By Hema Senanayake –

Hema Senanayake

Does the government incur any loss? This question has become the ultimate question that needs to be resolved in regard to the alleged bond issue scandal that involved with the Governor of the Central Bank of Sri Lanka (CBSL) and his son-in-law. This can be technically resolved. The purpose of this article is to do that.

Over this question, now the government is divided into two groups. One group says that nothing wrong has happened. The other group says that something has happened but the government is not incurring any loss on interest payments. What is common for both groups is that they are united in arguing the government is not making any loss because the government needed money urgently to meet payment obligations inherited from the previous regime and hence had to increase the borrowing limit from rupees 1 billion to 10 billion and it is quite usual that interest rate goes up due to the increased demand for money by the government.

If the Governor of CBSL upholds the above view he immediately should resign from his position because he has never understood how a central bank functions. If the Minister of Finance Ravi Karunanayake upholds the said view he must be forgiven because he is an accountant by profession, but he needs to enlighten himself on the subject if he wishes to be a good Minister of Finance. I guess both hold the above view.

Let us get back to our analysis. Any loss could be possibly have incurred not by increasing the issue of bonds from 1 billion rupees to 10 billion rupees but by having to pay higher rate of interest exceeding what is known as CBSL’s indicative price or rate. When the bond issue was declared the CBSL indicated that the targeted borrowing rate (indicative rate) was between 9 to 9.5%. Hence, if CBSL accepted any bids over 9.5% interest, the government has to pay higher interest than what it expected to pay. This point is very clear. Now on February 27, 2015 the CBSL accepted bids up to 12.5% and it was an increase of at least 2% of interest rate. This increment of the rate of interest can be justified if CBSL had no other alternative to raise money badly needed for the government by that time. The government says that was the case and hence the government is not incurring any loss – And this perception is grossly inaccurate and misleading. Why?

When the national government needed to borrow money, it can be done so within the stipulated limits approved by the parliament. There are various methods of borrowing. One method of borrowing for government is to issue bonds. It is the Treasury that sells government bonds not CBSL. The Treasury can issue (sell) bonds either to market or direct to CBSL. However, the issue of bonds is partly an action of executing monetary policy of the country. Executing monetary policy falls under the purview of CBSL. Therefore, it is the CBSL that ultimately determine whether any particular bonds are purchased by the CBSL or are offered to the private buyers through auctions or through private placements. Sometimes CBSL purchases certain amount of bonds initially and offer the same or part of it to the market subsequently in order to execute the monetary policy. What does this mean? Let us investigate further.

It means that if the CBSL could not have sold bonds to private buyers at indicative rate which was 9 to 9.5% the CBSL could have purchased the Treasury bonds and as a result the government would have got whatever the money it needed without allowing the interest rates to go up. Is this possible? Yes, indeed and let me give you an example here from the U.S.

Subsequent to the Great Financial Crash of the United Sates which took place in 2008, the Federal Reserve (U.S. version of central bank) decided to buy bonds worth of 85 billion dollars each month. This effectively means that in every two months the Federal Reserve was buying bonds nearly worth of 1% of GDP. Out of this $45 billion was used to buy U.S. Treasury bonds each month. This program was known as quantitative easing. This simply means that Federal Reserve was just writing checks to U.S. Treasury. This is an increase of money supply. Of course many economists feared that quantitative easing would create an unprecedented level of inflation. But it did not happened so far. Why?

One reason is that when a central bank writes a check to buy bonds it is totally different than writing a check by a commercial bank to buy bonds. In both cases money supply in the economy is increased. (Please note that money supply is not increased if bonds are issued to non-commercial banking sector). But when the bonds are paid back the money supply is reduced in the case of paying back to Federal Reserve and this is not happened in the case of paying back to commercial banks. In order to understand this peculiar phenomenon you got to understand the true version of Fractional Reserve Banking. Ceylon Today published an article on this subject on May 16, 2015 with the caption “Basics of Money Creation.”

In the case of this particular bond issue, at least one commercial bank, namely Bank of Ceylon (BOC), wrote a check amounting to 3 billion rupees (please consider crediting an account is like writing a check to that account holder). Mostly, it is a case of increasing money supply. The check went to the company of the son-in-law of the Governor of CBSL. If the BOC could write a check, then why the CBSL could not have written a check direct to the Treasury. In fact Sri Lanka’s central bank does it time to time in order to execute the monetary policy. Therefore, CBSL could have done the same in this particular instance too, after accepting private bids which were within the indicative rate of interest. CBSL could have issued the bonds to market later what it bought when the rates were conducive. This is the most important point.

The next point is that there was no reason for the CBSL to take a decision to allow the increase of the rate of interest. Just four days prior to this bond auction the Monetary Board met. At meetings of Monetary Board, the Board reviews the monetary policy including the rates of interest. I suggest you to read carefully the Board’s decision made at that meeting. It is as follows:

“… the Monetary Board at its meeting held on 23 February 2015, decided to maintain policy interest rates of the Central Bank unchanged at their current levels. Accordingly, the Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) of the Central Bank would remain at 6.50 per cent and 8.00 per cent, respectively.”

The Monetary Board did not see any reason for the market rates to go up because private sector credit growth was well within the expected limits and the inflation was running low. The CBSL’s the said indicative rate of interest for the bond auction was well within the Monetary Board’s expectation. Once the CBSL accepted bids with higher rates, subsequent market rates and subsequent bond rates also went up. As a result of this particular bond issue, the 30-year bond interest rate was being artificially increased. As a result the government makes losses on interest payments. The government continues to make additional losses in terms of the payment of higher rates every time Treasury Bills and Bonds are issued from 27 February 2015 onwards until the anomaly is resolved. These are the assumptions made in calculating the loss for the government and those assumptions are accurate. The government cannot deny it. The truth can be painful. But it is important to accept the true facts.

“Never hide things from hardcore thinkers. They get more aggravated, more provoked by confusion than the most painful truths.” ― Criss Jami