On 13 May, a three-member bench of the Supreme Court (SC), including the Chief Justice, rejected the fundamental rights petition regarding the recent controversial Treasury bond issue of 27 February. But what did the ruling actually mean in practical terms?
Merely that the case will not be allowed to proceed to a full hearing because, strictly speaking – procedures of the Central Bank (CB) had not been transgressed and no law had been violated by any of the respondents. The judges seem to have taken a strictly legalistic view and decided to reject the petition ruling out any further consideration.
The ruling does not mean that the actions taken by the respondents in this instance
1.were fair and above board or
2.that the Treasury did not incur unnecessarily higher interest costs.
What it means is simply that, in the opinion of the judges, there was no legal basis for the granting of leave to proceed to a hearing.
However, an official statement had been issued on 19 April, about the (then unreleased) report of the three-man committee appointed by the Prime Minister to report on this matter. It contained a strong recommendation to investigate the actions of Perpetual Treasuries (PT), one of the main respondents in the petition to the SC. The potential conflict of interest due to PT being owned by the family of the CB Governor’s son-in-law was thus highlighted and was public knowledge.
It was also public knowledge that, although the CB announced that only 30-year bonds worth Rs. 1 billion would be issued at yields in the region of 9.25-9.75% per annum, eventually Rs. 10 billion were issued at yields up to 12.5% per annum. It’s plain that this resulted in a much higher cost for the Treasury, especially since it is a bond that runs for 30 years, irrespective of how that cost is calculated. The fact that PT was awarded Rs. 5 billion of the bonds (50%) at yields in the range 11.5% – 12.5% per annum raises further questions.
The petitioners’ main requests were that the Supreme Court –
1.Declare that the Governor, Senior Deputy Governor and Superintendent of Public Debt have not discharged their duties in a manner that is necessary for the preservation of public trust
2.Direct the Monetary Board to carry out an independent inquiry by a competent panel of professionals well versed in the rules, systems, procedures and processes applicable to the public debt management under the supervision of Court and to report thereon and
3.Direct the Monetary Board and Respondents from the Central Bank, in consultation with stakeholders, to formulate new systems, processes, rules and regulatory frameworks which assure transparency and best good governance practices are in place in respect of future public debt issuance
Most people would feel that these are very reasonable requests in the circumstances.
Judging by newspaper reports, the defence counsel had painted Treasury Bonds as very complex financial instruments and also confused the deliberations by raising even totally irrelevant issues. For example, that the weighted average yield of the issued bonds was lower than the coupon rate of the bonds, and that the bonds’ weighted average yield is low compared to similar bonds of the past (which were issued in different market conditions).
Let us strip away this grossly exaggerated complexity with a simplified example. Suppose identical government-owned flats are being auctioned instead of Bonds. The government department concerned announces that it intends to sell just one flat and provides a minimum reserve price. After bids are closed the government goes ahead and sells nine more flats at much LOWER prices. One bidder, who is closely connected to the department head, is awarded five flats at very low prices and makes a killing.
Would any reasonable person not think there is something odd requiring an independent investigation? Has the government not lost money on the deal? Does it matter what the flats were worth in the past or could be in the future?
The defence counsel also appear to have moved the focus to the letter of the law and away from the spirit. Procedures and laws have to sometimes make allowance for flexibility and trust the judgement of those implementing them. There is an implicit assumption that decision-makers will act with integrity and common sense, if not wisdom.
The CB’s processes allow for increasing the amount of bonds to be issued when required but there is an underlying assumption that it will not be done at yields wildly divergent from the prevailing levels of interest rates. The Public Debt Department has “raising adequate resources to meet the cash flow needs of the government AT THE MINIMUM COST” as its primary goal
The laws empowering the Treasury to issue bonds and the CB, as agents, to sell them to the market are based on similar expectations of prudence. It is debatable whether, in this instance, such expectations have been met. At a minimum, the request for a deeper, independent investigation seems quite reasonable.
The three-man committee report
The report of the three-man committee was finally tabled in Parliament on 19 May – one month after it was submitted to the Prime Minister and, coincidentally, six days after the SC’s determination. Although it uses diplomatic language it reveals many facts and provides background information to justify its recommendations for deeper investigation of the CB, PT and Bank of Ceylon.
The Committee has thanked a respected, retired Deputy Governor, W.A. Wijewardena, for assistance with ‘technical aspects’, but they have clearly not fully utilised his services to comprehend the mechanisms used by the CB to manage market interest rates when issuing government securities. Wijewardena was reported to have subsequently disassociated himself from the findings of the Committee.
Much is made about the use of ‘private placements’ as opposed to ‘auctions’, with the former made out to be a surreptitious, sinister process. In reality, private placements have been used by the CB for many years due to the country’s specific economic circumstances.
The fundamental driver for the use of private placements is the persistence of national budget deficits. They compel the Treasury to borrow large and growing sums of money, mainly via the issue of short-term Treasury Bills (up to 12 months) and Treasury Bonds. The CB has to ensure that interest rates stay reasonably low (to reduce interest cost to the government) but higher than the inflation rate in order to control inflation and encourage savings. These two factors pull in opposite directions and the CB has to play a delicate balancing role.
The demand for funds by the government has consistently been greater than the surplus funds available from the private sector (including banks) and, therefore, so-called ‘captive sources’, institutions controlled by the government including the EPF and ETF, are pressured into picking up the slack. Most of the ‘private’ placements are taken up by these institutions and not by ‘cronies’. Furthermore, the private placements are executed via the accredited primary dealers so it’s not clear why the report states that they are “erratic and has no rationale”.
There are arguments for and against the CB interfering with free market forces but with a chronic mismatch between demand and supply in a relatively illiquid market, a sensible compromise is perhaps required. A hands-off approach would lead to erratic, unstable financial markets unless political leaders can be persuaded to act rationally in economic matters, and that would take us into the realm of psychology rather than economics.
According to the report, the Governor “believes that the market should determine the interest rates and was not agreeable with the artificial depression of interest rates from September 2014 up until the elections. So his instructions to the staff of CBSL have been to ensure that they move towards a market based system to raise funds and the price determined to pay for that funding is market driven”. This is not borne out in practice though, and for the reasons mentioned above.
Another crucial aspect that the report glosses over is the cost of borrowing. In the past, whenever a private (or direct) placement was done, the interest rate paid was fixed close to the corresponding auction rate and the prevailing market rate. Thus the increase in the amount of securities issued did not unduly distort the market interest rate structure (i.e. the yield curve).
However, in the case of the bonds issued on 27 February, the yields accommodated spanned from 9.35% pa to 12.5% pa (over 300 basis points), which is quite surreal, especially for a long tenor such as 30 years. Shortly thereafter, market interest rates settled at lower levels highlighting the absurdities inherent in this particular auction.
The report contains a cryptic passage: Answering the reason to go for a 30-year bond, he (the Governor) said the monetary board and the PDD decided to start with the longest tenure bond and work backwards. He explained that if you start at a shorter end, the interest rate will shoot up due to the duration of the curve and market will start building up the interest rates”. One wonders whether the 30-year rate zooming off is preferable to a short-term rate ‘shooting up’.
According to the report, three senior CB officials have said that there is no ‘loss’ to the government “given the fact that market conditions vary with regard to the Treasury Bonds depending on various factors and the volume of funds raised”. Their logic is hard to fathom.
The report is quite critical of PT and calls for a full-scale investigation. In passing, it also reveals two interesting points.
The first is that PT actually placed bids for Rs. 13 billion via Bank of Ceylon, in addition to the Rs. 2 billion in its own name, all at rates of 11.5% pa or higher i.e. 75% of all the bids received were from PT. What could have persuaded PT to be so gung-ho about 30-year bonds that normally are of no interest to anyone except insurance companies and pension/provident funds? The CEO of PT is reported to have stated that “the said information was available in the public domain and does not amount to insider information”. The mind boggles since no one else in the ‘public domain’ had an inkling about the upcoming massive increase in the issue size or the interest yield.
For the benefit of the uninitiated, the price change of a bond for a given change in interest rate increases with the tenor of the bond, since the interest benefit persists for longer e.g. the price change for say a 1% pa change in interest rates on a 30-year bond is approximately twice that of a six-year bond. And it so happens that the longest Treasury bond on issue is 30 years.
The second point arises from a quote attributed to the Chief Dealer of the Bank of Ceylon. He had said “Perpetual Treasuries made a call with regard to placing the said bids and mentioned that the funding for such bid is by an Insurance Company”, but the CEO of PT had subsequently denied this. Given the size of the bid which is well beyond the credit capacity of PT, it would be well worth checking if such an insurance company was a pre-arranged party to the transaction and whether it purchased the bonds from PT at a higher price.
In the aftermath of the issue of this bond, there were some market rumours that such a deal took place soon after the bonds were issued and, when the controversy erupted, the transaction was reversed and buried.
The report is light in criticism of the Governor but does not exonerate him completely. It observes that “it is not unfair for the public to expect a high level of integrity in the conduct of the officials of the CBSL that includes the Deputy Governors and the Governor. Therefore, the monitoring of the digital footprints of the officials of the CBSL will espouse the cause in maintaining public trust”.
The key point in the statement issued on 19 April by the Ministry of Policy Planning and Economic Affairs, was that “the committee found that Governor Arjuna Mahendran had no direct role in deciding to accept bids over and above the one billion rupees stipulated in the 30-year bond tender and accept up to 10 billion rupees”.
The basis given for this assertion is that the responsibility for acceptance of bids “is vested with the PDD as per the Operational Manual of the PDD. The decision to accept the excess amount has been taken by the Tender Board Committee that comprises eight members. The governor of Central Bank of Sri Lanka is not a member of the Tender Board Committee. The Committee concluded that there was no evidence to the effect that the governor had direct participation with regard to the activities of the PDD and the Tender Board Committee.”
However, the Prime Minister making a statement in Parliament on 17 March was reported to have said, “When the Governor of the Central Bank was informed that over Rs. 20 billion bids had been received, he instructed the Public Debt Tender Board to select bids up to Rs. 10 billion. He did so in the presence of two Deputy Governors. The claim that the Governor interfered with the work of the Tender Board is not true. Thereafter the Tender Board submitted their recommendations, which were approved by the Governor without any changes”.
The actual report too suggests that the Governor gave the final instruction to the Public Debt Department (PDD) to accept Rs. 10 billion worth of bonds after seeing all the bids totalling Rs. 20 billion. The words used are unusually ambiguous – “the Governor had requested to seek the possibility to accept the Government funding requirement from the market”. The PDD thereafter approved the issuing of Rs. 10 billion.
In the face of all this, it is difficult to understand how the Governor’s role can be interpreted as not being “direct”.
In terms of Article 148 of the Constitution, it is the Parliament alone that ultimately has “full control over public finance” and hence issuance of Treasury securities. That is where the next act in this drama will be staged, when the debate opens in a few days.
In addition, a special Committee of 13 Parliamentarians has also been appointed by COPE to look into the matter. And now, the previous Governor Nivard Cabraal has waded into the debate with a detailed statement defending his record and a challenge to the Prime Minister to participate in a public debate.
Interesting times are ahead.
By a Special Correspondent – a version of this article appeared in The Financial Times