By Arjuna Mahendran –

Arjuna Mahendran

On Thursday 26 February 2015, I had been at the central bank for a month and was still familiarising myself with the bank’s operations. That morning the former ministers of finance and highways and an advisor to the prime minister dropped by my office. They were accompanied by the finance secretary and senior management of the road development authority (RDA). I invited the 3 deputy governors of the central bank to attend the meeting. The meeting was to ascertain how much extra funding was needed by the RDA to revive highway construction that had stalled due to non-payment to contractors. Before the meeting, I requested that economic research staff of the central bank contact the RDA to verify the funding needs of the organisation.

At the meeting I recall that the Chairman RDA requested Rs 15 billion immediately and another Rs. 75 billion in a month’s time. The central bank research staff confirmed that these figures tallied with their estimate of arrears of payments by the RDA. Soon thereafter, I attended a larger conclave called by the minister of finance with over 50 groups of private road construction contractors who were awaiting the payment of their fees to resume the stalled construction of roads and highways. The minister persuaded most contractors to take a substantial haircut on their contract fees in exchange for receiving their delayed payments. It was evident to me that the contractors were in urgent need of the funding.

Prior to the meeting with the ministers at the central bank, the board of the central bank met for its regular fortnightly meeting. The finance secretary, who was an ex-officio member of the board explained how the finance ministry was in urgent need of additional funding as he was receiving several claims of unpaid bills from the previous financial year. A deputy governor told the meeting that an auction to raise funds through the issue of a 30-year bond had been planned early in the year. He also stated that the Employees Provident Fund (EPF) had Rs. 2 billion surplus cash available to invest in this bond. The board agreed to proceed.

Upon further inquiry I found that the finance ministry had already formally asked the central bank to borrow a total of Rs.172 billion in the month of March 2015. Of this large amount, Rs. 13.6 billion had to be raised by Monday 2 March 2015. This implied that the extra funds requested by the Chairman RDA had not been included in the finance ministry’s estimate. Moreover, there was a large repayment of Rs 128 billion worth of bonds which were maturing in mid-march 2015. I discussed this with the senior managers of the department issuing government debt and asked them how they proposed to raise these large sums which far exceeded the sums already borrowed in January and February 2015. They responded that they would hold an auction of 30-year bonds that week for a sum of Rs.1 billion and raise a much larger amount through accepting any extra auction bids in excess of Rs. 1 billion plus a sizeable private placement of bonds with bond dealers. When I suggested that it was absurd to advertise a Rs 1 billion auction when we were expected to borrow an average of over Rs 40 billion a week, they replied that advertising a larger amount would signal the market that the government was in desperate need of funding.

When I looked at the weekly ‘run-rate’ at which the central bank was borrowing money for the finance ministry through private placements over the preceding 6 months, it was evident that borrowing amounts over Rs 5 billion a week would be impossible using private placements as the main funding method. The deputy governor overseeing the debt department reviewed the proposed strategy of the department officials to borrow the large amounts of money required by the finance minister. He agreed that their strategy simply didn’t make sense. 

He had found that the operational manual of the department stipulated clearly that bonds should be raised as far as possible through the conduct of public auctions. This was the diametrical opposite of the staff’s preference to resort to private placements as far as possible. What he also found was that the method of issuing private placements placed enormous discretion in the hands of the front office staff in the debt department. There were no rules for the choice of dealers with whom bonds would be placed privately. Moreover, the staff could award higher rates of interest on bonds sold privately to dealers who offered to buy larger volumes of bonds. There was no limit placed on the extent to which these interest rate ‘incentives’ could vary. In short, private placements conferred enormous power to the debt staff and ample room for corrupt practices, considering the large volumes of money changing hands. When I visited the department I found that telephone calls were not recorded, there were no CCTV cameras and personal mobile phones were being freely used. Moreover, the dealing room of the department had no physical segregation from support staff as is usually prescribed to avoid the spread of inside information outside of the dealing room.

It has never been explained why the 30-year bond auction was advertised by the debt department as having an interest rate coupon paying 12.5 percent of the bond’s face value, while the staff were reported to be informally telling dealers to bid for the bonds at the auction at a putative interest yield of 9.75 percent. Most likely, this large gap between the advertised rate and the putative rate would give the staff wide discretion to issue bonds through private placements at rates anywhere within this gap. By the date of the auction, Friday 27^th February 2015, the staff had only been able to raise Rs. 3.4 billion through private placements. This was why I suggested to the staff of the debt department that they accept Rs. 10 billion at the auction so that we could at least meet the target of Rs. 13.6 billion required by the finance ministry on the following Monday. The Rs.10 billion worth of bids accepted were all made at or below the advertised 12.5 percent rate of interest. I politely told the staff that substantial private placements were not in keeping with best international practice in bond markets and the issue would be reviewed by the board.

The auction bid sheets shown to me by the staff showed that large bids for the bond had been made by the Bank of Ceylon. These bids had been made after 11 am when the bank of Ceylon had asked the debt dept. staff to extend the closing time to accommodate these late bids. I didn’t have any inkling that these bids were made on behalf of another dealer as was later revealed. When questioned by the Commission of inquiry (COI), two years later in 2017, the chief dealer of the bank of Ceylon made a curious revelation. He said he was approached on the day prior to the same 30-year bond auction, by an officer of the central bank (not attached to the debt department) to make a personal bid on this officer’s private account for the 30-year bond at 12.5 percent. This implied that the finance ministry’s need for additional funds was already circulating outside the confines of the debt dept.

The central bank board ratified my decision to suspend private placements temporarily until the practice was fully reviewed. The large borrowings in March 2015 were successfully achieved through several bond auctions where the size of issue advertised was increased to Rs 10 billion each. Thereafter at several board meetings the question of whether private placements should be reinstated was discussed. The conclusion of the board was that the manner in which the private placements were conducted in the past had deviated from international best practice and the department’s own operational manual. Therefore it was not desirable to rely excessively on private placements of bonds as a means of issuance. Auctions have become the norm for issuance of government bonds ever since.

If, as has been alleged, I wished to favour a particular dealer, I needn’t have moved away from the earlier system of private placements and the concomitant wide discretion it afforded central bank staff for cutting off-market deals with favoured dealers in complete secrecy. A dealer could have offered a large volume of funds and privately negotiated a placement of bonds at a very high rate of interest with the central bank without having to bid in a public auction. Rather, my intention was to fix a broken bond market which was not generating the desired volumes of money required by the government.

To be continued………….