By R.M.B Senanayake –
The Central Bank Governor has admitted that there was a failure by him to communicate with the market. Financial markets operate on information which is why the leakage of inside information and trading on insider information are considered criminal offences in financial markets. Raj Rajaratnam was caught and jailed in USA for this offence as did several others before. But such offences have gone unpunished in the local stock market despite the efforts of Mr. Tilak Karunaratne the former Chairman of the SEC. Rogue traders got rid of him and carried on with impunity. Why Inside information disclosure and trading on such information is treated as crimes is because the gains of one person is a loss to others. Financial market profits are a zero sum game as economists point out.
The Primary Dealers were created by a former Governor ( A.S. Jayawardene I think) because the banks which took up all the Treasury bond and bill issues did not show any enthusiasm to market them to the public. This has implications for monetary policy since holdings by banks is money printing while holdings by the public come from genuine savings of the people. The market was a creation of the Central Bank and the Bank nourished and supported it. The Central Bank was not concerned only with the rate of interest but also to gather the maximum amount possible for the government. If it was only interested in a competitive price it should limit the issue to about Rs 500 million which is the capacity of the market. Some one might say that the primary dealers have made bids for much more. But many of those bids at high interest rates are spurious and they submit them without expecting them to be expected.
The Tender is not a public auction with open outcry as used to prevail in the stock market prior to electronic trading. Nor is it a private placement. The quantity on offer is always beyond the capacity of any individual primary dealer. Only the banks would have the capacity to bid for high quantities but the primary dealers have to be sustained if the objective of monetary policy to tap the savings of the public through the creation of a secondary market in the bonds is to be achieved. It is therefore not a public auction where the Central Bank is interested in obtaining the most price and not the volume. It wants both the maximum volume at the best prices. So the Central Bank has been guiding the market to bid at levels which the Bank thought were acceptable. So the Public Debt Department contacts the primary dealers and guides them about the acceptable range of interest rates. The bank gives guidance on the range of interest rates acceptable to it. Somebody has misunderstood the working of the process and thought the Central Bank is only interested in getting the most competitive price.
What then was the information available to the Primary dealers who tendered for the 30 year Bond issue? The Monetary Board of the Central Bank met on the 24th February and issued a monetary policy statement saying there will be no change in monetary policy and hence interest rates will be unchanged. The 30 year bond issue was shortly thereafter. Incidentally this Bond issue gave short notice. Generally the Public Debt Department of the Central bank indicates to the Primary Dealers what they have in mind for the interest rates to be quoted for the Bonds. On this occasion too the primary dealers say the Public Debt Department of the Central Bank contacted them over the phone canvassing bids for the above auction around the previous market rate of around 9.35% and 9.75% range.
The Committee should examine the bids made by the several primary dealers. Perpetual Treasuries seems to have put several bids of : Rs 500 million; 1 billion and also Rs 3 billion through the Bank of Ceylon on their behalf. Their bids have ranged from 11.25 to 12.50%. They have put high bids despite the counsel by the Public Debt Department indicating that their interest ranged from 9.35% to 9.75%. The Central Bank for some inexplicable reason and despite the earlier counsel of the Public Debt Department, accepted bids for Rs 10 billion and went up to 12.5%. All of the bids of Perpetual Treasuries seems to have been accepted. According to some Primary Dealers, the Central Bank could have taken up to Rs 4 billion at the previous rates without pushing up the interest rates to 12.5%. Why did the Bank not do so?
Immediately after this Bond issue the Central Bank which had earlier announced no change in monetary policy stance has changed its mind. There was a penal rate under the Standing Facility with the Central bank where banks depositing money would be paid a lower rate of 5% or so whereas the usual rate was 6.5% for deposit only for 3 days for the month. The Central Bank did away with this penal rate reflecting a change in interest rate outlook. Secondary market Treasury bond rates were then trading at low yields due to above market sentiments and the monetary policy directions. 30 year bonds also traded around 9.35% and 9.75% range and the Central Bank private placements were also done at these rates.
But shortly thereafter the Central Bank allowed the Treasury Bill rate at the primary auctions also to rise by about 1% or so. So did the Monetary Board mislead the market about no change in the monetary policy stance?
The Bond issue was for Rs 1 billion and a similar bond had been issued not very much earlier for a rate of about 9.5%. Why did the Public Debt Department decide on Rs 1 billion instead of Rs 10 billion for the issue? Because they are well aware of the capacity of the market. The number of primary dealers is few and each has a paid up capital of Rs 300 million. It is only those primary dealers who are themselves banks or connected to banks who can raise sufficient funds to buy a large quantity of the bond issue. Otherwise each primary dealer will quote for about 10% of the issue. Often they put bids at high rates of interest which they don’t expect to win. They need to show the funds by settlement date and the Central bank has on line access to their bank accounts.
How much in the aggregate did Perpetual Treasuries quote for on this occasion and was it higher than their usual average in the past? The Committee should scrutinize them. The Bank of Ceylon has also quoted for Rs 3 billion of the bonds on behalf of Perpetual Treasuries. This too needs to be probed.
The bids are normally based on market practice and the constraints on the Central Bank. The Treasury needs endless money all the time and the Public Debt Department knows it too well. But Treasury Bonds are not the only form of borrowings. There are the Treasury Bills of short term duration for which the Bank holds an auction every Wednesday. The Bank also has the authority to make provisional advances to the Treasury. The DST account in the Bank of Ceylon can also overdraw. So the need for extra money is no excuse for increasing the size of the bond issue. In fact after this issue too there have been bond issues where the Central Bank has paid much less than the 12.5% paid on this issue to Perpetual Treasuries and has borrowed much more than the Rs 10 billion. I think the Bank has borrowed about Rs 75 billion in 3 auctions by 15/3/15.by way of 7 year, 10 year and 20 year bonds at much lower rates of interest. The Committee should review them.
The Public Debt Department is conscious of the need to keep down the interest rates at which it raises money for the Treasury. Incidentally central banks in some developed countries have entrusted the public debt management function to an independent agency outside the Central Bank for there is a possible conflict of interest in the Central Bank carrying out this function along with its main function to determine monetary policy .In fact in developed countries even the management of the National Provident Fund is not vested in the Central Bank.
Be that as it may the primary market dealers know that the Central Bank would prefer to carry on with a low interest rate policy to promote private sector investment which is required to sustain economic growth and this was the declared monetary policy up to the issue of the 30 year bond. The Primary Dealers also know that the Central Bank will not want to raise interest rates steeply over a very short time. Any increase in interest rates they expect to be gradual and in short spurts.
The Primary Market Dealers are the creatures of the Central Bank. This market did not develop spontaneously. A previous Governor promoted the primary dealers as an adjunct of the Central Bank to assist it to place Treasury securities with the public. So the Central Bank was not expected to harm the market in a way to cause financial losses to the primary market dealers. But the primary dealers say they sustained losses owing to the new procedure.
There is an inverse relationship between the interest rates on the bonds (the yields) and the bond prices. When interest rates on new issues go up the prices of bonds in the market fall. But the primary market dealers hold bonds in their portfolios bought earlier at prices which reflected the interest rates which prevailed then. They offer them to the public. Since the interest rates were then lower their bond prices would have been higher. Now when the Central Bank raises’ the interest rates on the new issue of bonds the prices of existing bonds in the portfolios of the primary dealers fall from their previous levels and they sustain unrealized losses. The Committee must find out how much were those losses. Such losses may not matter to those who are permanent holders of the long term bonds for they will hold them to maturity to enjoy the interest. They generally do not trade in them although they could do so if they wished. But primary dealers and brokers suffer losses because the secondary market bond prices fall from their earlier levels. They have to sell some of these bonds in order to invest in the new bond issue. If their bids are accepted they would need to sell them to raise the funds to accept their bids. They would then lose money. These primary dealers are up in arms owing to this predicament they were placed in by the Central Bank.
Enter Perpetual Investments another primary dealer. The primary dealers make their bids knowing the thinking of the Central Bank which will not want to increase interest rates too steeply. So it is this same piece of information which will guide them in making their bids for the new issue. But they have made high bids ranging from 11.25% to 12.50%. Did they expect them to be accepted? The Committee should look at their bids and those of others who have access to the same information and decide what made Perpetual Treasuries to quote much higher? They too would have to sell their holdings of bonds in whole or part to raise the funds to accept their bids if they were selected. One writer says “There are rumors in the market that also, during the last week several 5-10 year bonds at prevailing rates were sold by CB Governor’s son in law Arjuna’s company and reinvested in the 30 year bond, because he had inside information from the Central Bank that the rates would go up to 12.5%.”
The Committee should find out the sales made by Perpetual Treasuries after the bond issue was announced by the Central Bank. The grapevine says they sold their portfolio of low interest bonds in the market and even sold short in the forward market. The latter would definitely raise suspicion. The Committee must scrutinize their transactions from their bond portfolios and also check if the Bank of Ceylon came to an arrangement with them to tender for part of the issue? Did Perpetual make profits or suffer losses? According to the other primary dealers the profit Perpetual Treasuries could have made from a single transaction could be more than Rs. 200 million and his gain is a loss to the Government and the other Primary Dealers. They would definitely have made large profits which the Committee must find out. In financial markets one man’s gain is another man’s loss although it is not apparent to the ordinary public. Economists call it a zero sum game. It is the same with the stock market which is why insider trading is a crime for it amounts to cheating others.
The Primary Market Dealers are appointed by the Central Bank and are licensed and supervised by the Central Bank. It is the duty of the authorities to ascertain if there was insider trading. The market which consists of the primary dealers is fragile and needs to be sustained and developed by the Central Bank. That was the role of previous Governors like A.S Jayawardene.The Central Bank should have considered the size of the market and the financial capacity of the non-bank primary dealers in deciding on the size of the issue and the amount to be awarded. If it took a larger amount without raising the interest rates there would have been no objection. But how can it justify raising interest rates so steeply from the existing rate on long term bonds and causing losses to the primary dealers except Perpetual.
Economists agree that a Central Bank cannot control long term interest rates but only the short term rates. The Bank has given a wrong signal to the market and it will lead to over-all increases in the lending rates in the banks and other financial institutions. The Central Bank by its unorthodox action has disturbed the entire structure of interest rates which will be detrimental to economic growth by the private sector investments. The government too would have a greater interest burden which is quite unwarranted. The conduct of the Central Bank is a flagrant departure from monetary policy orthodoxy.
Central Bank could have collected 30 year funds at a much lower rate if the auction was conducted properly and also avoided the increase in the treasury bill rates at the next auction to such a magnitude. Therefore this has resulted in Government paying more for long term as well as short term funds.