By W A Wijewardena –
Offering Rs. 1 billion and ending up taking Rs. 10 billion
Immediately after the Treasury bond auction on 27 February 2015, the news of a massive impropriety that had taken place in the auction spread across the market like a wildfire. The news said that the Central Bank had offered to borrow Rs. 1 billion through a 30-year Treasury bond, but ended up in borrowing 10 times of that, amounting to Rs. 10 billion.
This was unusual compared to the previous practice of the bank that not more than two to three times of the amount on offer was taken. Then, it further said that a half of the amount borrowed, namely, Rs. 5 billion, had been taken from a primary dealer connected to the newly appointed Governor of the Central Bank at a spuriously average bargain price of Rs. 91 per 100 rupee bond when the going market price of a 30-year bond was around Rs. 120.
Bond interest rates are different from their fixed interest rates
This particular bond had carried a fixed interest rate of 12.5% which the Government had promised to pay the bondholder annually on the face value of Rs. 100. However, bonds are traded in the market and depending on the market price, the actual interest yield, known as the bond interest rate, would differ from the fixed interest rate.
Since this bond had a market price of Rs. 120 per 100 rupee bond, the applicable bond interest rate was about 9.2% per annum. In other words, if an investor buys this bond for Rs. 120, he would get in interest income of Rs. 12.50 and when it is expressed as a percent of the purchase price, it amounts to a yield rate of 10.4%.
When the income tax of 10% paid in advance is deducted, the after-tax bond yield is about 9.2% which is the rate which the bidders of the bond have to quote in the bid document. The Central Bank had advised all the primary dealers informally that they should not upset the prevailing interest rate structure in the economy. Hence, they were supposed to bid at an after-tax interest rate of around 9.5% or at a price of Rs. 116 per 100 rupee bond.
Online bond auction system
These bond auctions are held electronically by using a dedicated telecommunication line between the Central Bank’s computer system and those of the primary dealers. The auction starts at 8.30 in the morning of the auction day and automatically closes at 11 a.m. Once a primary dealer has submitted a bid to the system, he is bound by the rules to honour it even if he may have made a mistake either in the price or the amount. Hence, primary dealers are extra careful when bidding not to bid at rates or for amounts which they cannot accommodate. Any extension of the auction time is done only if there are interruptions to the telecommunication lines but even then, they have to be certified by Sri Lanka Telecom, the service provider.
Central Bank could have generated a premium income for Government
The bid sheet of the bond auction on 27 February 2015 shows that almost all primary dealers had submitted their bids as per Central Bank’s informal instructions. The prices quoted by them had ranged between Rs. 104 and Rs. 119 per 100 rupee bond generating a premium income for the Government. In fact, if the bank had accepted only Rs. 1.3 billion, it could have issued the bonds at prices ranging between Rs. 104 and Rs. 119 generating a premium income of Rs. 94 million for the Government. Since the weighted average bond interest rate applicable to that issue is around 10.5%, it would also not have disturbed the prevailing interest rate structure unduly. If the bank had accepted only Rs. 1.3 billion from the auction, any additional fund needs could have been raised by using its practice, known as direct placements, of offering the balance requirement to primary dealers at the weighted average rate of 10.5%.
Since it was the prevailing market rate for this particular bond, no primary dealer would have been able to make any undue profit by selling them immediately to other investors. However, this could not be done due to three arbitrary decisions taken by the Governor on that particular day without the sanction of the Monetary Board, the legal body which owns the Central Bank with powers to make such decisions.
Increasing interest rates effectively before the bond auction
The first was the increase in the interest rates effectively contrary to the decision which the Monetary Board had taken four days ago not to change the interest rate structure until it will review the conditions of money supply, credit levels and inflationary pressures late in March 2015.
As revealed at the Second COPE inquiry into the bond scandal, Governor Arjuna Mahendran had walked into the regular morning meeting of the Market Operation Committee at about 8:30 a.m. on the day of the bond auction and made a surprise announcement that he wanted to increase interest rates and for that purpose, he wanted to abolish the lower interest rate payable to commercial banks which had been using the Central Bank’s standing deposit facility for parking their excess money for more than three occasions a month.
The normal standing deposit facility rate of the bank was 6.5%, but to force banks to lend money to customers instead of safely parking with the Central Bank, those who had used the facility for more than three occasions were paid a lower rate of 5%. Since almost all banks had made use of this facility, the average market interest rate was around this lower end at 5%.
When the decision was taken to remove it, the average market interest rates would invariably jump to its higher bound, namely, 6.5%. Market watchers believe that this decision, arbitrarily taken by Governor Mahendran against the determined policy stance of the Monetary Board, would have justified the interest rate increase that was to take place later in the day.
Throwing away a valuable weapon to control the market misbehaviour
The second and third decisions were also taken arbitrarily by Governor Mahendran yet in another bizarre behaviour he had demonstrated on that day. That was to storm into the Public Debt Department when the auction was taking place at around 10.45 a.m., a move which no Governor had done previously.
The evidence before COPE has revealed that he had met both the Superintendent and the Additional Superintendent of Public Debt and announced that from that auction onward, all moneys needed by the Government would be raised only through auctions and the direct placement system which the bank had been adopting since 1997 would be abolished. In effect, these two decisions effectively took away from the Public Debt Department a powerful weapon it had possessed in order to prevent collusive activities by primary dealers to increase interest rates and thereby corner the market.
The decision taken by the Treasury Bond Tender Board that day and all issues of Treasury bonds thereafter were a testimony to the occurrence of such collusive activities. This decision not only ruined the otherwise smoothly functioning market, but also led crafty primary dealers to make full use of it to profit at the expense of the other investors, mainly, the state managed funds. However, two and a half years after the direct placement system was abolished, the Central Bank reintroduced it in July 2017 when it was found that without that weapon, it could not control the market (available here).
Flooding the Public Debt with bids
Within minutes of Governor Mahendran’s leaving the Public Debt Department, bids began to pour in from the primary dealer, Perpetual Treasuries, in excessive amounts and at spuriously low prices. Just before the close of the tender at 11 a.m., four bids were submitted by Perpetual Treasuries in its own name for Rs. 2 billion at prices ranging from Rs. 92 to Rs. 98; three bids were submitted by another primary dealer, Bank of Ceylon, for Rs. 13 billion on behalf of Perpetual Treasuries at prices ranging from Rs. 87 to Rs. 90.
This was an unusual bidding pattern since the Central Bank had offered to the market only Rs. 1 billion and the Bank of Ceylon had previously bid for other customers at prices ranging from Rs. 109 to Rs. 119. The excessive biddings and all bids coming after Governor Mahendran’s announcement that direct placements had been abolished and all the fund requirements of the Government would be met out of the auction in question raised the suspicion that the primary dealer Perpetual Treasuries had access to exclusive information which was not available to other primary dealers.
A Governor taking decisions for a Tender Board
Then, repeating his bizarre behaviour of the day, Governor Mahendran visited the Public Debt Department in the company of two other Deputy Governors at about 12.30 pm. The evidence placed before the COPE has revealed that he had access to the bid sheet, perused it and then directed the Superintendent of Public Debt to accept all the bids. Had she acceded to it, out of the bonds of Rs. 20 billion to be issued, Rs. 15 billion would have been for the Perpetual Treasuries. However, after the Superintendent and the Additional Superintendent had protested, Governor Mahendran had once again perused the bid document and instructed that up to Rs. 10 billion should be accepted. In that list, a half of the bids accepted had been from Perpetual Treasuries.
Displaying the lack of professional due diligence
In this case, on a number of counts, the Governor and the senior officers of the bank had not demonstrated that they had acted with due professional diligence. First, the Government, it appeared, needed money to pay outstanding bills and that was a liquidity requirement. For that purpose, a prudent central bank would not have raised a 30-year bond and committed the Government to pay interest at 12.5% for all these years. Short-term funding requirements should be met out of short term borrowings.
Second, the Central Bank is the agent of the Government and before committing the Government to a high borrowing liability, as the bank had done in the past, it would have got the concurrence of the General Treasury. Instead, it was an arbitrary decision taken, keeping the Treasury completely out of the picture. Third, the Governor deciding on the price as well as the amount of the auction vitiates the role of the Tender Board which had been appointed by the Monetary Board to decide on the tenders.
Fourth, direct placements had been abolished by an arbitrary decision of the Governor without assessing its merits and subsequent consequences. Fifth, the Monetary Board, the authority on these issues, had just become an active defender of the whole impropriety thereby allowing the reputation and the credibility of the bank to be eroded beyond repair.
Losing confidence of investors
But, this single episode caused to erode the Central Bank’s reputation and credibility both within Sri Lanka and outside. The Government led by Prime Minister Ranil Wickremesinghe, instead of taking prompt action to control the damage, fought tooth and nail, to defend the Central Bank’s action. Many foreign investors in the Government securities market became agitated and shocked. The impression that a few selected individuals, with the connivance of the top leadership in the bank, could defraud all other investors with total impunity caused them to withdraw from the market. Thus, within 10 months, the foreign investments in Government securities which stood at $ 4.5 billion as at the beginning of 2015 fell to $ 2 billion. But the Government, more specifically the Ministry of Finance, and the Monetary Board did not seem to have taken notice of the haemorrhage of the country’s foreign reserves putting pressure for the exchange rate to depreciate and forcing the Government to seek a bailout package from IMF.
A bond explosion far worse than a bomb explosion
This writer in March 2015 drew the attention of the Government to the emerging catastrophe by noting that the bond explosion in 2015 caused a far worse damage to the bank compared to the bomb explosion that took place in 1996 (available here). There was very good reason for this writer to say so. In the bomb explosion, the bank managed to restore normalcy within a few months. Also, the Central Bank employees demonstrated the highest degree of integrity when they were under attack by terrorists. This writer recalls that the officers attached to the Currency Department, amidst the fear of being buried alive by a collapsing building, put all the currency which they had taken out for the day’s business back to trunks and safely deposited it in the vaults before leaving the building that was in flames. However, the dishonesty displayed by some officers of the bank during the first bond explosion and the subsequent ones that followed within the last two-year period would make these honest officers hide their heads in shame.
Governor alone is responsible under the law
It is usual for Governors to blame their officers for the follies that they commit as was done by the Bank of Thailand Governor Rerngchai Marakanond when he was taken to courts for losing the nation’s foreign reserves in a futile attempt at fixing the Baht-Dollar exchange rate in 1997. The Governor Rerngchai took the position that it was his officials who had advised him to sell dollars in the market. But the courts did not accept his plea and found him guilty of negligence. John Exter, the architect of the Central Bank of Sri Lanka, knew of this possibility. Hence, he introduced in section 22 of the Monetary Law Act that the Governor is responsible for all action done by the officers of the bank, whether they are good or bad, as the CEO of the bank. Hence, in the Exter Report, he qualified that the person to be appointed as Governor should be a person of ‘unquestioned integrity’.
Continuing to play hide and seek will be to the Government’s own peril
The Yahapalana Government played hide and seek throughout the last two-year period with respect to a number of bond explosions that had taken place in the country. When the pressure was mounting from the civil society, it just came out from the hiding place and pretended to seek the culprits. But after the pressure had subsided, it began to hide and play with the culprits.
With the new evidence which is now in public domain, the Government can no longer play this game. If it does so, it will do so to its own peril. And if it continues to hide and seek, it will be the biggest disappointment for a large number of people who had voted this Government to power in 2015.
*W.A. Wijewardena, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at firstname.lastname@example.org