled by the member governments with the central bank acting as fiscal agent. In most Member States currently such lending is ultimately financed by the central bank which includes this lending in its balance sheet. Likewise, the Medium-Term Financial Assistance for Member States' balance of payments provides for credits by recourse to Member States; in this event, it is current practice in a number of Member States that such loans are not financed out of the budget but through the central bank.
From a strictly formal point of view, these transactions constitute
central bank financing of the public sector; from an economic point of
view, however, such operations are not in contradiction with the aims of
Article 104. The national central banks should thus be allowed (albeit
not be obliged) to extend loans to the governments for these purposes.
2. Prohibition of privileged access of the public sector to financial institutions
Given the importance of institutional investors in the financing of the State, the ban on privileged access forms a key element in the submission of government borrowing to market discipline. In addition, the prohibition of privileged access can be seen as a complement to the prohibition of central bank financing. Governments should not be allowed to circumvent the locking of their access to the central bank by obliging other financial institutions to provide them with financial funds. Article 104 a reads as follows:
1. - Any measure, not based on prudential considerations, establishing privileged access by Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States to financial institutions shall be prohibited.
2 - The Council, acting in accordance with the procedure referred to in Article 189 c, shall, before 1 January 1994, specify definitions for the application of the prohibition referred to in paragraph 1.
Note that, in contrast to Article 104, secondary legislation for Article 104 a was necessary for its applicability.
Even more so than with respect to central bank financing, the prohibition of privileged access touches upon a great variety of national traditions, institutional particularities of certain Member States and country-specific practices in the financial field. The questions raised in the preparation of secondary legislation therefore proved to be complex. A balance had to be struck between the respect of the principle laid down in Article 104 a and the desire to preserve certain national practices, which in the strict sense constitute privileged access but whose principal objective is not the supply of cheap funds to the public sector and whose effects on the financial discipline of governments is negligible. Basically, three definitions had to be provided:
- privileged access,
- prudential considerations,
- financial institutions.
Besides, in common with Article 104, the definition of public undertakings
had to be specified and has been drafted in identical terms.
- Privileged access
The definition of privileged access of the public sector to financial institutions contained in Council Regulation No. 3604/93 in the first instance covers any obligation to acquire or hold liabilities of the public sector. However, it covers more than that. It also includes the granting of certain advantages in order to encourage financial institutions to acquire or hold public debt. This concerns tax advantages which may benefit only financial institutions or financial advantages which do not comply with the principles of a market economy. The prohibition is limited to obligations or encouragements which take the form of a binding legal instrument. Freely held public debt by financial institutions does not fall under the prohibition. Certain types of obligations imposed on financial institutions are exempted from the prohibition. First, this applies to obligations linked to the organization of financial markets like those imposed on primary dealers who help to issue government bonds. Furthermore, the obligatory funding of social housing at special conditions, the compulsory centralization of funds at public credit institutions and financial obligations linked to the repair of disaster damage fall outside the scope of the ban on privileged access under certain conditions.
These conditions include the requirement that the private sector has
access to the same advantageous borrowing conditions as the public sector.
With respect to the centralization obligation, it is necessary for compliance
with the rule that the arrangement existed on 1 January 1994. New arrangements
of this type cannot thus be introduced.
- Prudential considerations
According to Article 104 a, obligations to hold public liabilities arising from prudential considerations should not necessarily fall within the prohibition of privileged access. Indeed, prudential measures can lead to privileged access to the extent that they encourage the holding of public debt which, in normal circumstances, represent a low risk. Such encouragement is a by-product of prudential considerations and may be justified. However, rules for prudential supervision should not become a way to circumvent the prohibition of privileged access.
Secondary legislation provides a definition of prudential considerations
rather than listing the measures that are acceptable. The definition makes
reference to the soundness of financial institutions, the strength of the
financial system as a whole and the protection of the customers. National
prudential rules, for example in fields where Community legislation is
absent, can be considered a valid ground for an exemption; nevertheless,
consistency with European Union law must be assured. Rules must not, under
cover of prudential supervision, be used to establish disguised privileged
- Financial institutions
Article 104 a prohibits privileged access to financial institutions, which is more limited than privileged access to financial markets. This means, for example, that a measure like the compulsory subscription to government bonds by private households would not be covered by Article 104 a. However, the definition of financial institutions adopted in the Council Regulation is wide and includes banks, insurance companies, investment funds and pension funds. In order to account for financial innovation which may lead to the creation of as yet unknown financial institutions, the list includes a "catch-all" item so as to minimize the risk of circumvention of the prohibition. Central banks are excluded from the list of financial institutions because interaction with Article 104, regulating the relation between the central bank and the public sector, was to be avoided for the sake of clarity. Likewise, the institutions belonging to general government as defined by the European system of integrated accounts are excluded on the argument that it cannot be forbidden to general government to have privileged access to itself. The post offices are a special case. In principle, they are financial institutions, which means that the public sector cannot have privileged access to them. However, as a reflection of the ongoing reforms of post offices in many Member States, the Council Regulation is careful to distinguish different institutional situations. The post office financial services are not considered as financial institutions when they form part of the general government sector or when their main activity is to act as the financial agent of the government. This is in analogy with the fiscal agent function that the central bank still can perform for the government without violating the principles of no central bank financing under Article 104. The exclusion of bodies belonging to general government from financial institutions has to be seen against the background of the ongoing process towards greater autonomy of some entities and the wide variety of the organizational framework of the government sector in Member States.
With respect to the definition of the public sector, the treatment of
central banks raises a particular issue in the context of privileged access.
They are excluded from the public sector, in order to avoid minimum reserve
requirements being unintentionally forbidden. In fact, by imposing such
requirements on banks, central banks have "privileged access" to financial
institutions, which should not be banned. Central banks, even after being
removed from the public sector, are, however, in principle in a position
to provide privileged access of the public sector to banks by privileging
government debt instruments in the design of their monetary policy instruments.
For example, a central bank could limit credit operations based on collateral,
exclusively or in a discriminatory way, to government paper. Such practices
would be incompatible with the prohibition of privileged access, as indicated
in a recital to the Council Regulation.